Catastrophe Bonds: Managing India’s Rising Climate Risk and Financial Exposure

PWOnlyIAS

July 10, 2025

Catastrophe Bonds: Managing India’s Rising Climate Risk and Financial Exposure

Climate change is increasing natural disasters, raising India’s financial risk. Catastrophe bonds offer a crucial way to manage and transfer this risk effectively.

  • In 2025, catastrophe bond issuance has reached $17.68 billion in the first half alone, just $14 million shy of the all-time annual record.
  • The first CAT Bond exchange-traded fund (ETF) was announced in the first quarter of 2025.

About Catastrophe Bond

  • Cat bonds are insurance-linked securities that convert disaster risk into tradable financial products.
  • These bonds allow governments or organisations to transfer disaster risks (like floods, earthquakes, or cyclones) to investors.
  • If a pre-defined disaster occurs, investors lose part or all of their principal; this money is then used for relief and reconstruction.
  • If no disaster happens during the bond’s term, investors get their principal back plus a high interest rate (coupon).
  • Since cat bonds are tied to specific, non-market risks, they appeal to investors looking for portfolio diversification.

Example: Zenkyoren (Japan)  has officially issued the world’s first earthquake catastrophe bond.

Global Adoption

  • After major U.S. hurricanes in the 1990s, insurers turned to cat bonds to manage large-scale disaster risks.
  • Since then, over $180 billion in cat bonds have been issued globally, with $50 billion currently active.

How Do Cat Bonds Work?

  • Sponsor: Typically, a sovereign government pays premiums and defines the disaster risk being covered.
  • Intermediaries: Organisations like the World Bank or Asian Development Bank issue the bond, ensuring trust and reducing counterparty risk.
  • Investors: Global investors, including pension funds and hedge funds, purchase the bonds attracted by higher returns and low correlation with traditional markets.
  • Trigger Conditions: Specific parameters (like magnitude or wind speed) determine if the bond pays out.
  • Cat bonds offer high returns due to the risk of losing principal in the event of a disaster.
  • These bonds are not linked to financial markets, making them a powerful tool for diversification.

Does India Need Cat Bonds?

  • India is increasingly vulnerable to floods, cyclones, wildfires, and earthquakes.
  • Insurance coverage remains low, meaning individuals and governments bear most of the loss.
  • Cat bonds can protect public finances, ensuring rapid access to reconstruction funds.
  • India’s good sovereign credit rating makes it well-positioned to secure favourable bond terms.
  • The government already allocates ₹15,000 crore ($1.8 billion) annually for disaster mitigation, which can help reduce bond premiums.

Regional Potential: A South Asian Cat Bond

  • India could lead a South Asian regional cat bond, covering risks across countries like Nepal, Bhutan, Bangladesh, Sri Lanka, and Myanmar.
  • This would:
    • Spread the financial risk
    • Lower premiums for each participant
    • Improve disaster preparedness across the region
  • Example: A regional bond could cover earthquakes in the Himalayas or tsunamis in the Indian Ocean basin.

Pros:

  • Higher Yields: Offer above-average returns compared to traditional bonds.
  • Diversification: Expose investors to non-correlated risks, enhancing portfolio resilience.
  • Alternative Reinsurance: Provide insurers with an additional channel to transfer risk.
Cons:

  • Principal Loss: Investors risk losing some or all of their investment if a trigger event occurs.
  • Coverage Gaps: Payouts may not fully match the insurer’s actual losses.
  • Climate Uncertainty: Increasing frequency and severity of disasters heighten risk exposure.

Challenges

  • Trigger issues: If the disaster doesn’t meet the exact trigger (e.g., 6.5 magnitude earthquake instead of 6.6), the bond may not pay out.
  • Public perception: If no disaster occurs, the money spent on premiums might seem wasted.
  • The solution lies in:
    • Transparent cost assessments
    • Comparing premiums with historical disaster recovery costs
    • Working with reliable risk modellers and intermediaries

The World Bank’s Capital at Risk (CAR) Notes program 

  • Through this program, the Bank issues instruments like catastrophe and pandemic bonds, where investors’ principal is partially or fully at risk.
  • In the case of CAT bonds, the World Bank acts as an intermediary—signing a risk transfer agreement with a country and issuing a bond with matching terms. This shifts part of the disaster risk to investors.
  • Investors benefit from potentially higher returns than traditional bonds and portfolio diversification through exposure to new risks and regions.

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Quick Revise Now !
UDAAN PRELIMS WALLAH
Comprehensive coverage with a concise format
Integration of PYQ within the booklet
Designed as per recent trends of Prelims questions
हिंदी में भी उपलब्ध

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