Can insurance-linked securities mobilize investment in climate adaptation?

Posted On January 12, 2021

A woman plants mangroves to protect the coastline of Timor-Leste. Resilience investments are often in infrastructure but can also be in natural capital, such as investing in mangrove restoration to protect vulnerable coastal communities from tropical storms, or in community-building exercises that strengthen disaster response. Photo: UNDP Timor-Leste/Yuichi Ishida

 

The cost of adapting to climate change increases every year. Between now and 2030, adaptation in developing countries is projected to cost US$180 billion annually and skyrockets to US$280-500 billion as we get closer to 2050. The past five years are among the warmest ever recorded and the economic impacts from tropical storms, droughts and wildfires are reaching record levels around the world. Despite the need to improve our resilience, investments in early warning systems, climate resilient infrastructure, improved agriculture, natural capital such as mangroves and coral reefs, and water resource management, have remained stagnant. Adaptation finance still represents a fraction of overall climate finance and less than 20 percent of what is needed, even if absolute numbers are slowly rising US$22 to US$35 billion from 2016 to 2018).

But closing the gap between current adaptation financing levels and the need is a challenge. Public sector budgets are maxed out and attracting desperately needed private investment remains notoriously elusive. The challenge to mobilizing private investment into adaptation and resilience projects has always been–how do we get our money back? While we’ve been debating adaptation’s return on investment, the damages from intensifying hurricanes, wildfires, and droughts as a result of the climate crisis have cost hundreds of billions of dollars and displaced millions of people.

Perhaps the answer to attracting private financing to adaptation lies not in identifying revenue streams but in quantifying the savings. Assets are increasingly at risk of being stranded not just for their carbon emissions but for their insurance costs. As the physical impacts of climate change increase, asset owners, including governments, corporations and investors, may encounter insurance premiums that drive up the costs of business to unsustainable levels.

To reduce their financial liability, insurers transfer unmanageable risks to reinsurers and then into capital markets via insurance-linked securities (ILS), such as catastrophe or “cat” bonds which cover low-probability, high-impact events. Cat bond investors set money aside into a trust to cover losses from catastrophes, such as earthquakes, floods and even pandemics, beyond the insurance or reinsurance policy cover in exchange for a generous coupon payment. However, the European Insurance and Occupational Pension Authority cautions that as extreme events related to climate change become more severe and frequent, the market for cat bonds may decline or lead to pressures for higher returns to compensate for higher risks.

While current ILS instruments are useful for transferring risks, they are not designed to reduce underlying risks or build resilience to disasters. As climate change continues to exacerbate the impacts of natural hazards, next-gen ILS instruments, such has resilience bonds, leverage upfront investments in resilience as a way to reduce insurance premiums and kickoff a virtuous cycle of pricing incentives for investing in protection and preparedness.

Developing a resilience bond requires first recognizing the risk that needs to be mitigated, such as flooding from tropical storms, then identifying opportunities to improve resilience, such as upgrading coastal protection systems, and then quantifying the potential cost savings in the event of a disaster when compared to “business as usual” (BAU). The projected cost savings between the resilient and BAU scenarios is used to reduce the cost of insurance premiums and the savings are then securitized into a resilience bond to provide capital for the identified resilience investments. These investments are often in infrastructure but can also be in natural capital, such as investing in mangrove restoration to protect vulnerable coastal communities from tropical storms, or in community-building exercises that strengthen disaster response.

While resilience bonds offer a promising structure to incentivize investment in adaptation and resilience, they are not without challenges. The success of these instruments requires a high probability of a hazard (such as a tropical storm), a high exposure of assets (such as valuable coastal properties), and a high vulnerability to potential damage (such as prolonged flooding) combined with the likelihood that a given intervention (such as building a seawall and improving drainage) could dramatically reduce the risks. Wealthy coastal communities like Manhattan, Malibu and Palm Beach, have the right mix of high hazard, high exposure and high vulnerability to test out these financing structures and pilot programmes are already in development. But how do we bring these types of adaptation finance solutions to developing countries where the need is great, but the hurdles are high?

UNDP’s flagship Insurance and Risk Finance Facility will be looking at this question as it begins operations in ten developing countries in 2021. Developing countries face challenges such as low insurance penetration, land title disputes, lower property values and expensive upfront modeling costs, all of which can pose a challenge when trying to leverage insurance savings to incentivize investments in resilience. While the concept of resilience bonds may need significant tweaking to be applicable in developing countries, it is clear that insurance will be a powerful tool in both managing the socioeconomic and financial consequences of climate change and incentivizing investments in adaptation and resilience.