In the mid-1990s, institutional investors and insurance companies entered into a high-stakes game with hundreds of millions of dollars of property and lives on the line. It happened in the wake of Hurricane Andrew and the Northridge earthquake, after which insurance companies realized that their traditional model was not equipped to deal with such massive natural disasters.
The system usually relied on pooling risk across millions of policy holders, but when enough damage happened in clusters, it could overwhelm it. In those cases, reinsurance (the insurance of insurance companies) wouldn’t suffice. Thus, the birth of the catastrophe bond, a vehicle through which they could spread the risk to other players and tap into the resources of the capital market to pay their claims.
I get it, insurance isn’t the sexiest or most interesting of topics, but it underpins much of the global economy. In many countries, certain types of insurance are mandatory, for example car insurance to ensure victims are compensated in the event of an accident; workers compensation insurance; or fire insurance on buildings without which businesses would not be allowed to continue operating.
Insurance allows individuals and organizations to engage in higher-risk activities knowing that they’ll have a safety net to catch them if they fail. This leads to improved economic stability for the whole system. In 2024, the global insurance industry collected up to 7 TRILLION euros in premiums, a number that’s expected to keep growing in coming years.
However, it’s an industry that relies on the predictability of health outcomes, extreme weather events, and the like. The spike in unpredictability brought about by the climate crisis is an existential threat to insurance companies that risk facing insolvency if too many policy holders put in claims at once.
The industry has been aware of climate-related risks since as early as the 1970s. Yet, their failure to prepare has led them to pull out completely from some areas deemed as uninsurable in the wake of record-breaking natural catastrophe losses. State Farm, one of the biggest home insurers in the U.S, has paused their activities in California, for example, and will not renew tens of thousands of policies after suffering losses of 6 billion USD in both 2022 and 2023.
While insurance companies have been using AI for years to create state-of-the-art risk prediction models, to fully capture the risks inherent to climate change would require the integration of climate models like those from the IPCC. After all, the risk does not increase in a linear way. Instead, certain tipping points or planetary boundaries would result in an extreme sort of domino effect if reached, increasing risk exponentially in many areas.
Scientists and actuaries “are sailing past each other like ships in the night despite the fact they are using the same language of climate risk”, said Kris de Meyer, head of the UCL climate action unit.
Ian Smith and Kenza Bryan, “The uninsurable world: how the insurance industry fell behind on climate change” for the Financial Times
Of course, academics and insurers are looking at the data for different ends, but their research should feed into each other instead of standing in isolation. It also begs the question, why aren’t insurance and reinsurance companies stepping up to lobby for stricter climate-related policy and regulation? Even if they pull out of high-risk areas and pump up their premiums, many are unlikely to survive the climate crisis.
It’s not just that they don’t lobby for climate regulation, some of them even lobby against it. They’re investing hundreds of billions of dollars into fossil fuel companies while, at the same time, denying legitimate claims when extreme weather events, exacerbated by the greenhouse gases those oil and gas companies release, become more frequent and intense. Even if you think their investments in high polluting industries justify their loyalty to them, the numbers simply don’t add up, especially in the long-term.
This leads us back to where we started: catastrophe bonds. Let’s dig a little deeper into how these bets are hedged. Bonds are financial “vehicles” usually used to invest in safe, short-term securities (you’ve probably heard of government issued bonds).
In the case of catastrophe bonds, they’re usually issued by insurance companies and bought by institutional investors. That means that the investors place their money (the principal) into the bond for a period of 1-3 years during which the insurer is paying a premium.
I wasn’t exaggerating when I said that this is essentially a bet. If certain pre-agreed upon events take place, the insurance company gets to keep some or all of the principal investment. But if not, the investor gets their principal back plus interest (the previously mentioned premiums that the insurance pays).
In 2024, the market yielded a 17% return, making it one of the most profitable alternate investments. Given that it’s not tied to the stock market, it’s also isolated from external shocks like Trump’s tariffs. That makes it a really attractive option for investors looking to diversify their portfolio.
I’ll give you some examples. An institutional investor might put their money in a catastrophe bond that has an “indemnity trigger” or a “parametric trigger”. In the first case, they could lose their money if the insurance company’s claims exceed 1 billion USD. In the second case, they would choose a single, objective measurement like a hurricane’s wind speed or an earthquake’s magnitude. If a natural disaster that fit those qualifications were to take place, the insurance company would be able to cash in those bonds to pay for the resulting claims.
Insurance companies might be the main players issuing these bonds, but they’re no longer alone. Blackstone Inc. and Apple both joined them with bonds protecting their property assets and operations from natural disasters. The World Bank also issued a whopping $630 million to the government of Chile to protect against earthquakes. This would give low- and middle-income countries an alternative to taking on crushing debt in the wake of extreme weather events in the future.
