Is the CAT in or out?

Catastrophe bonds have been touted in recent years as a way for reinsurers to mitigate extreme weather risks that may be linked to climate change.[1] Cat bonds are bonds whose coupon and principal payments depend on the non-occurrence of a predefined catastrophic event, the performance of an insurance portfolio, or the value of an index of natural catastrophe risks.

We identified approximately USD5.2bn of bonds outstanding that are linked solely to extreme weather events such as hurricanes, typhoons, flooding, windstorms as well as wildfires.[2] In a world of extreme weather events brought about by climate change, these bonds would allow insurance companies the opportunity to transfer risks to capital markets, thereby enabling them to provide greater coverage and protection against high impact events. From the investor’s perspective, Cat bonds offer favourable terms compared with corporate bonds of similar credit quality as well as an avenue to improve overall portfolio risk profiles.

But there are two key issues holding up the inclusion of CAT bonds in a climate-themed bond universe.  Firstly, it is possible that Cat bonds, by the nature of the insurance they represent, could result in less climate resilience on the ground. If insurance coverage against extreme weather is more widely available through a liquid Cat bond market, it may dis-incentivise the required changes in planning, building and infrastructure required to adapt to climate impacts.

Secondly, Cat bond models would need to reflect the risk of extreme weather brought about by climate change and adjust price accordingly. Without accurate climate change forecasts factored in, climate-aware investors may actively avoid purchasing Cat bonds given that they do not pay out if extreme events occur. By factoring in heightened frequency and extremity of events in risk models, Cat bonds would be compatible with climate-aware investors. However, such data and track record is as yet unavailable to insurance companies and although the science linking temperature increases with extreme weather impacts is clear, these impacts are not expected to occur until the latter half of the century.[3] Hurricane Sandy was a bellweather event in catastrophe risk modelling as it showed how a relatively weak storm, combined with high flood levels, and population densities could result in a catastrophic event.

Climate change impacts are just one factor in these models and the link to more frequent and extreme events remains difficult to input as yet. Furthermore, it is unclear if Cat bond investors, by hedging against the probability of extreme weather events, are supporting climate resilience or not. A standardised way of climate-proofing insurance coverage as well as increased transparency that catastrophe bonds do not incentivise construction in areas at risk to extreme weather will be required before they may be viewed as contributing to climate resilience.