As disasters strike, infrastructure crumbles and investors scramble to find value in catastrophe bonds, a new kind of debt instrument has been launched that may be welcome news.
Resilience bonds can be used to deal with all sorts of risks, from tropical storms to earthquakes. This new type of bond structure has been developed to expand financial protections in the form of insurance coverage for vulnerable communities while leveraging project finance capital for more resilient initiatives.
In a recent report, Re:focus Partners, a firm that works with municipalities, engineering firms and investors to design innovative projects, finds that as the frequency and severity of different types of disasters have grown, the gap between insured losses and economic losses has also grown. With governments and agencies struggling to meet needs with taxpayer dollars (never mind funding new resilient-centric projects), and insurance instruments designed to only pay after a disaster strikes, there is little room for preventative financing measures.
This is where resilience bonds come in. The idea for them was born out of meetings sponsored by Re:focus between disaster experts in the insurance industry and public sector.
At their essence, resilience bonds are a twist on conventional catastrophe bonds. Cat bonds, as they are known, only pay when disasters strike. They assume the risk that an insurance company might ordinarily bear. In the wake of recent hurricanes and wildfires, many cat bonds are facing losses and prices on the secondary market have been falling. As of the first quarter of 2017, the cat bond market was worth $27 billion with issuances of approximately $1.4 billion above the 10-year average.
Resilience bonds differ in that they provide a rebate that can serve as a funding mechanism for risk-reducing projects, such as seawalls and floodgates. As Re:focus describes them: “If catastrophe bonds are similar to life insurance policies that only pay out when the worst disasters strike, then resilience bonds are more like progressive health insurance programs that provide incentives to make healthy choices—quitting smoking or exercising regularly—that reduce long-term risks and the cost of care. In the case of infrastructure, this is like cities upgrading coastal protection systems or reinforcing whole neighborhoods of houses to reduce physical and financial damage from storms and floods, which in turn lowers potential losses passed up the chain to state and federal disaster budgets.”
Practically, resilience bonds work like this: The first step is for the issuer to use financial catastrophe models to validate if and how much a resilience project reduces expected losses. This is used to set the value of the resilience rebate from the reduced cost of coupon payments to investors. The second step is to capture the cost savings from the reduction in coupons paid to investors and distribute these savings to bond sponsors in the form of that resilience rebate, which can be used to finance risk reduction investments.
As business groups push for flood insurance reform, and the Federal Emergency Management Agency (FEMA) struggles with how to operate on a slashed budget, resilience bonds could be silver linings for storm investors.
