CAT to the rescue: Govts, insurers must issue cat bonds for citizens’ financial protection from weather events

The devastation wrought by incessant rainfall in Kerala and Uttarakhand has forcefully brought home the heightened risks arising out of climate change. Extreme weather, events that are dissimilar to 90-95% of weather events, is one of the symptoms of climate change. India is vulnerable to it as NDMA estimates that 27 states and Union territories are disaster-prone.

Disasters take a huge toll on individuals and larger communities. The financial fallout is generally handled by insurance and government support through mechanisms such as disaster response funds. The protection is suboptimal because the available options in India are not good enough to meet increased natural risks. We need to dip into a much larger global basket of insurance-linked securities (ILS), particularly catastrophe bonds aka cat bonds. Insurance against extreme events works best if insurers are able to spread the risk among a wide pool of investors. That way, neither will insurers be financially overwhelmed by a disaster, nor will they have to disproportionately raise premiums to cover increased risk of some events like floods.

Catastrophe bonds have emerged over 25 years as a popular option for insurers, reinsurers, global corporations and even governments as a way to protect themselves against natural disasters. The way it works is that issuers, insurance or reinsurance companies or governments, issue short-period bonds that are bought by investors, typically PE firms or hedge funds. These bonds provide good, fixed returns to investors. Investors lose the principal amount they invested in the event of a catastrophe and the bond issuer gets the money. That’s why in July the Jamaican government issued cat bonds that will provide it with financial protection of up to $185 million against losses from named storms for three Atlantic tropical cyclone seasons. In India, it’s possible to evolve a policy where the state could top up its disaster response fund with a financial cushion provided by cat bonds.

What it means for Indians, rich or middle class or poor, is that with cat bonds both insurers and governments will have more financial heft to insure better off citizens or aid poorer citizens. Insurers get the assurance of cash payout to lower premiums and offer coverage of extreme events. Governments can get extra cash to spend on relief and rehabilitation. It is precisely because cat bonds are so useful that the World Bank has a cat bond market access facility for member countries. India is no slouch at financial innovation. And it is buffeted by many weather events. Cat bonds should be actively encouraged.