Mentor’s Comment:  Catastrophe bonds (cat bonds) are in the spotlight as India explores innovative disaster risk financing amid rising climate-related calamities. With low disaster insurance penetration, India is considering cat bonds to strengthen post-disaster response, reduce fiscal shocks, and lead a regional South Asian initiative. Global success stories and India’s proactive mitigation funding have revived interest in adopting this financial tool.

Today’s editorial analyses the Catastrophe bonds (cat bonds). This topic is important for  GS Paper III (Disaster Management) in the UPSC mains exam.

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Let’s learn!

Why in the News?

As climate change causes more frequent disasters, countries and insurers are using cat bonds to manage risk. These bonds help raise funds from markets for recovery and rebuilding after disasters.

What are catastrophe bonds?

• Catastrophe bonds are risk-linked securities that transfer disaster risk from issuers (usually governments or insurers) to investors. They are triggered when a predefined catastrophic event (like an earthquake, cyclone, or flood) occurs.
• Eg: The World Bank issued cat bonds for Mexico and Pacific Island countries to cover tropical cyclone and earthquake risks.

How do they function as instruments for disaster risk financing?

• Governments (sponsors) pay premiums, and the principal becomes the insured sum; if a disaster hits, investors lose their principal, which goes to recovery. Intermediaries like the World Bank issue the bond, ensuring reliability and reduced counter-party risk.
• They ensure quicker payouts, reduce dependency on budget allocations, and transfer risk away from insurers to global markets.

Why is disaster risk insurance penetration low in India?

• Lack of Awareness and Financial Literacy: Many individuals, especially in rural and hazard-prone areas, are unaware of the importance or availability of disaster insurance. Eg: Farmers vulnerable to floods or droughts often rely on government relief instead of purchasing crop insurance.
• High Premium Costs and Perceived Low Returns: Insurance premiums are often considered unaffordable or unnecessary, especially when disasters seem unlikely in the short term. Eg: Urban households in seismic zones like Delhi-NCR rarely insure homes against earthquakes.
• Limited Private Sector Participation and Poor Outreach: The insurance market remains underdeveloped, with few disaster-specific products and limited last-mile delivery mechanisms. Eg: MSMEs in coastal Odisha remain uninsured despite repeated cyclone exposure due to poor insurer penetration.

How can cat bonds address this gap?

• Access to Global Capital Markets: Cat bonds transfer disaster risk from governments to global investors, increasing the funding pool for post-disaster recovery. Eg: After Hurricane Maria (2017), Mexico accessed $150 million via a World Bank-backed cat bond, enabling rapid relief.
• Ensure Quick Payouts for Emergencies: Cat bonds use trigger-based mechanisms (e.g. earthquake magnitude, wind speed) to enable fast disbursement of funds. Eg: In 2021, the Philippines received $52.5 million within weeks after Typhoon Rai, due to pre-agreed cat bond triggers.
• Reduce Fiscal Pressure on Governments: Pre-disaster financing through cat bonds helps avoid budget shocks and reduce dependency on ad-hoc aid or borrowing. Eg: A cyclone-risk cat bond for Bay of Bengal can pre-finance relief for Odisha and Andhra Pradesh.

How can India benefit from a regional South Asian cat bond?

• Shared Risk Pooling for Cost Efficiency: By joining a regional cat bond with countries like Nepal, Bangladesh, and Sri Lanka, India can pool disaster risks, reducing the premium burden and increasing affordability. Eg: The Pacific Catastrophe Risk Insurance Company (PCRIC) pools risk for Pacific island nations, lowering overall costs.
• Boosts Regional Cooperation and Preparedness: A shared bond encourages joint early warning systems, emergency planning, and data sharing, improving collective disaster readiness. Eg: SAARC Disaster Management Centre can coordinate common triggers and payout parameters across South Asia.
• Access to Larger and Diverse Capital Markets: A regional bond can attract more global investors by offering diversified risk, improving fund availability post-disaster for quick response and recovery. Eg: The World Bank’s Southeast Asia Disaster Risk Insurance Facility (SEADRIF) supports countries like Laos and Myanmar through pooled financing.

What are the key risks in designing and implementing cat bonds?

• Basis Risk (Mismatch Between Trigger and Actual Loss): There’s a risk that the bond may not pay out even when severe losses occur, if the predefined trigger (e.g., earthquake magnitude or rainfall level) is not met, undermining trust and utility.
• High Setup and Transaction Costs: Cat bonds require specialized modeling, legal structuring, and investor engagement, which may be too complex or expensive for lower-income or disaster-prone regions without external support.

Why should India diversify its disaster financing amid climate risks?

• Rising Frequency and Intensity of Disasters: Climate change is increasing the number of extreme weather events like floods, cyclones, and droughts. Sole reliance on budgetary support and relief funds is unsustainable, making diversified financing (like cat bonds, parametric insurance) essential.
• Reducing Fiscal Burden and Ensuring Faster Relief: A diversified disaster financing system helps minimize delays in post-disaster response and lessens pressure on state and central budgets, allowing for quick payouts and resilient recovery.

Way forward:

• Promote Risk-Based Financing Instruments: Encourage the use of catastrophe bonds, parametric insurance, and public-private partnerships to diversify disaster risk funding and ensure timely payouts.
• Strengthen Institutional Capacity and Data Systems: Develop robust disaster risk assessment tools, improve climate modelling, and integrate early warning systems to design effective and credible financial instruments.

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