Gulf could turn a crisis into opportunity with catastrophe bonds

Eva Manez/Reuters

• ‘Cat’ bonds take risk of disaster
• Insurance could aid government
• High returns for investors

Torrential rains, flash floods, cars adrift in streets turned into rivers – these are scenes often seen these days, from Malaysia to Valencia.

They are also becoming more common in the Gulf.

Flooding in April 2024 in the UAE, for example, killed five people and cost $1.8-$2.3 billion in property damage, according to Gallagher Re reinsurance brokerage. 

In July 2022 torrential rains in the northern Emirates killed seven people and  caused millions of dirhams worth of damage. 

In 2021 Cyclone Shaheen hit Oman, killing 14 and causing damage costing about $100 million, according to the Omani authorities.

Up to now the financial costs of these disasters have largely been borne by governments. 

Yet, with many predicting that these extreme weather events will become more frequent and more damaging, other responses may also have to be considered.

“With the Gulf region facing more frequent extreme weather events,” Aisha Said Al-Sarihi, from the National University of Singapore’s Middle East Institute, tells AGBI that “Gulf countries have to prepare for such risks, not just react to them.”

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One way to prepare could be by investing in a financial instrument with a hint of the apocalypse to it: the catastrophe, or Cat, bond.  

“One-point-five degrees to 2 degrees and more of continuous global warming would put the region in extreme danger of crises like water scarcity, extreme heat and sandstorms,” says Vijay Valecha, chief investment officer at Century Financial in Dubai. 

Faced with this, “the scope and possibility of Cat issuance could further fructify as primary entities look for additional sources to raise and mitigate their risks,” he says.

So how might Cat bonds help?

Hedging bets

Cat bonds are insurance-linked securities that transfer risk from the insurer to any investor willing to bet on a contractually pre-defined catastrophe not occurring. 

If the disaster does happen, the investor may lose part – or even all – of the capital they have invested in the bond. 

If it does not, then there is a major reward as a result. 

As an example of how big that reward can be, in 2023 Cat bonds on the Swiss Re Global Cat Bond Index posted a 19.7 percent gain. That compared with an 8 percent global industry benchmark for hedge fund strategies that year, according to Bloomberg.

As storms and floods have increased in frequency, Cat bond issuance has also been surging, with an all-time high in 2023. About $16.4 billion of these were issued that year worldwide, says consultancy Artemis, expanding the total outstanding market to $45 billion.

According to Century Financial 2024 has also been good, with the Swiss Re Cat bond index posting returns of 16 percent, year-to-date.

“While Cat bonds are bad for investors should the natural calamity tied to the bond arise,” says Valecha, “in ordinary times, for the investor, the underlying interest rates are not tied to the current financial market conditions.”

Instead, Cat bonds return a floating stream of payments to retail investors so that even at times of low interest rates average high yields are maintained.

With Cat bonds linked only to whether or not a disaster happens, this can also make them counter-cyclical, helping investors both hedge and diversify.

The result has been highly lucrative for those willing to participate.

“The underlying Swiss Re Index has had just one negative year across its 23-year history,” says Valecha.

Amr Alfiky/Reuters

Heading to the Gulf?

Currently, Cat bonds are largely confined to the Western hemisphere and Europe. 

“In order for insurance linked securities to blossom there needs to be good insurance penetration and/or government support,” says Jeff Mohrenweiser, a senior director of the insurance team at Fitch Ratings.

Despite steady growth in the regional insurance sector, penetration rates remain low, with a GCC average of 1.5 percent, compared to 12 percent in the US, according to CME. 

At the same time, “investors are looking for uncorrelated risks with a good return, but also for risks that are well understood,” says Gerald Glombicki, an expert in insurance linked securities at Fitch. 

In the Gulf potential disasters include drought and flash flooding, which may be problematic when it comes to classifying their scope and nature.

In addition, “it is unknown how well the Cat bond’s premium issuance and loss pay out coverage would comply with the broader sharia-compliant framework,” says Valecha. 

Sharia-compliant insurance, or takaful, is a key part of the GCC insurance landscape.

In the region, too, “the dominant mindset is that the government should take action in response to disasters,” says Al-Sarihi. 

The region’s largely wealthy governments have been able to rebuild and compensate for losses directly, up to now.

Yet, in future, this may change. 

“Climate risks and disasters have not been happening with this frequency in the region in previous decades,” says Al-Sarihi. 

“Governments are also dealing with a lot of other challenges, such as economic diversification and the impact of the energy transition. 

“Climate risks are costly, and while the government can shoulder the burden to some extent, they can’t cover everything,” Al-Sarihi says.

Cat bonds may be one way to start bridging the gap.