The growing cat bond market could help plug the natural disasters insurance gap, but its wider sustainability credentials are still being debated
Last year only 38 per cent of global economic losses caused by natural disasters were insured, according to estimates from global reinsurer, Swiss Re – just $108bn out of total losses of $280bn.
As climate change increases the frequency and severity of extreme weather events, these economic losses will continue to grow, it says.
In the EU just one quarter of “climate-related catastrophe losses” are currently covered by insurance, say financial supervisors the European Insurance and Occupational Pensions Authority and the European Central Bank.
The growing catastrophe bond market could help to plug this insurance gap.
Cat bonds are securities typically used by insurers and reinsurers to transfer risks on their balance sheets – associated with high-risk policies, such as those covering wind damage – to investors.
A cat bond will pay out to an issuer if a pre-determined catastrophic event in a specified geography takes place, for instance if a hurricane in a given country causes damage above an agreed financial value, or if wind speeds in a certain location pass an agreed threshold.
By enabling this risk transfer to happen, cat bonds can mean insurers and reinsurers are more likely to provide coverage to consumers and businesses that need it, including for emerging climate-related risks. For this reason the ECB and EIOPA have encouraged insurers to consider issuing more cat bonds.
Cat bond investors receive higher coupons than with most other fixed-income securities, but they can also lose more money if the underlying catastrophic event does occur.
These bonds have historically focused on earthquakes and hurricanes, with some other risks included in “multi-risk” cat bonds, which can, for instance, also include volcanic eruptions.
Emerging categories of cat bond
But newer risks such as wildfires, floods and droughts are increasingly being explored, potentially boosting insurance coverage for catastrophic events that have previously been largely uninsurable.
In California, for example, multiple cat bonds associated with wildfires have been issued since 2018. Some stand-alone flood cat bonds have also been issued in the US.
Last month, the World Bank said it intends to issue its first drought-related cat bond within the next 12-18 months.
The cat bond market kept growing in the first half of 2024, with nine new sponsors issuing cat bonds, including the government of Puerto Rico, according to newly released data by Swiss Re. In comparison, 2023 saw 13 new sponsors entering the market over the whole year.
The first half of 2024 was also the most active on record, with 49 transactions amounting to $12.3bn of primary issuances.
Sustainable investment?
Although the capital these bonds generate is directly linked to natural disasters, and therefore they have a clear environmental and social dimension, there is debate about whether or not they should be classed as “sustainable” investments.
According to a discussion paper published last year by the ECB and EIOPA, some environmental, social and governance-focused investors are already “turning to cat bonds as an instrument for impact investment”. It adds that “collateralised assets from several cat bonds have been invested in green initiatives”.
Florian Steiger, a cat bond specialist manager and founder of Icosa Investments, a Swiss-based company that launched a new cat bond fund in January 2024, says these bonds should be classified as sustainable investments because they provide people with capital to rebuild their lives after a catastrophe has occurred.
The company’s website also specifies that cat bonds have the potential to contribute to several sustainable development goals.
Others take a different view. Mara Dobrescu, director of fixed income strategies at investment research company Morningstar, says cat bonds do not “fix” anything and only distribute funds once damage has occurred. Therefore, there is no direct element of prevention and they are not really contributing to longer-term sustainable development.
Catastrophe risk pricing
Catastrophe bond investors are also not “making money on catastrophes”, Steiger is keen to stress, as in the event of a natural disaster, “cat bond investors would be losing money . . . as that capital is then paid out to the people affected by such an event”.
Morningstar’s Dobrescu argues investors need to be remunerated for the risk taken. Several disasters happening at the same time, liquidity issues on behalf of the cat bond issuers themselves and complex modelling are some of the unique risks present in the market, she notes.
The pricing of a cat bond depends on the underlying risk factors, such as the likelihood of a catastrophe occurring, its severity, and which pay out triggers have been chosen.
An independent third party will usually develop a simulation of events based on historical data and the latest available science to create a risk model, which will then inform the price of the bond. Such modelling will be influenced by the extreme weather events being exacerbated by climate change.
Mariagiovanna Guatteri, chief executive of Swiss Re’s insurance-linked investment advisors corporation, an investment company focused on cat bonds, says “every time there is an event, we learn more about potential losses”.