While transactions like those between insurance companies and investors are purely profit-driven, the catastrophe bonds issued by the World Bank could be seen as impact investing-adjacent since there’s alignment of capital with environmental or social purpose. Of course, any catastrophe bond would hopefully be redirected to the communities most impacted by the triggering event, making them an important instrument in the midst of the climate crisis. However, they feed into an insurance industry that lacks transparency and is leaving the most vulnerable among us exposed by refusing to insure them.
To be fair, some insurance companies are taking steps to promote climate resilience and adaptation. Some are providing incentives to homeowners or business owners that install preventative measures like flood-resistant barriers. In sub-Saharan Africa, the Agriculture and Climate Risk Enterprise (ACRE) “makes use of the data from automated weather stations, satellites and other mobile technologies to bring affordable insurance to smallholder farmers”. While ACRE acts as an intermediary for actual insurers and their clients, their service allows insurance coverage to reach historically underserved areas and clients.
Because their payouts are based on specific environmental or climactic parameters, they’re called parametric insurance products. If the data shows that there’s been drought in the areas ACRE covers, for example, policy holders would automatically receive insurance payouts to cover the cost of their lost seed. These types of solutions are becoming increasingly important as the gap between the damage caused by extreme weather events and the coverage available for them widens.
While on the topic of catastrophe bonds, we might as well cover their close relatives, green bonds. Green bonds still far outpace catastrophe bonds nearly 35 to 1 with over $575 billion USD being issued in 2023 compared to $16.45 billion. One simple explanation is that green bonds encompass a far larger set of purposes than catastrophe bonds do. Really any environmental project could be financed through green bonds, which leaves the sector vulnerable to greenwashing.
The reason I bring green bonds up is to discuss one of their subsets that overlaps significantly with catastrophe bonds: resilience bonds. Really, they’re a type of catastrophe bond that rewards the issuing party if they implement measures that bolster their resilience to natural disasters. Take as an example a local government in a flood-prone area.
When issuing a catastrophe bond to raise funds for recovery in case of a future flood, they could link this bond to a flood-resistant infrastructure project. They would have to prove that this project, like installing seawalls, would reduce their the damage done when this hypothetical flood occurs. The investor providing the principal capital for the bond would then agree to receive less interest when the local government completes this resilience project.
Because the investor is willing to take home less profit if the bond issuer completes a climate adaptation project, one could say that buying resilience bonds is a form of impact investing (in contrast to traditional catastrophe bonds). The investor might still get comparable rewards, however, since green bonds often have a variety of tax credits and exemptions.
Resilience bonds have other benefits for the communities they protect that catastrophe bonds don’t. In addition to helping them adapt, they’re usually issued by the government or local organizations instead of multinational insurance companies. This gives the community more autonomy and control of how the funds are used. It can also reduce the pressure on government disaster relief programs and insurer-of-last-resort programs.
These types of alternative financial instruments are becoming increasingly important as insurance companies prove time and time again that their ultimate goal is chasing profit, not helping people. Not only are they leaving the most vulnerable populations uncovered, some are actively lobbying against measures to increase climate resilience. Take this case from the U.S:
Last year, Jones worked with state Sen. Josh Becker and the Nature Conservancy on a bill that would have required the models used by insurers to account for risk mitigation efforts such as forest treatment, creating defensible space around homes, and home hardening.
“The insurance industry killed it,” Jones said. “They killed the bill through lobbying and donations to lawmakers. They basically went in front of the insurance committee of the Senate and the Appropriations Committee of the Assembly and, and said, ’We’re opposed to this,’ and convinced those two committees to gut the bill.”
Marcus Baram, “How big insurance’s investment in fossil fuels came back to bite it” for Yale Climate Connections.
Thankfully, there are some governments tightening the reigns on their national insurance industries. The UK, for one, is running stress tests on their insurers to examine their actions following a hypothetical sequence of adverse scenarios. In the US, a task force was set up during the Biden administration to coordinate between different actors on the topic of climate resilience, but its future remains to be seen under the new president.
Lastly, it’s worth mentioning that insurance companies and institutions aren’t the only source of resilience available to communities. It’s important to remember that community organizing, mutual aid, and their subsets can serve to stabilize an area impacted by natural disasters just as much, especially if their high-risk status deemed them uninsurable.
It’s not rare for people to be left behind by profit-driven corporations, or even overlooked by underfunded and understaffed government agencies. In that case, we must learn to turn to each other. And in preparation for such times, we must bolster community resilience through initiatives like community gardens, tool libraries, and the like. We never know when we’re going to need it.
