CAT bonds are on the rise
While natural disasters grow more frequent, Wall Street finds new ways to provide capital
Welcome to the Green Peach, your weekly insight into Green Finance and the latest investments in Climate Tech.
This has nothing to do with kittens, sorry cat people. CAT bonds is short for catastrophe bonds, a financial instrument that was conceived in the 1990s and has seen a tremendous rise in popularity since then.
When Hurricane Andrew struck Florida in 1992, it caused $27 billion in damages, of which $15.5 billion was covered by insurance. It led to the failure of eight insurance companies.
To protect themselves against bankruptcy in these scenarios, insurance companies share the risk with reinsurers, which basically issue insurance to insurance companies. Like a nesting doll. This spreads the risk, but it doesn’t solve the problem, as an increasing occurrence of natural disasters puts both insurance companies and reinsurers at risk, in some cases forcing them out of riskier markets such as California and Florida.
So what insurance companies need is protection against exposure to natural disasters that could force them into bankruptcy by calling for enormous payouts.
And that’s where the magic of capital markets happens.
What are catastrophe bonds?
Let’s start with the basic definition of a bond.
Bonds are investment securities where an investor lends a set amount of money (the principal) to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor’s money. (Forbes)
Catastrophe bonds have the same basic mechanism, but there’s a big catch.
Investors give insurance companies a set amount of money and can expect to receive regular interest payments until maturity, which is when they should get their principal back. However, the insurance company is not allowed to touch the money, it just keeps it there. If a predefined and very precisely outlined catastrophic event occurs, such as a hurricane causing damage for $600 million or an earthquake reaching a magnitude of 7.0, the insurance company will take all the principal, and the investor will lose every single cent.
So what’s in it for the investor?
Investors earn fat returns on their money (higher than regular bond rates), and if no disasters occur (or if the agreed-upon threshold isn’t reached) they get their principal back. Everybody’s safe, everybody’s happy. If the catastrophe occurs, then investors are hit with a huge loss. But hey, you gotta take the risk if you wanna make the money.
And what’s in it for the insurance company?
In case there is a catastrophe and huge costs in damages are incurred, the insurance company will have all the money it needs to pay out damages and will not risk bankruptcy. In exchange for access to this pool of money, they will have to pay interest on it even if they don’t use it, which is going to be their “loss”. Safety has a price.
How does climate change relate to all of this?
As natural disasters grow more frequent due to a warming climate, insurance companies find themselves having to pay damages more often and at an ever-increasing scale, thus the need for more funds. At the same time, because the risk of losing the CAT bond principal is higher, interest rates on these securities grow higher, and investors are attracted by higher returns. So demand grows on both sides. Risk builds up for investors, yes, but they are happy to take that risk for a rate of return as high as 20% (2023).
CAT bonds are still a very risky asset class for investors, and they are often part of diversified and sophisticated investment strategies which include modeling natural calamities.
This is just one example of how finance and markets interact with climate not just by funding new technologies and the transition to clean energy, but by tackling the consequences of the changing climate we are already witnessing.
In case you want to know more, check out the Federal Reserve Bank of Chicago.
Photo by Dylan Calluy on Unsplash
Disclaimer: the information contained in this newsletter is not intended as, and shall not be understood or construed as, financial advice. I am not an attorney, accountant, or financial advisor, nor am I holding myself out to be.