An Emerging Disaster Preparedness Tool: Catastrophe Bonds

An Emerging Disaster Preparedness Tool: Catastrophe Bonds

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Water crashing over bridge during Hurricane

Although the numbers for losses incurred by 2018 disasters aren’t in yet, it’s likely that 2018 will be another record-breaking year for disaster losses in the US. Given the steady increase in disaster-induced losses, governments of all levels are pursuing the smartest ways to ensure the security, safety, stability and success of their constituents. As governments strive to build an environment in which their citizens can grow and prosper, catastrophe bonds present an emerging, innovative opportunity for governments to build the fiscal stability and community resilience required to do so.

Catastrophe bonds are insurance-linked securities (ILS) that transfer insurance risk from the insurance companies to the global capital markets. They work by protecting governments or government entities against a specified disaster with an established objective metric such as mortality rate, wind speed, or flood water level. If a disaster meets the specified trigger conditions, the bond investments are released to be applied towards response and recovery.

For example, a government could issue a bond to protect against earthquakes that reach a magnitude 6.5 on the Richter scale. If an earthquake of that magnitude occurs within the bond maturity period – typically three years for a catastrophe bond – then the bond proceeds are made available to help the government repair its insured losses. If no disaster occurs, the investors get their investment back with interest.

Federal, state and local governments, and government entities such as a transit authority or sewer authority, are eligible to issue catastrophe bonds. After Hurricane Sandy, for example, New York City’s Metro Transit Authority (MTA) issued a catastrophe bond that provides storm surge reinsurance protection. In the event a storm surge occurs, the bond investments will be made available to the MTA to make repairs to disaster-induced damages.

Larger cities like New York may be able to issue catastrophe bonds on their own, however a regional approach can provide a more effective solution for smaller jurisdictions. A group of jurisdictions or council of governments (COG) that may be impacted by a hurricane or tornado, for example, can create their own combined financial entity to issue a catastrophe bond.

Catastrophe bonds provide several benefits to localities frequently impacted by natural disasters. By securing funds in advance of a disaster, they help to decrease the impact of extreme natural hazard events on capital flows and also minimize disruption to municipal budgets. As a result, they may signal more stability to private developers and other investors. As an ILS, they are trigger based and not claims based, which can eliminate the costs and delays of inspecting and adjusting impact costs after an event.

The direct mitigation benefits associated with these financial mechanisms are readily apparent, however they also hold a resilience value that can help local leaders build stronger communities. For example, because the catastrophe bond transaction will require analysis of exposure and vulnerability, leaders are likely to shift into their long-term planning mode to develop contingency plans and, better still, to consider land use options and infrastructure requirements. This helps local leaders make better-informed choices to increase their community’s ability to build back from disasters stronger and more quickly.

Finding ways to transfer risks is important to the fiscal sustainability of public entities, citizens and businesses. ILS both bolsters resilience to catastrophic loss and de-risks public budgets.

Joyce Coffee is a Director at the American Society of Adaptation Professionals and a member of the Adaptation and Resilience Expert Group of the Climate Bonds Initiative. As president and founder of Climate Resilience Consulting she collaborates with IBTS on some of their resilience and community finance initiatives. @joycecoffee

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