Explainer: How catastrophe bonds help manage the risk of climate change

(Credit: Unsplash)

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Patrick Henry, Senior Writer, Formative Content

  • Extreme weather events around the world are on the rise as a consequence of climate change.
  • The market in catastrophe bonds could grow to $50 billion by the end of 2025.
  • Insurers use the securities to shield themselves against losses from consequences of climate change such as natural disasters.

Wildfires, hail storms and a deep winter freeze helped push insured losses from natural disasters to $40 billion in the first half of 2021, the highest level in a decade. With extreme weather events like these on the rise as a consequence of climate change, insurance companies are looking for new ways to protect themselves from the growing financial risk.

How do catastrophe bonds work?

Basically, cat bonds, as they’re often called, allow insurance companies to transfer the risk of natural disasters covered by their policies to investors – for a price.

They were first issued in the 1990s at a time when the insurance industry was reeling from a series of costly catastrophes including Hurricane Andrew, which had devastated Florida and the Gulf coast and driven some insurers out of business.

Since then, the cat bond market has grown steadily. To give a recent example, American insurer USAA raised $300 million in November 2021 to cover risks including US tropical cyclones, earthquakes and severe thunderstorms, according to market analysts Artemis.

a chart showing the catastrophe bond market issued vs.  outstanding notional, 10.5 year  compound annual growth rate (CAGR)
The catastrophe-bond market is growing at a compound annual rate of nearly 10%. Image: Swiss Re

The money raised with these bonds is set aside to cover potential losses. If triggers spelled out in the contract – insured losses from a hurricane reaching a specific level, for example – are met, the insurer gets to use the money to offset what it has paid out to policyholders. In that case, it no longer has to repay the holders of the bond, who can lose their investment.

If the natural disasters covered by the bond don’t occur, the investors get their money back in full when the bond matures, usually in three to five years. And along the way, they collect regular interest payments.

What’s the appeal of catastrophe bonds?

The main tool insurance companies use to offload risk is called reinsurance, whereby they buy policies from other insurers that limit their losses in case of a disaster. This prevents any one company from taking on too much risk.

But reinsurers, just like any insurance company, don’t always pay out on every claim. And the policies they sell typically last just one year. Catastrophe bonds, by contrast, are set up to remove ambiguities by setting out clear triggers for payment and allowing insurers to lock in the price of protection for a longer period of time.

a chart showin that catastrophe-bond issuance surged to a record $8.5 billion in the first half of 2021.
Catastrophe-bond issuance surged to a record $8.5 billion in the first half of 2021. Image: Swiss Re

The main attraction for investors is that these bonds pay higher interest rates than most other varieties, so they can potentially make more money. The other big benefit is that, because catastrophe bonds are tied to specific natural events, they provide returns that are largely unaffected by economic cycles and the ebb and flow of financial markets. That can make them a useful buffer when other investments sour.

What’s the World Economic Forum doing about climate change?

Climate change poses an urgent threat demanding decisive action. Communities around the world are already experiencing increased climate impacts, from droughts to floods to rising seas. The World Economic Forum’s Global Risks Report continues to rank these environmental threats at the top of the list.

To limit global temperature rise to well below 2°C and as close as possible to 1.5°C above pre-industrial levels, it is essential that businesses, policy-makers, and civil society advance comprehensive near- and long-term climate actions in line with the goals of the Paris Agreement on climate change.Global warming can be beaten thanks to this simple plan

The World Economic Forum’s Climate Initiative supports the scaling and acceleration of global climate action through public and private-sector collaboration. The Initiative works across several workstreams to develop and implement inclusive and ambitious solutions.

This includes the Alliance of CEO Climate Leaders, a global network of business leaders from various industries developing cost-effective solutions to transitioning to a low-carbon, climate-resilient economy. CEOs use their position and influence with policy-makers and corporate partners to accelerate the transition and realize the economic benefits of delivering a safer climate.

Contact us to get involved.Mission Possible Platform: Delivering industry pathways t…

Jamaican storms, California wildfires and catastrophe bonds

Insurers aren’t the only ones turning to catastrophe bonds. The World Bank priced a bond in July 2021 that gives the government of Jamaica protection of as much as $185 million against losses from named storms during three Atlantic tropical cyclone seasons ending in December 2023.

The Los Angeles Department of Water and Power in October 2021 raised $30 million to shield it from California wildfire losses.

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