Climate change implications for the catastrophe bonds market: An empirical analysis

• Published in: Economic modelling 2019-09, Vol.81, p.274-294
• Main Authors: Morana, Claudio, Sbrana, Giacomo
• Format: Article
• Language: English
• Subjects: Atlantic hurricanes; Catastrophe (cat) bonds and insurance-linked securities (ILS); Climate change; El Niño Southern Oscillation; Global warming; Multiples; Semiparametric dynamic conditional correlation model
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2019.04.020

Since their introduction in the mid-1990s, the return per unit of risk or multiple on catastrophe (cat) bonds has steadily declined. This paper investigates whether this pattern is consistent with the historical evolution of natural disaster risk, using average multiple figures over the period 1997–2017. Assessing the accuracy of cat bond pricing is important, since about 50% of outstanding risk capital in the cat bonds market is currently exposed to Atlantic hurricanes -a risk that global warming, among other disruptions, is found to enhance- and pension and mutual funds in European and other OECD countries currently own about 30% of the market. In this respect, while our findings suggest that falling multiples are primarily related to the Fed's expansionary monetary stance and to portfolio shift effects, we do also find evidence of significant undervaluation of global warming risk in the cat bonds market. This finding, also in light of the unfailing appetite of institutional investors for such securities, casts doubts over the sanity of the market and over cat bonds as suitable investment products for risk averse investors. Sounder investment opportunities might be found in the green bonds market, which allows for the funding of immediate investment in climate change mitigation too. •We investigate the global warming evidence and implications for disasters risk.•We find that radiative forcing drives the trend in temperatures anomalies.•It also accounts for enhanced effects of ENSO and Atlantic hurricanes.•We then investigate the implications of global warming for cat bonds pricing.•Predictive regressions point to undervaluation of risk in the cat bonds market.