So, who pays for these losses? Prior to Hurricane Katrina in 2005, the majority of the costs of natural disasters were paid by insurance companies (57 percent) with a decidedly lower share borne by the federal government (26 percent). The balance was covered by businesses, state governments, charities and individuals.
Following Hurricane Katrina, that picture changed dramatically. According to the Federal Reserve Bank of New York, the federal government now pays the majority of all costs associated with natural disasters. To be sure, there are compelling reasons for the federal government to step up when tragedy strikes. Nonetheless, the growing frequency and severity of natural disasters is straining the resources of the government. By some estimates, the US spent more than $135 billion on disaster relief in just the last two years. The federal government has become the de facto insurer of last resort.
Fortunately, a tool has been developed – called a catastrophe bond – that can shift a portion of this risk, and cost, away from the government and back to the private sector.
A bit of history. After Hurricane Andrew devastated Florida in 1992, insurers needed a way to shift, or "cede", a portion of the risk of natural catastrophes off their balance sheets. Insurers created the idea of "catastrophe bonds." The instrument works as follows. Insurers offer to pay private investors a specified return of, say, 5 percent. The bond pays out that return at the end of one year unless a "trigger" is met - for example, a Category 4 hurricane in Florida or a 7.0 Magnitude earthquake in California.
Since 1994, more than 200 catastrophe bonds have been placed in the market. For insurers, the instruments have proven effective risk management tools. For investors, the bonds are attractive because they are not correlated to any other financial investment - for example, the stock market.
And here is the important twist. Innovative governments have begun to embrace this private sector solution as part of integrated risk management strategies.
In 2006, Mexico became one of the first countries to issue a cat bond. Eager to mitigate the financial risk of earthquakes and to ensure its ability to deploy disaster funds quickly, the Mexican Government placed a $160 million cat bond. The experiment proved so successful that, in 2009, Mexico issued a "MultiCat" bond that was expanded to cover hurricane risk as well.
In Turkey, the Government recently decided to place a $100 million bond to mitigate earthquake risk. In the current, low-interest rate environment, the bond proved so popular among investors that Turkey quadrupled the size of the bond to $400 million. With a yield of 2.5 percent, the Turkish Catastrophe Insurance Pool effectively purchased $400 million of earthquake protection for an annual "premium" of $10 million.
A handful of state governments in the US have also been early adopters. In 2009, North Carolina became the first state government to issue a cat bond for hurricane risk. In 2011, California sponsored a $200 million bond for earthquake risk.