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From earthquakes to tornadoes, natural disasters have inflicted billions of dollars of damage this year. But so far they have had minimal impact on the catastrophe bond market. These disaster risk financing tools are designed to transfer risks to capital markets. Yet, critics argue, they can transfer scarce financial resources from poor countries to the rich. That argument isn’t well founded.
The case against cat bonds is made in a recent report, co-authored by Jwala Rambarran, a former Trinidad Central Bank governor. It called on the World Bank to rethink its use of this “complex and costly” financial instrument. The report, published by the Vulnerable Twenty Group which represents countries particularly exposed to climate change, highlighted Jamaica’s cat bond which did not pay out despite the battering inflicted by several hurricanes including Beryl in July. It criticised cat bonds’ rigidity, noting they only pay out if a disaster precisely hits the pre-agreed trigger based on the path and severity of the storm.
Certainly, transferring hurricane risk to the capital markets does not come cheap. Jamaica is in effect paying $10.5mn a year, or 7 per cent of par, for the insurance premium element of the bond’s coupon. The comparable figure for the previous cat bond which was paid for by international donors until it matured in December 2023 was 4.4 per cent. The higher costs reflect the widening of credit spreads with higher interest rates and the market’s assessment of increased hurricane risk.
Investors are doing well, for now. After several years of poor returns, rates shot up. The Swiss Re Global Cat Bond Total Return Index posted a 19.7 per cent return last year, the highest since 2002. In the first half, it returned a solid 5.8 per cent this year. But strong returns are partly down to a relative lull in major catastrophes. That won’t last.
The Jamaican government itself had no complaints about the bond’s failure to pay out, saying it was designed to respond to a direct hit from a major hurricane, or close brush with one more intense than Beryl. It had layers of other financing and risk transfer instruments to respond to events of different severity.
Countries prone to natural disasters have to weigh up the bonds’ costs and benefits. They are not a one-size-fits-all solution and not all will be convinced the premiums are worthwhile at current levels.
Yet the World Bank expects to increase its issuance significantly in coming years, possibly covering a wider range of countries and disasters including drought. Despite the high cost of transferring risk, countries are keen to build up their resilience against future shocks. The crude nature of cat bonds, designed to facilitate speedy payouts, is a feature not a bug.
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