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November 20, 2023

Catastrophe bond market grows as extreme weather events increase

Wildfires in Canada July 2023
Wildfires in Canada this year. Catastrophe bonds have largely been used to cover natural catastrophes (Photo: Noah Berger/AP Photo)

As storms, floods and fires linked to climate change become more frequent, catastrophe bonds are increasingly being used as an alternative to insurance, with potential advantages for investors and infrastructure

As climate change causes more frequent and more extreme weather events, catastrophe bonds offer an alternative means of financing repair efforts following events such as hurricanes, floods and earthquakes.

Cat bonds can be used for various types of major risks, but have largely been used to cover natural catastrophes. The cat bond market emerged following hurricanes Andrew and Hugo and California’s Northridge earthquake in the early 1990s, says a report from analytics company Morningstar.

“One role [of cat bonds] is to provide additional capacity for the reinsurance market typically … the other function is that they have to produce an attractive rate of return [for investors] and generally over the last 15 years they have,” Claude Brown, partner at law firm Reed Smith, tells Sustainable Views.

As climate change has greater impacts, cat bonds will increasingly be used to finance redevelopment efforts, says Brown, describing them as offering a “smoothing effect” for the insurance and reinsurance industries. Cat bonds are typically issued with multi-year maturities, while the reinsurance industry typically operates with yearly renewable plans.

“We’ve seen increased activity with more cat bonds being launched in recent years,” Morningstar director of fixed income strategies Mara Dobrescu tells Sustainable Views. As of June 2023, Morningstar’s global database included 46 funds focused on cat bonds and/or private insurance-linked securities, totalling $16.5bn globally.

Cat bonds, however, remain in the hands of what Dobrescu terms “sophisticated investors”, who “really understand the product”.

Mediterranean cat bonds?

The June, July and August period of 2023 was the hottest on record, with temperatures reaching 0.66C above average, and a number of other major weather events took place this year, including wildfires in Canada and Hawaii and severe flooding in China.

“Supply in the cat bond market should increase [in line with climate change], simply because the amount of capital at risk is increasing. It remains to be seen whether it’s going to be met with investor interest,” says Dobrescu.

Europe’s Mediterranean Sea reached the highest temperature in four decades in August 2023 as the entire region faced extremely high temperatures. Brown thinks a cat bond market could emerge in the Mediterranean. “Temperatures in the Mediterranean have been getting hotter and hotter,” he says. “You probably need two or three years of exceptional wildfires and temperatures before a market will develop there.”

The most developed cat bond market currently covers hurricanes and storms in Florida, says Brown. Other major markets include those covering earthquakes and hurricanes in the Caribbean and seismic activity in New Zealand, the Philippines and Japan.

Weather prediction technologies

There are, however, still lots of unknowns around cat bonds. “There’s quite a lot of liquidity risk embedded [with cat bonds] — the bonds are still very niche, [and] difficult to value,” Dobrescu says. “Also, you’re exposed to underlying model risk, which means that these bonds have been modelled under an assumption that natural disasters occur at a certain frequency and this is based on long-term data.”

Digital technologies and artificial intelligence have improved the ability to predict weather patterns, but Brown says: “The challenge at the moment is that we are getting extreme weather events in places that people didn’t think that there would be extreme weather events … the impacted areas are broadening and the market hasn’t fully caught up with that yet and I think the severity of losses is increasing.”

Yields compensate for losses

In November, the International Association of Insurance Supervisors published a report outlining the need to address growing insurance protection gaps resulting from more frequent and extreme natural catastrophes. The report suggests greater collaboration between public and private sector stakeholders, including the inclusion of cat bonds. 

Shigeru Ariizumi, IAIS protection gaps task force chair, said in a statement that “managing the financial impact of natural disasters, thus enhancing societal resilience” should become a priority for the insurance and reinsurance industries.

Despite potential uncertainties, interest in the cat bond market remains strong, largely due to high return rates. “The investor is currently getting a coupon that is close to 9 per cent … and that’s for a probability of annual loss that has oscillated between 1 and 3.5 per cent,” Dobrescu with Morningstar says.

“At this point in time you could say that the yield on these bonds more than compensates for the risk of losses,” she adds.

A service from the Financial Times