That risk is determined by complex, proprietary modeling that has grown up 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 to transform amorphous climate uncertainties into exchangeable risk objects, into ‘just another asset class.’” If a single catastrophe rises above a certain predetermined damage threshold, then raised funds go back to the sponsor of the bond to pay out claims. If it doesn’t, then investors continue to collect interest. Essentially, cat bonds ask investors to place a well-informed bet on the weather.
After the financial crisis, ILS products took off as institutional investors like hedge funds and pension funds went searching for reliable sources of yield that weren’t so directly tied to the rest of the economy. But financial markets will only shoulder so much risk. While the full effect of Ian on the ILS market remains to be seen, Stonybrook Capital’s report paints a bleak picture: “Many diversified Cat funds are now deep in the red for the year (if not earlier), and all will have ‘trapped capital ‘ again. Some will now report experience that is far below their investor representations in 5 of the last 7 years.” The ripple effects of that could be profound, leading to a dramatic rise in prices for policyholders. Making matters worse is the fact that the Federal Reserve is also hiking interest rates, potentially rendering cat bonds less attractive to institutional investors who can find better returns elsewhere.
Though it’s a critical lifeline to people rebuilding from climate-fueled 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 burglary. “The problem with climate change is that now you have a systemic risk that’s getting worse. You don’t have a random pool where some people will be OK and some people won’t,” said Rachel Cleetus, policy director with the Climate and Energy program at the Union of Concerned Scientists. That assertion is backed by data: According to a recent report from the National Oceanic and Atmospheric Administration, the number of billion-dollar weather-related disasters per year is rising. In coastal states like Florida, Cleetus adds, “you find out that almost everybody is exposed.”