In case you missed it, catastrophe bonds recently made it to the cover of the Wall Street Journal: a once-sleepy, wonky corner of the insurance market is poised for disruptive growth. “Cat” bonds are effectively a cheaper source of large-scale insurance coverage against clearly measured risks like earthquakes, storms, or even disease outbreaks.
That’s an exciting prospect for cash-strapped governments and development agencies, which face insurable risks from natural disasters like last year’s earthquake in Nepal or the ongoing consequences of drought in Ethiopia.
The insurance industry’s rich jargon aside, these are simple products. Like a bond, someone lends you money and you pay them an interest rate. The twist is that if a pre-agreed disaster or other event happens, you don’t have to repay. Setting out clear conditions for “triggering” the bond based on objective data like the violence of an earthquake reduces uncertainty about the value and timing of your post-disaster income. That, in turn, facilitates planning and preparation.
Generally, though, coverage hasn’t trickled down to the poorer and most at-risk countries—precisely those which are most vulnerable when aid fails to arrive or arrives piecemeal. Parsing data on cat bonds handily provided by Artemis, an industry observer, shows that less than a twentieth of the total value of these products issued since 1996 covers risks in countries that the World Bank classifies as upper middle-income or below (places where income per capita is $12,475 or lower). They have mainly covered risks in the US and other high income countries (HICs).
Notes: Catastrophe bond issuance data from artemis.bm. CGD analysis. Totals overstate issuance due to overcounting, for example allocating the full value of a contract to both categories if both US and Caribbean risks are covered.
Information, cost, and basis risk seem to be at least three constraints on scaling catastrophe bonds up and across:
Agreeing on these contracts requires technical nous
They’re bespoke, so you need to pay for advisors and catastrophe modeling experts
The contracts are (mainly) based on triggers rather than actual losses. That creates basis risk—a storm might cause damage, for example, but not invoke the bond’s trigger.
Examining the handful of transactions that do cover developing regions bears this out. There are cat bonds covering risks in Turkey, Mexico, and a group of Caribbean countries (through CCRIF, a regional mutual insurance facility). Those issuances depended on technical and policy support from the World Bank, without which it would have been difficult—probably impossible—to navigate these complex transactions.
One way forward is to rely on centres of technical excellence like the World Bank to facilitate risk transfer deals. And it makes sense for the Bank to deliver those transactions alongside its other “risk finance” tools, like emergency credit lines. But this deal-by-deal approach is unlikely to catalyse a broad market of catastrophe bonds covering a full range of developing countries’ risks.
We might be sanguine about the gap between insurance demand in insurance supply if aid were much more effective at tackling the consequences of natural disasters—in short, if aid were ‘as good as insurance.’ But the premise of a new CGD working group focused on improving emergency response is that ex-post aid is increasingly unfit for purpose because it is overstretched, small compared to needs, prone to arriving piecemeal and late, and able to distort incentives to invest in lowering losses.
As a result, one of the exciting questions that our working group is tackling is how donors can scale up access to these kinds of insurance instruments, perhaps by streamlining access to the necessary technical assistance, bearing some share of premiums, or commodifying them so that more institutions, agencies, and governments can more readily deploy them.
If ex-post aid is a bad substitute for insurance, there’s a compelling argument for substituting insurance for aid. Cat bonds are one part of the toolkit. Scaling up this market for lower-income countries would provide better shielding against many risks that undermine development overseas. It would leave more cash in donors’ pockets to tackle the kinds of emergencies that are hard or too expensive to insure against. And it would provide the kind of protection to poorer and vulnerable places that rich countries and large firms are choosing for themselves.