Expensive cat bonds help vulnerable countries weather the storm

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From earthquakes to tornadoes, natural disasters have caused billions of dollars in damage this year. But so far they have had minimal impact on the catastrophe bond market. These disaster risk financing instruments are designed to transfer risks to the capital markets. However, critics argue, they can transfer scarce financial resources from poor countries to rich ones. This argument is not well founded.

The case against cat bonds is presented in a recent report by Jwala Rambarran, former Governor of the Central Bank of Trinidad. He asked the World Bank to rethink the use of this “complex and expensive” financial instrument. The report, published by the Vulnerable Twenty Group, which represents countries particularly exposed to climate change, highlighted Jamaica’s cat debt that has not paid off despite being hit by several hurricanes, including Beryl, in July. He criticized the rigidity of cat bonds, noting that they pay out only if a disaster hits exactly the pre-agreed trigger based on the path and severity of the storm.

Of course, transferring hurricane risk to the capital markets does not come cheap. Jamaica actually pays $10.5 million a year, or 7% of face value, for the bond’s coupon insurance premium element. The comparable figure for the previous cat bond, which was paid by international donors until it matures in December 2023, was 4.4%. Higher costs reflect widening credit spreads with higher interest rates and the market’s assessment of increased hurricane risk.

Investors are doing well, for now. After several years of poor returns, rates have risen. The Swiss Re Global Cat Bond Total Return index returned 19.7% last year, the most since 2002. In the first half of the year, it has returned a solid 5.8% this year. But the strong returns are due in part to a relative lull in major catastrophes. This won’t last.

The Jamaican government itself had no complaints about the bond’s default, saying it was designed to respond to a direct hit from a major hurricane, or to approach one more intense than Beryl. It had layers of other funding and risk transfer instruments to respond to events of varying severity.

Countries prone to natural disasters must weigh the costs and benefits of bonds. They are not a one-size-fits-all solution, and not everyone will be convinced that premiums are worth it at current levels.

However, the World Bank expects to significantly increase its issuance in the coming years, potentially covering a wider range of countries and disasters, including drought. Despite the high cost of risk transfer, countries are keen to build resilience to future shocks. The crude nature of cat bonds, designed to facilitate quick payouts, is a feature, not a bug.

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