In May 2006, Mexico placed a new financial instrument that provides the country with compensation in the case of an earthquake in three at-risk areas of the country’s Pacific coast and around Mexico City. This is the first “catastrophe bond” placed by a Latin American country and is expected to be the first step in the Mexican government’s plan to secure insurance against natural disasters, including hurricanes.
The operation comprises two instruments: a straight “parametric” insurance, under which Mexico will receive payments if an earthquake of a certain magnitude hits the prescribed regions over the next three years, and two catastrophe bonds whose principal will be written off if such a disaster occurs. The total face value of the two bonds is $160 million which, when added to the monetary compensation provided by the insurance contracts, totals $450 million in compensation ($150 million contingent on occurrence of an earthquake in each region). The cost to Mexico also has two parts: an annual spread of 230 basis points on the catastrophe bonds, and the direct insurance premium of about $14 million.

An operation of this type illustrates the economic advantages of using market insurance to obtain protection from potential shocks—in this case, natural disasters. Market insurance is more cost effective than the alternative of “self-insurance.” It is also an instrument less subject to manipulation or distortions by the political system. The importance of these issues should not be underestimated. Even this fairly modest initiative is reported to have taken almost three years to structure, largely because of the intricacy of the budgetary approval process. It is noteworthy that obtaining the insurance as part of a bond offering may be simpler because the public debt management offices generally have broad authority to issue debt instruments, and interest payments do not require specific budgetary allowances.