Insurance companies increasingly use catastrophe bonds to get financial protection for payouts on damages caused by weather disasters writes Dr Emmanuel Kypraios, School of Business and ICARUS
While we are increasingly accustomed to hearing about storms approaching the Irish coast and dealing with the orange, yellow and occasionally red warnings associated with them, have you ever wondered who bears the financial cost of flooded or damaged properties, villages and communities when storms lead to catastrophes? After all, the figures are considerable, with Storm Ophelia, the worst storm to hit Ireland in 50 years, causing €70m worth of damage in 2017.
Now, one might say "we have insurance to cover such damages" and we know how important it is for insurance claims to be processed as soon as possible after natural catastrophes, so families and communities can return to some kind of normalcy. The insurance industry itself needs insurance which is where the reinsurance industry comes in. They insure your insurance provider and ensuring they will remain solvent to insure you next year, despite the size of claims and pay-outs they will be dealing with.
One of the main ways the insurance industry maintains its ability to provide coverage is through the catastrophe bonds, or cat bonds for short. A recent financial innovation, catastrophe bond provides the issuer, usually an insurer or a reinsurer, with financial protection in case of a major catastrophe, usually an extreme natural event such as a hurricane or an earthquake, or even a pandemic like Covid-19.
Catastrophe bonds allow insurers to pass on some of the risk they carry in their balance sheets to the capital market and qualified investors who are willing to absorb this risk for the right price. This means that they can count on the catastrophe bonds they have issued to protect them from going under when a disaster occurs, and the insurer is liable for large amounts of money that would normally threaten the insurer with insolvency.
But why on earth would an investor want to provide protection to an insurance company against a monster natural catastrophe? To answer the question, you need to understand that we are not talking about small retail investors but large institutional investors and pension funds, with hundreds of billions, sometimes trillions worth of assets. These investors are always looking for new investments and ways to spread their risks, as they are naturally heavily invested in the stock market, which is susceptible to global economic trends.
Providing protection against a natural catastrophe is a nice way to spread the risk of their investments, as a natural catastrophe is generally unconnected to global economic trends. Storm damage is largely uncorrelated with the level of unemployment, interest rates or the consumers' confidence index.
Of course, this protection is provided for the right price and with very specific terms - and I mean really specific terms. The prospectus covering the deal can be, as a broker described them, "telephone book-thick" (the prospectus for ATLAS Re 2016 is 258 pages long), covering all aspects of a cat bond and most importantly the conditions that will trigger it. For example, a cat bond could be triggered if an earthquake of magnitude 7.5 or above hits a specific region of the US west coast within the next three years or if an insurer’s claims exceed $500m following a specified natural catastrophe. As for the right price, the returns for cat bond investors have been generous to date, considering the risk of the investment.
But how is this possible when extreme weather events are becoming more frequent? Aren’t investors losing money as cat bonds trigger to cover the insurance losses? It is true that climate change has increased the frequency of extreme weather events. In the aftermath of Hurricane Sandy in 2012, Andrew Cuomo, then Governor of New York said that we experience "a 100-year flood every two years now".
However, a natural catastrophe does not immediately equal losses for cat bond investors. This is partly because some areas are underinsured or because the insured losses are solely covered by the insurer and the reinsurer without triggering losses to the cat bond investors.
To date, few catastrophe bonds have been triggered and even less have paid out to insurers. For example, the 2017 US hurricane season resulted in almost $300 billion worth of damages and several catastrophe bonds were triggered during this catastrophe. Six years later, claims are still being negotiated.
What does that mean for us? As long as investors make money, they will keep on coming back to the cat bond market. They will keep providing the much-needed protection to our insurance providers, so they can offer affordable insurance coverage to us. In this case, catastrophe bonds will offer social value, creating resilient communities around the world.
But it's not all a bed of roses. When considering financial innovations that can be used for good, some healthy scepticism is necessary. If extreme weather events do dramatically intensify and cat bonds do start to be triggered more often, investors might decide that the returns do not match their risk, and flee the market.
2021's Hurricane Ida was the most expensive hurricane on record in Florida, with $36 billion in insured losses there. In October 2022, Hurricane Ian was ranked among the top 5 storms to ever hit the US and caused an estimate $67 billion of insured losses, breaking Ida’s record. If this is a pattern, we are in trouble.
This article originally appeared on RTE Brainstorm