Amid escalating concerns about global climate disasters, hedge funds have been adeptly seizing opportunities to capitalise on the climate crisis by investing in catastrophe bonds.
Traditionally, catastrophe bonds are used by the insurance industry in order to protect themselves against huge losses in the event that a certain catastrophe occurs. Investors put their money at risk in case these disasters happen, and it will be their private capital used to cope with the losses that arise when catastrophe does hit.
However, they are rewarded with astonishing profits if the defined catastrophe does not occur. Over the past year, this has paid off hugely for hedge funds, for which catastrophe bonds are a top-performing alternative investment, according to Fortune.
Successful investing in catastrophe bonds requires science-based tracking of global warming and weather patterns, in order to ascertain when tragedy will strike. Comprehensive models to predict hurricanes and earthquakes are already in use, with models for wildfires and flash floods in active development.
The market is growing beyond the traditional insurance industry, as other players have entered the market to issue catastrophe bonds. For example, Blackstone, Inc. has issued catastrophe bonds regarding natural disaster losses affecting their property assets. Alphabet, Inc. also issued them to protect their California operations.
Up until 2020, returns on catastrophe bonds had been underwhelming. However, from 2023 to 2024, the market in catastrophe bond issuance has jumped from $16.4 billion to $43.4 billion, according to Artemis.
Impact Investing
Although one can question whether betting on whether vulnerable communities will be hit by climate disaster is ethical, the structure of the catastrophe bond is such that they shift financial risk of natural disaster from those who take out and offer insurance to the capital markets.
Impact-focused catastrophe bonds, with an aim beyond mere money-making, can offer significant benefits to individuals. For example, the Turkish Catastrophe Insurance Pool (TCIP) has as one of its objectives: “Reduce citizens’ dependence on the government to fund the reconstruction of private property after a devastating earthquake”. Notably, though, TCIP does not cover ‘human losses’.
Hedge funds have already begun framing their investments in catastrophe bonds as ‘impact investing’. Moreover, a large number of catastrophe bonds are being classified as ‘ESG relevant’ under the European Union’s Sustainable Finance Disclosure Regulation (SFDR). Stephan Ruoff of Schroders Capital told Impact Investor that 60% of its catastrophe bonds are classified as such.
An example of catastrophe bonds being used for good is the World Bank’s offering of a $350 million catastrophe bonds package in earthquake insurance coverage to the Government of Chile, in March 2023. The World Bank says about this financial construction: “The transaction provides Chile with financial protection to mitigate the potentially disruptive economic impacts of earthquakes and resulting tsunamis.” Moreover, it also “reduces the potential need to mobilize debt in an event’s aftermath”.
This latter benefit is of great use to vulnerable countries, that are predominantly located in the Global South. For example, after experiencing devastating floods in 2022, Pakistan became heavily indebted towards the global community, as the $9 billion in disaster funds made available to it were largely in the form of debt.
Potential Use for the Loss and Damage Fund
On the first day of COP28, the framework needed to establish the Loss and Damage fund was ratified by 198 attending countries. The Loss and Damage Fund is established in order to help vulnerable countries cope with losses caused by climate change disasters. An estimate in the ‘Climate Vulnerable Economies Loss Report’, reflects that the financial need for such countries corresponds to several trillion dollars.
Under Decision 2/CP.27, international financial institutions are encouraged to contribute to funding mechanisms. In order to overcome the major loss and damage funding gap, we will need the active involvement of private parties. Regardless of how they frame their activities, private funders (such as hedge funds) are inherently profit-oriented.
Yet, innovative investment structures, such as catastrophe bonds can play a major role in bridging the funding gap, while still allowing private parties to retain their capitalist nature.
Following the funding of the Loss and Damage fund at COP28, Artemis already highlighted that when private capital starts to be involved in this fund, catastrophe bonds and other insurance-linked securities would be viable options.
The downside of using catastrophe bonds for humanitarian concerns is that they come with onerous terms and remove policy autonomy from countries. But it remains an option well worth exploring.
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