The value to society of cat bonds
- Cat bonds give access to world capital markets for insurance against natural catastrophe.
- The premiums for cat bonds include an updated pricing of climate related risk and a valuation of preventative action.
- For developing economies cat bonds provide effective access to capital for catastrophe assistance and for reconstruction.
Cat bonds provide increased insurance capacity
The global financial markets are approximately 80 times larger than the market for non-life insurance and have therefore a much greater capacity to absorb shocks such as the economic effects of a natural catastrophe. To gain access to the financial markets capacity was the most important reason for the development of cat bonds after hurricane Andrew in 1992.
Cat bonds provide pricing of risk and preventative action
When a cat bond is constructed models are created to predict the probability that the insurance policy will be triggered. Regardless of whether the trigger is parametric or based on actual damage. (read more) the models give the prospective investor a view of the risk that the security will be used and the investment will lose value. The risk carrier can affect the chances that the policy will be activated regardless of the choice of trigger. Preventative actions, such as demands on urban planning, construction norms, updated building regulations and adequate preparation for dealing with a potential catastrophe reduce the risk of actual damage. This may even allow parametric values in the policy to be set at a higher level. The risk carrier who has not done his homework will need to pay higher premiums when issuing cat bonds and this in turn creates incentives to invest in preventative actions. As cat bonds have a relatively short life they also give an updated valuation of climate related risks.
Cat bonds provide insurance in developing economies
Even if cat bonds have mainly been used to manage risks in developed economies up until now, the use of cat bonds for developing economies has been developing fast in recent years. Cat bonds provide possibilities for countries and regions in areas that risk being affected by a catastrophe to gain access to alternative forms of capital. This is important not least because these regions are usually under insured and governments are forced to take on a very large responsibility for the economic effects.
The development of new insurance instruments has been led by the World Bank, which has produced a framework, MultiCat, which has been used to issue cat bonds in Mexico. A group of 16 Caribbean islands have themselves structured cat bonds using this framework with the help of the World Bank as structuring agent. In 2015 the first cat bond covering Chinese risks was issued, and in 2016 it is estimated that cat bonds covering some of the climate risks in Africa will reach the market.