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Catastrophe Bonds
Context:
Amid rising climate-induced disasters and economic losses, Catastrophe Bonds (Cat Bonds) are gaining attention as innovative financial instruments, prompting discussions on India's potential role in sponsoring them for disaster risk transfer and post-disaster recovery financing.
What are Catastrophe Bonds (Cat Bonds)?
- Cat Bonds are insurance-linked securities (ILS) that allow countries or insurers to transfer catastrophic risk to capital markets.
- They function as high-yield debt instruments, where the investor may lose principal if a predefined disaster (like an earthquake or cyclone) occurs.
- Typically issued by a sovereign government through intermediaries (e.g., World Bank, ADB, reinsurance firms).
- The premium (coupon) paid is higher due to the high-risk nature of these bonds.
Global Adoption and Relevance:
- Initiated in the late 1990s, post-Hurricane Andrew in the U.S., when reinsurance capacity became insufficient.
- Over $180 billion in issuances globally; ~$50 billion currently outstanding.
- Popular with pension funds and hedge funds for portfolio diversification, as natural hazard risks are non-correlated with financial markets.
Need and Scope for India:
- India faces high disaster vulnerability: cyclones, earthquakes, floods, and wildfires.
- Rising climate-linked disaster frequency and severity raises risks to public finance and recovery efforts.
- India's credit rating and $1.8 billion/annum allocation for disaster risk reduction since FY21-22 strengthens the case for sponsoring cat bonds.
- India can lead a South Asian Cat Bond for regional risk pooling (e.g., earthquakes in Nepal/Bhutan/India, cyclones in Bay of Bengal).
Disadvantages and Precautions:
- Trigger design flaws (e.g., magnitude 6.6 threshold when a 6.5 earthquake causes damage) may prevent payouts.
- Non-occurrence of disaster may raise questions over cost-effectiveness.
- Transparent cost-benefit assessments comparing premiums paid vs historic post-disaster recovery costs are essential.
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