Explainer: How catastrophe bonds help manage the risk of climate change

Wildfires, hail storms and a deep winter freeze helped push insured losses from natural disasters to $40 billion in the first half of 2021, the highest level in a decade. With extreme weather events like these on the rise as a consequence of climate change, insurance companies are looking for new ways to protect themselves from the growing financial risk.

Basically, cat bonds, as they’re often called, allow insurance companies to transfer the risk of natural disasters covered by their policies to investors - for a price.

They were first issued in the 1990s at a time when the insurance industry was reeling from a series of costly catastrophes including Hurricane Andrew, which had devastated Florida and the Gulf coast and driven some insurers out of business.

Since then, the cat bond market has grown steadily. To give a recent example, American insurer USAA raised $300 million in November 2021 to cover risks including US tropical cyclones, earthquakes and severe thunderstorms, according to market analysts Artemis.

The money raised with these bonds is set aside to cover potential losses. If triggers spelled out in the contract - insured losses from a hurricane reaching a specific level, for example - are met, the insurer gets to use the money to offset what it has paid out to policyholders. In that case, it no longer has to repay the holders of the bond, who can lose their investment.

If the natural disasters covered by the bond don’t occur, the investors get their money back in full when the bond matures, usually in three to five years. And along the way, they collect regular interest payments.

The main tool insurance companies use to offload risk is called reinsurance, whereby they buy policies from other insurers that limit their losses in case of a disaster. This prevents any one company from taking on too much risk.

But reinsurers, just like any insurance company, don’t always pay out on every claim. And the policies they sell typically last just one year. Catastrophe bonds, by contrast, are set up to remove ambiguities by setting out clear triggers for payment and allowing insurers to lock in the price of protection for a longer period of time.

The main attraction for investors is that these bonds pay higher interest rates than most other varieties, so they can potentially make more money. The other big benefit is that, because catastrophe bonds are tied to specific natural events, they provide returns that are largely unaffected by economic cycles and the ebb and flow of financial markets. That can make them a useful buffer when other investments sour.

Insurers aren’t the only ones turning to catastrophe bonds. The World Bank priced a bond in July 2021 that gives the government of Jamaica protection of as much as $185 million against losses from named storms during three Atlantic tropical cyclone seasons ending in December 2023.

The Los Angeles Department of Water and Power in October 2021 raised $30 million to shield it from California wildfire losses.