An Introduction to Catastrophe Bonds and the L3C  

Catastrophe bonds (or cat bonds) are high-yield debt instruments used to raise money for companies in the insurance industry in the event of a natural disaster. A bond is a financial instrument in which the issuer (a government or company) sells bonds to investors, which gives the issuer capital, raising money. They pay the investor with regular interest payments, usually twice a year, and give them back the original investment (the principal) at the end of the bond’s maturity (when it expires, usually 3 or 5 years). Catastrophe bonds do this by letting issuers receive funding from the bond if a specific condition or event occurs, like an earthquake or tornado. These bonds have a short maturity, typically 3-5 years. The main investors in them are hedge funds, pension funds, and institutional investors. Cat bonds are attractive due to their higher interest rate – higher than other fixed-income securities. This is because they aren’t typically linked to financial markets, as they are dependent on natural disasters, delivering stable interest payments when interest rates are low. As well as their enticing interest rates, they can be used for diversification, providing income in low interest rate periods, and as a lifesaver for insurance companies, providing them with money when they need it most. A type of insurance-linked security, they can be structured to be triggered based on a specific event, a specific dollar amount of damage, the number of events, or the strength of the event, making it highly customizable, almost like a bet.  

If the bond isn’t triggered, the investor walks away with the principal and the interest at the end of the bond’s maturity. If the bond is triggered, the investor will gain the interest gained before the event, but will lose the principal and the future interest, the money being transferred to the issuer, helping them pay for the damages of the trigger of the bond. The short maturity helps mitigate the risks, making it less likely for the investor to lose their money, while still providing the insurance company with some financial security and resilience.  

Climate change, which raises the strength and frequency of extreme weather events, will inevitably raise the risk to humanity and the cost of debt for developing countries. This means that government budgets have to be reallocated to provide aid when an event occurs. Policymakers therefore have to think about how they can ensure financial stability and climatic resilience. Disaster risk finance includes insurance protection and reserve funds, but cat bonds are gaining increasing attention. With the increasing impact of catastrophic events, reinsurance protection has become uneconomical, necessitating other sources of protection. 

Cat bonds began in 1992, following Hurricane Andrew, costing 26 billion USD(80-100 Billion now) in damages – bankrupting 11 insurance companies. This meant that insurance companies reduced exposure to hurricane risk and increased premiums for affected communities. This marked the beginning of the industry’s rapid adoption of catastrophe risk modeling. Public catastrophe funds were set up to address the market failure resulting from a lack of capital. The first cat bond was used to diversify the risk from one reinsurer across multiple capital markets to improve capital management in the sector. A large share of the market was used to protect from primary perils, like hurricanes and earthquakes, now growing with secondary perils, like floods, wildfires, and droughts, as these are becoming more frequent and intense.  

Issuers of cat bonds have mainly been private, although now, Jamaica and the Philippines, as well as NGOs like CCRIF, have issued sovereign cat bonds, supported by multilateral development banks, which move risk from an issuer to an investor in return for interest payments. When the bond is triggered, the issuer receives a payout from the bond, which reduces or eliminates the original principal, the interest being generated from investments in low-risk securities in a Special Purpose Vehicle(SPV). SPVs are legal entities created by a company or organisation, with its own assets and liabilities, created for a specific objective while isolating financial risk. Concerns have been raised over how ethical financialising natural hazards is, but due to the aid it provides to those who need it, it should be considered ethical and helpful. High transaction costs and resource commitments mean that cat bonds have been questioned for their cost-effectiveness, transferring risk instead of reducing it. If they become overly complex and challenging, they may be stopped, like with pandemic bonds from the World Bank. Despite this, their future is promising, due to their attractive yields, and their low correlation with conventional risks, especially while the markets are volatile.  

Their issuance reached record levels in 2023 and is expected to grow further. Both corporate entities and financial regulators are interested in cat bonds, as they are considered sustainable, promoting environmental and social objectives, triggering the expected growth in issuances, through multilateral development banks, of secondary peril coverage. The World Bank could issue the first drought cat bond in Africa in 2025, hoping to increase issuance by 400% until 2028. 

A leading example, showing the positive and helpful effects of cat bonds and insurance surrounding natural disasters, is the Lemonade Crypto Climate Coalition, or L3C. Using blockchain and cryptocurrency, they deliver affordable climate insurance to the world’s most vulnerable farmers. They are a Decentralised Autonomous Organisation (DAO), providing parametric climate and weather insurance to subsistence farmers and livestock keepers in emerging markets. A DAO is a type of digital management structure governed by smart contracts with decisions recorded on a blockchain, which removes the need for human intervention, letting everything happen securely, without much outside effort required. The coalition was formed with Avalanche, Chainlink, DAOstack, Etherisc, Hannover Re, Pula, and Tomorrow.io. The insurance is architected as a stablecoin-denominated, decentralized application on Avalanche. Farmers buy the insurance using their phones, in global stablecoins or local currency, and payments are automatically sent back to farmers on their phones, in local currency, enabling them to recover much quicker from any climate-related setbacks.  

By using a DAO instead of a traditional company, smart contracts – which are blockchain-based – take the place of insurance policies, with automatic data feeds, or oracles, replacing claims professionals; This allows them to harness the communal and decentralized aspects of web3 and real-time weather data, delivering affordable and instant climate insurance to those who need it. The Lemonade Foundation is providing the capital to backstop the DAO’s smart contracts. Hopefully, other investors will be able to fund the DAO’s liquidity pool in the future. DAOs can use securitized smart contracts and stablecoins, removing cryptos volatility, being able to deliver functionality like an SPV, and potentially welcoming insurance-linked securities or capital market funding to support their growth. It could support insurance and reinsurance businesses as a special purpose insurer or protected cell company. It is interesting when it comes to considering how tech could construct efficient ways to bring in third-party capital to new concepts of insurance. As more ventures tend to DAOs and related architecture, their applications to the ILS market in the future are fascinating.