A new paper authored by Sayuri Shirai, ADBI Fellow at the Asian Development Bank Institute (ADBI), explores how banks can utilise catastrophe bonds and puts forward an interesting suggestion, that as sponsors or co-sponsors, banks could bundle the climate exposure from their other assets into cat bonds to hedge against growing climate risks.
The report highlights that climate change has become a direct and material risk to financial stability.
“For banks, physical hazards, ranging from acute events such as floods, storms, wildfires, and heatwaves to chronic stressors such as sea-level rise and long-term temperature increases, can impair asset quality, erode collateral values, and disrupt client operations,” the paper reads.
However, Shirai outlines that for banks, participating in insurance-linked securities (ILS) and catastrophe bonds is not only an effective way for them to manage their own climate-related exposures, but it also serves as a key opportunity to innovate and strengthen their role in sustainable finance, and also contribute to systemic resilience.
“Unlike contingent credit lines offered by multilateral development banks, which provide governments with post-disaster liquidity, banks’ involvement in ILS and CAT Bonds is about sharing risk with investors, whether by purchasing these instruments, sponsoring them, or embedding them into lending products.
“In this context, banks can play multiple roles as distributors, financiers, data providers, and risk-sharing partners. They can bundle parametric coverage into agricultural, SME, or mortgage loans to enhance household and enterprise resilience; collaborate with insurers to develop region-specific indices; and use transaction data with remote sensing to reduce basis risk,” the paper reads.
An interesting take that’s shared in the paper, is where Shirai suggests that as sponsors or co-sponsors, banks can securitize climate risk by pooling loans or other assets with high physical exposure into a special purpose vehicle (SPV), which then issues a catastrophe bond to investors.
“If a disaster triggers the bond, investor funds are released to the bank, helping it absorb losses and maintain lending. In this way, banks effectively securitize climate risks, shifting part of their exposure to global investors,” Shirai said.
This suggestion would be particularly interesting because it would let banks transfer and hedge the climate-related risks embedded in their loan portfolios by packaging them into catastrophe bonds, therefore creating a new market mechanism to price and distribute climate risk.
Additionally, Shirai notes that as product developers, banks can also embed parametric triggers directly into lending products.
An example shared in the paper explains that a farm equipment loan may automatically extend repayment terms if rainfall falls below a defined threshold, or a business loan in a cyclone-prone region might lower interest rates temporarily if wind speeds exceed a set level.
“Scaling up such instruments requires public–private partnerships. Governments can subsidize insurance premiums, while banks handle distribution and customer service. Development banks may act as anchor investors in CAT Bond issuances. Commercial banks can bundle climate-responsive lending products with insurance for microfinance institutions and smallholder farmers. Reinsurers and modeling firms can contribute hazard indices to improve trigger accuracy and reduce basis risk.”
The paper continues: “As climate-related physical risks become increasingly systemic, embedding risk transfer tools into banking frameworks is no longer optional: it is a financial necessity. Banks that innovate and adopt such tools early will be better prepared to withstand climate shocks, safeguard financial stability, and channel investment into long-term resilience.”
Finance Watch, a European non-profit focused on financial regulation, recently issued a call for the creation of a climate systemic risk buffer for the banking industry.
Perhaps such a buffer could, rather than being a more traditional financial one, also incorporate risk transfer and hedging mechanisms, such as insurance or catastrophe bonds. In that way, banks can take greater ownership of the climate risks their asset and loan portfolios hold and how they manage it, while transferring some of that risk to external capital sources that have a long-term appetite to hold them.
In the past, we have seen some examples of large financial institutions utilising catastrophe bonds as a way to hedge out some of the catastrophe exposure held in their asset portfolios.
Probably the best example of this was seen with the two Wrigley Re catastrophe bonds from Blackstone, as these transactions saw the investment giant using the cat bond structure to source catastrophe risk transfer protection for its expansion real estate investment portfolio.
These Wrigley Re cat bonds secure Blackstone a source of contingent catastrophe risk financing should a major earthquake or hurricane strike an area where its real estate related investment exposures are high.
Another great example of a financial institution taking a proactive step to reduce its exposure to catastrophe risks using an ILS structure and third-party reinsurance capital is the case of the two Sierra Ltd catastrophe bonds.
These two cat bonds provide parametric insurance protection from the capital markets to Bayview Asset Managements Cayman Islands based Bayview MSR Opportunity Master Fund, LP, a mortgage focused investment strategy.
Showing Bayview using the ILS market to carve out some of the earthquake exposure held within a portfolio of mortgage loans, so this is very similar to what US banks could be doing with their loan portfolios, to reduce their exposure to climate related risks.
