As climate change leads to more and worse storms, the growing catastrophe bond market provides some reassurance.
When a natural disaster strikes a city, the government has to jump into action. There might be fires to put out, people to pull out of rubble, and water to pump out of tunnels, not to mention relocation and rebuilding efforts that come after the fact. That all takes money, and if the damage isn’t insured, the city will have to pay for it somehow.
It turns out the damage very rarely is properly insured. Between 1980 and 2004, only 1 percent of natural disaster losses in developing countries were insured, as were only 30 percent in developed nations, according to the World Bank. These damages make for huge unanticipated drains on local budgets, all the more pressing when economic activity has slowed down due to the disaster itself.
How to deal with this situation is one of the pressing questions facing cities as they prepare for a changing climate. Indeed, private finance took center stage last week at the COP21 climate talks in Paris, with presentations on decarbonizing investments and the growth of the green bond market to finance environmentally beneficial infrastructure. But there’s another tool that more and more governments are adopting to smooth out their post-disaster financial woes: the catastrophe bond.
“Cat bonds” work a lot like insurance, but with a twist. First the sponsor—it could be a city government, transit agency, or even an insurance company—decides what sort of disaster they want to protect against: hurricane, tornado, earthquake, etc. They also pick a specific, measurable trigger associated with that event, like a Richter scale magnitude, the value of damage inflicted, or a mortality rate. They then can sell the bond to general institutional investors with large pools of money and very sophisticated modeling abilities. If a natural disaster triggers the bond conditions, the sponsor gets the money from the account to use for response and recovery; if nothing triggers it before the time limit of the bond runs out, the investors get their money back.
A cynic might look at cat bonds and see masters of capital taking bets on other people’s misfortune. That is technically the case. But the process also allows for cities (and insurance companies) to move some of their risk into capital markets, where it turns out people with lots of money are happy to pick up the tab.
There’s an added benefit for the sponsor in knowing the insurance money will come through, says Michael Bennett, who works with cat bonds as the World Bank’s head of derivatives and structured finance. With traditional insurance, you pay in every month and there’s always the chance that your auto insurance company goes bankrupt right before you file the claim for your totaled Maserati. With cat bonds, the payout is sitting in a collateral account, waiting for the trigger.
As a way to hedge against future disasters, cat bonds look like a natural choice for cities that expect to be hammered by the effects of climate change in the decades to come. But so far, Bennett says, cat bonds tend to be clustered in developed countries. There are a bunch of them for hurricanes in the Southeast U.S., wind storms in Western Europe, and earthquakes in Japan, but not so many in the developing world, where exposure to climate effects is greatest.
In part that’s due to the volume of information required to bring a bond to market. ”You need both historical data, which a lot of countries haven’t collected in a very systematic way, and you also need data you can use for the trigger, which would be a data source trusted by the investors,” Bennett says.
The groups investing in cat bonds want a diversified portfolio, like any other form of investment. Since the existing cat bond market is pretty homogeneous, Bennett notes, there’s a market incentive for new and unusual types of catastrophe bonds. This could make it easier for less developed countries to attract investors for cat bonds tied to disasters that are becoming more frequent and severe due to climate change.
To that end, the World Bank has been busy setting up catastrophe bonds to insure small Pacific island countries against cyclones, earthquakes, and tsunamis. It mediated a more involved arrangement for Uruguay, which produces around 80 percent of its electricity from hydropower. If climate change leads to a major drought, Uruguay will have to import fuel for power, so the state-run utility set up a $450 million cat bond triggered by the combination of drought and high oil prices.
The reinsurance giant Swiss Re (they insure insurers) also worked on that deal. Reinsurers are interested in cat bonds as a hedge against natural disasters wiping out large swaths of capital in the insurance industry, as happened with Hurricane Andrew in 1992. Nikhil da Victoria Lobo, who works with governments to set up cat bonds as the head of Swiss Re’s global partnerships section for the Americas, says that in addition to the money, government leaders benefit from the analysis investors perform to decide how to buy and sell cat bonds, which is often more sophisticated than what officials or agencies can produce.
“I don’t claim that the market has a perfect perception on what is the true risk on any issue—the financial crisis has shown us that,” he tells CityLab. “But the market does bring an independent and additional rigor to analyzing risk. In some ways, what investors are doing when they buy a cat bond is voting with their feet on what they think is a climate risk of a location.”
There has been a steady growth in the cat bond market since it began in the 1990s, but it’s still relatively small: $7.2 billion in new issues this year, with $25.5 billion in outstanding bonds, according to analysis service Artemis. That’s a fraction of the volume of green bonds, which had more than $38 billion in new issuances so far this year. Cat bonds are more complicated to set up than a traditional bond, but that’s a project more cities should be looking at, whether or not we get an effective carbon reduction treaty out of Paris.