France’s emlyon business school has found that resorting to catastrophe bonds (CAT bonds) to insure losses caused by extreme climate events only serves to make investors richer.
The study questioned whether it was possible to rely on innovative financial instruments to manage flooding, fire and storm risks that now characterise our climate in order to push forward with achieving the UN's Sustainable Development Goals.
Catastrophe bonds, also called 'CAT bonds,' are usually issued by insurers or reinsurers to transfer extreme natural catastrophe risk to capital markets and transfer a specified set of risks, usually related to extreme weather events, from a sponsor to investors. Researchers in the study held that the bonds systematically overestimate risks and artificially inflate returns for investors.
Bernard Forgues, professor of strategy at emlyon business school, says: “CAT bond models cannot forecast accurately extreme climate events. Their predictive power turned out to be low and is showing no sign of becoming any better over time. Regardless, the market continues to consistently grow, bar a dip around the time of the global financial crisis.”
Tellingly, secondary data revealed that market actors are aware of the inaccuracy pervading the modelling of these tools yet continue to remain active in the market. This finding that financial innovations designed to tackle environmental and sustainability issues are in fact focused on increasing profit for investors, and that the CAT bond returns are driven largely by economic factors.
Carried out by Bernard Forgues in collaboration with Dror Etzion, McGill University, and Emmanuel Kypraios, Maynooth University, researchers compiled a comprehensive list of all CAT bonds ever issued since their conception in 1996, to March 2016.
Assessing the forecast accuracy of this database they found that interest rates of the bonds are based on sophisticated predictive models which calculate the probability and impact of a given natural disaster. The data was compared with 10 CAT bonds which were triggered historically and caused capital losses to investors
Forgues adds: “If financial innovations such as CAT bonds are to be used to tackle the SDGs, they should be designed robustly, with mechanisms that incentivise actors to truly create social value”.
The researchers concluded that it would be advantageous to design tools and markets that discourage excessive profit-making and encourage sustainable development. Instruments like CAT bonds would better serve their purpose when traded via open markets.
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