The path that the typical insurance policy takes from homeowner to payout in the event of a catastrophe is complex. A homeowner buying a flood or earthquake insurance policy pays an annual premium to an insurance carrier, who services the policy and pays the homeowner in the event of a claim. Behind the scenes though, that risk doesn’t just sit on the insurer’s book. Instead, the insurer buys its own insurance policy in the form of reinsurance, enabling them to spread risk more broadly and avoid concentrated exposure to specific risks.
Over the past two decades, the advent of catastrophe bonds has begun to reshape the reinsurance industry. Where reinsurance has historically been underwritten by a small set of large specialized companies, catastrophe bonds have emerged to securitize risk. Much like a typical corporate bond, catastrophe bonds pay a periodic couponto holders and bear the risk of an underlying catastrophe--an earthquake in California, a typhoon in Hong Kong.
Far from competing with reinsurance, catastrophe bonds are serving as a complement by tapping new pools of capital to help bear the increasingly large and costly risks associated with climate change. With $30 billion outstanding, catastrophe bonds have grown large enough to begin to help drive down the cost of insuring costly or even uninsurable risks. While not without their critics, catastrophe bonds are likely to continue to grow. Complemented by technology-enabled insurance distribution, insurance is moving in the same direction as credit, with large, diverse pools of capital investing in a growing share of risks.