Complex Financial Products Aren’t the Solution to Climate Change or Pandemic: Opinion

Almost exactly four years ago the World Bank announced a pioneering project, the Pandemic Emergency Financing Facility, designed to develop a new insurance market and protect the world’s poorest countries against deadly disease. The PEF, as it’s known, was supposed to release funds quickly so that governments and organizations could mobilize “earlier, faster, better planned and coordinated” responses to future pandemics.

How’s that going now that the pandemic rubber has met the global economic road? Not great—for investors or those exposed to the coronavirus’s wrath. The bonds only paid out late last month, well after the scale of the pandemic’s impact had become clear. The world’s poorest countries are now able to apply to receive some of the $195.8 million allocated for “surge responses,” such as building temporary healthcare facilities. But several public health experts have criticized the complex set of triggers necessary for the money to be released.

The fate of the PEF should be watched closely by those championing innovative finance in another corner of the public good: climate change adaptation.

Having participated in numerous panels, workshops, meetings, and “informal coffees” on the topic of financing climate adaptation, I’m familiar with the impulse to try to solve a fiendishly tough but essentially straightforward problem with an over-engineered solution. The structure of these innovative financial instruments is often brilliant, but from almost any angle, they look fundamentally ill-suited to protecting vulnerable people from disease, disaster, or climate change—like trying to crack a very hard walnut with a mobile phone.

Insurance contracts and markets are often an attractive place to start. The flagship element of the PEF, for instance, was a “pandemic bond,” a novel financial instrument based on catastrophe bonds.

Cat bonds are usually issued by reinsurance companies as a way of managing the risk that a huge disaster like a Gulf Coast hurricane could come along, which would to lead to a huge spike in claims and therefore cost the re-insurance company a lot of money. If the dreaded event occurs, the people who bought the cat bonds lose some or all of their investment, which the issuer gets to keep to fund payouts. If the event doesn’t occur within the life of the bond, the people get their money back.

Why would these investors risk losing all their capital in this way? Either way, they receive relatively high interest payments. But catastrophe bonds also have a low correlation to other market events. Big hurricanes might wreak financial devastation, but they’re no more or less likely to happen during a recession or other major markets event. When a devastating hurricane does come, most of your other investments are probably unaffected, so the loss is bearable.

The idea of using catastrophe bonds to hedge against the impacts of climate change, particularly in developing countries, is much talked about but not often seen in the wild. The fate of the pioneering pandemic bonds demonstrates why.

One of the best known attempts to apply insurance-like financing to climate-related risks is the Nature Conservancy’s scheme for protecting coral reefs in Quintana Roo, the Mexican state that’s home to the resort city of Cancun. Sometimes incorrectly described as a “bond,” it involves an arrangement with the state government whereby an existing fee paid by beachfront property owners is allocated to a trust. Those funds are then dedicated to three things: paying for ongoing reef maintenance work by marine biologists; taking out an insurance policy against weather risk; and setting aside as a safety net.

The World Bank hoped its pandemic bonds would spur the development of a whole new market in securitized risk; so, too, does the Nature Conservancy with its coral reefs. But as we saw in the throes of the pandemic, the people most in need of protection from something like a catastrophe bond are the ones least likely to be able to offer attractive terms to investors. The Quintana Roo vehicle is based on the existing stream of fees generated by one of the world’s premier resort destinations. Vulnerable groups and those protecting natural assets less lucrative than the Yucatan coast have neither the spare cash nor the information advantage to benefit from these sorts of bets.

A further problem with these products is that they’re only likely to be bought by investors who think risk is overpriced, and the whole problem with climate change is that risk is dramatically underpriced. After losing their principle on the first pandemic bond, investors will be less enthusiastic about the next one, and seek terms still less favorable to the issuers. As the risks of climate change increase, so too will the cost of buying insurance against it.

It’s hard not to conclude that the main reason to bring in private finance is simply to come up with any answer that doesn’t sound like “governments have to pay” or “regulations.” Sometimes new markets can be breathed into existence—but sometimes, as with pandemic bonds, they prove ill-suited to the enormous tasks we want them to fulfill.

Related:

• Pandemic Bonds Get Stay of Execution but Prospect of Wipeout Looms
• This Insurance Would Have Helped in Coronavirus Crisis But Nobody Bought It
• Coronavirus Outbreak Exposes Flaws in Design of Pandemic Bonds
• Coronavirus Likely to Trigger Pandemic Bond Payouts to Poor Countries
• Catastrophe Bond Prices Signal Coronavirus Nearing Pandemic Status
• World Bank Pandemic Bond Losing Value, Facing Criticism as Coronavirus Spreads
• Why Year-Long Ebola Outbreak Hasn’t Triggered Payout from Pandemic Insurance

Topics Catastrophe Climate Change COVID-19