Why the catastrophe bond market is growing

Catastrophe bonds are a growing form of investment that can be used to fund recovery from damage in climate-related disasters. Their structure can be attractive to both issuers and investors, but these bonds may not be as effective at covering damage as they promise.

What are catastrophe bonds?

Also called CAT bonds, catastrophe bonds "raise money for insurers, helping them pay claims if there's a natural disaster or catastrophe," said Investopedia. They are essentially "reverse insurance," where "instead of paying premiums to receive protection, investors receive premiums for providing protection." However, "investors risk losing their investment if a specified catastrophic event occurs before the bond matures." If the disaster does not occur, "these instruments are known to offer highly attractive equity-like returns, low volatility and low correlation to broader financial markets," said CNBC.

The CAT bond market has boomed in recent years and hit a record $17.7 billion in sales in 2024. This year, there have already been $18.2 billion in sales, surpassing the total for all of last year. "We're definitely going to see the first ever $20 billion year," said Steve Evans, the owner and editor-in-chief at the data provider Artemis.bm, to CNBC. The bonds pose a mutually beneficial agreement between the issuers and the investors. "Issuers hope to cover themselves against low-probability outcomes with costs that could overwhelm them," said The Economist. "Investors are hungry for assets that do not move in tandem with the rest of their portfolio."

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Why are sales growing?

The rise in the catastrophe bond market correlates with the growing number of disasters due to climate change. "Insurers have no choice but to identify ways to offload increasing risk, and they're doing it in the CAT bond market," said Richard Pennay, the chief executive at Aon Securities, to the Financial Times.

The bonds can allow for faster payouts after a disaster. Also, CAT bonds help diversify asset portfolios because "climate or geological hazards are historically not related to financial market movements," and are "mutually exclusive and independent of the financial risk curve," said The Hindu.

The growth of the catastrophe bond market has also called into question their ability to cover climate disaster damage. Bonds that pay out to fund disaster aid may seem like a bad investment in a time of increasingly extreme weather events. But that has not been the case. This is because there has not been much payout for aid even when severe disasters occur. A "defectively designed CAT bond could lead to no payout despite a significant disaster," said The Hindu. "For example, an earthquake CAT bond designed for a magnitude threshold of 6.6M for a certain grid may fail if a 6.5M event occurs and causes extensive damage." This happened when Hurricane Beryl hit Jamaica and the air pressure metric of the bond did not meet the threshold for payout.

Many catastrophe bonds are also only designed to pay out for "peak perils" or the most damaging event, like hurricanes and earthquakes. The problem is that "secondary perils," which include "everything from the current wildfires to hail and thunderstorms," have "expanded to take up a much larger share of total insured losses owing to the impact of climate change," said The Economist. "It is hard to fault bondholders for their reluctance to offer reasonably priced protection against new and more unpredictable disasters." Unfortunately, "in the absence of fresh financial innovation, it is likely to be the taxpayer who ends up on the hook."