This risk is driven by complex, proprietary modeling that has grown around the novel asset class. Zac Taylor, a professor at Delft University of Technology who studies climate risk and the insurance sector, writes that such modeling “has helped convert amorphous climate uncertainties into fungible objects of risk, into ‘just another asset class'”. If a single catastrophe occurs above a certain damage threshold, then the funds raised go back to the bond sponsor to pay out claims. When it doesn’t, investors continue to collect interest. Essentially, cat bonds ask investors to place an informed bet on the weather.
After the financial crisis, ILS products took off when institutional investors like hedge funds and pension funds were looking for reliable sources of returns that weren’t as directly tied to the rest of the economy. But the financial markets will only shoulder a limited risk. While Ian’s full impact on the ILS market remains to be seen, Stonybrook Capital’s report paints a bleak picture: “Many diversified cat funds are deep in the red for the year now (if not sooner) and all will ” have caught capital” ‘ again. Some will now report experiences that are well below their investor accounts for 5 of the last 7 years.” The implications of this could be profound and lead to a dramatic increase in policyholder prices. To make matters worse, the Federal Reserve is also raising interest rates, potentially making cat bonds less attractive to institutional investors who can find better returns elsewhere.
While it’s an important lifeline for people rebuilding from climate-related disasters, the insurance industry isn’t preternaturally well-equipped to weather rising seas and temperatures. Historically, insurance has protected against seemingly random and uncorrelated events, from car accidents to lightning strikes, kitchen fires and burglaries. “The problem with climate change is that you now have a systemic risk that is getting worse. You don’t have a random pool where some people are okay and some people aren’t,” said Rachel Kleetus, policy director for the Union of Concerned Scientists’ climate and energy program. This claim is supported by data: according to a recent report from the National Oceanic and Atmospheric Administration, the number of billion-dollar weather disasters per year is increasing. In coastal states like Florida, Kleetus adds, “you find almost everyone is exposed.”