Cat bonds in your investment portfolio: cushioning the impact of climate change

Cushioning the impact of climate change with cat bonds.

More powerful hurricanes and increasing numbers of earthquakes – climate change is real. What does climate change mean for the alignment of investment portfolios? Investments in cat bonds offer institutional investors interesting opportunities to help shape the future.

Climate change is jeopardizing the creditworthiness of government bonds

"Over the past three decades, there has not been a single year when the average temperature in Switzerland was less than the average," says Prof. David N. Bresch, Professor for Weather and Climate Risks at the Swiss Federal Institute of Technology Zurich, at Credit Suisse's EAM thought leadership event. He is drawing attention here to ongoing climate change and the fact that the greenhouse effect needs to be limited to a considerable extent if the goal of the Paris Agreement on climate change to restrict global warming to well below two degrees by 2050 is to be achieved.

Because every degree of temperature rise leads to a 7% increase in humidity. As a result, there is a greater probability of tropical cyclones and hurricanes. An increased probability of natural disasters can in turn impact the creditworthiness of government bonds if national budgets face the additional burden of major loss events. "Countries in exposed regions must practice good risk management in order to secure their creditworthiness in the long term," says Prof. Bresch.

Investors need to understand the risks of climate change

This development is not without problems for investors, because some government bonds would lose their investment-grade rating in the event of unusual natural disasters. Although countries are insured against losses caused by extreme events, there is a gap between insurance and climate risks that will increase greatly as global warming continues.

Because of such scenarios, investors are well advised to take transaction risks and physical risks into account in their allocation decisions. Forward-looking management of physical climate risks offers investors the opportunity both to capitalize the risk transfer and to finance resilience measures.

Climate change has an impact on the investment-grade rating of government bonds

Climate change is leading to a gap between insurance and climate risks

For many countries, the additional insurance coverage needed to avoid losing the investment-grade rating is too high.

Source: Standard & Poors and Swiss Re
Last data point: 2015

Developing climate compatible portfolios using models

For the realignment of investment portfolios, publicly available models can be employed to help make estimates about climate change. "When using models, it is crucial not to neglect climate signals," says Prof. Bresch.

He adds that it is also important not look at the climate risks of individual firms in isolation, but to observe the combined risk outlook of several companies together. This makes it possible to create climate compatible portfolios that help to anticipate the effects of climate change.

Climate change is leading to greater insurance losses

If the aim is to make an investment portfolio climate compatible, catastrophe bonds (cat bonds) are an essential component. Because climate change is having a significant influence on insurance-linked securities (ILS). The insurance and reinsurance sector is heavily exposed to natural disasters and the increasingly strong hurricanes and earthquakes caused by climate change are likely to increase the costs of losses by 10% to 15% over the next 40 years, according to Dr. Urs Ramseier, CEO and CIO of Twelve Capital.

Climate change is increasing the damage costs of natural disasters

Climate change is increasing the costs of insurance losses

Increase in damage costs over the past 30 years

Source: Property Claims Service
Last data point: December 31, 2020

Transferring the risks of climate change to the financial markets

For the insurance sector therefore, cat bonds remain an important component of financing in the event of natural disasters. Above all, risks in the US (hurricanes and earthquakes), of winter storms in Europe, bushfires and droughts in Australia, and typhoons and earthquakes in Japan are being transferred to the investment portfolios of institutional investors. Because with these risks, there is a very high concentration of insured assets in exposed areas.

Protect people against climate change by investing in cat bonds 

But other exposed regions – in Asia, for example – are also attracting increasing attention. Some 80% of the world's population have little or no insurance against natural disasters, and are thus totally exposed to climate change. In these regions, ILS structures offer exciting opportunities to help people make the high losses insurable.

"We believe that the segment within the cat bond market in developing countries will be further expanded," says Dr. Ramseier. He adds that the World Bank is one of the drivers in this area as one of the largest issuers in the cat bond market. For institutional investors, this also provides an attractive opportunity to actively shape the future over the next 10 to 20 years. The assumption is therefore that ILS will play a key role in the global process of creating resilience to climate change and in climate adaptation.

Incorporate the bonds in your investment portfolio as an alternative asset class 

Cat bonds are thus a good alternative in order to contribute to cushioning the impact of climate change. First because the reinsurance premiums for investors go up as a result of increasing losses because the ILS market mostly reacts directly to a natural disaster. For instance, premiums in the US have seen an increase of 20% to 35% over the past three to four years. That is reflected in the best coupons for ten years despite the ongoing negative interest rate environment.

Second, the Swiss Re cat bond index only correlates very slightly with other asset classes and thus automatically ensures that a portfolio is diversified. That is why this asset class should definitely be taken into consideration as a potential addition to a portfolio at times of low interest rates and market volatility. The recommendation is to invest 2% or 3% of the strategic asset allocation in cat bonds.

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