The following post is a part of a series that discusses 'managing risk for development,' the theme of the World Bank’s upcoming World Development Report 2014.
One thing financial markets are good at is innovating and creating new instruments that meet the ever-evolving needs of investors and economic agents managing their risks (such as national or subnational governments). In the mid-1990s, after hurricane Andrew and the Northridge earthquake in the United States, it became increasingly clear that some risks were too big to insure with existing instruments. This matters most to governments and insurers who have to pick up the pieces after a natural disaster as the frequency and cost of natural hazards have been increasing over the past few decades.
In the aftermath of a natural disaster, governments have to shift budgetary resources away from new investments for development to relief and reconstruction efforts. For insurance companies, catastrophic events can put pressure on their financial viability. One way to relieve the pressure is to transfer such risks to capital markets. That is how catastrophe bonds (cat-bonds) were born, as financial instruments to further disperse the risk of natural disasters more broadly and use the risk-taking capacity of institutional investors worldwide.