Climate perils inspire new investment products

Climate perils are pushing insurers to explore new ways to diversify risk, likewise inspiring new investment products. Earlier this year, TD Insurance issued the first Canadian catastrophe bond tied to the risk of earthquakes and severe convective storms, such as hurricanes, hailstorms, derechos and tornadoes, within Canada.

Colloquially known as “cat” bonds, the bonds are primarily instruments to serve insurers’ purposes, but they have implications for policy holders and investors. That includes the potential to mitigate rising premiums and options for diversifying investment portfolios that could align with climate action agendas. The Canadian debut follows what’s characterized as a correction in the global reinsurance market that has generally translated into higher rates, more stringent terms and changes in the weighting of risk.

“As the frequency and severity of natural catastrophes increases, it’s very important that we evolve our approach to stay ahead of those loss trends,” observed James Russell, president and chief executive officer of TD Insurance, during a recent webinar sponsored by the financial ratings agency, Morningstar DBRS. “The traditional approach to managing this risk is to increase the amount of reinsurance purchased. That also drives up costs and that’s where diversification can help. This is where the cat bond really fits in.”

Cat bonds have emerged over the past decade as a means for issuers — typically insurance companies and governments — to transfer risk to the capital markets. Proceeds from the bond placement are invested in high-yield, highly liquid securities, which are held in a trust account as collateral and then paid out if or when insurance claims related to a single specified kind of catastrophic event reach a triggering level.

The bonds have a fixed term, maturing in one to five years. Investors receive the interest on the securities in the collateral account and an additional risk premium over that period. However, they could lose part or all of their principal depending on the volume of payouts during the bond term.

The fixed term is the attractive element for bond sponsors, allowing them to lock in protection for a multi-year period and hedge against a fluctuating reinsurance market. For investors, there is an opportunity for robust returns with what can be a low probability of loss, depending on the bond parameters. In the case of the TD Insurance bond, for example, payout from the collateral account is triggered when a qualifying event exceeds CAD $2.35 billion in claims, but is terminated once claims surpass CAD $2.5 billion.

“I believe the modelled risk was 0.4 per cent,” Russell noted. “So, investors get a risk premium (3.29 per cent), which is greater than the probability of reaching this.”

Victor Adesanya, vice president, global insurance and pension ratings, with Morningstar DBRS, cited data from Swiss Re showing that cat bonds delivered a 17.29 per cent average return, globally, to investors last year, down from the record high of 19.69 per cent in 2023. Across a broader portfolio, the bonds could be described as nonconformists dancing to their own tune.

“Cat bonds have a low correlation to traditional investments. The outcome depends on the occurrence or non-occurrence of a specific event so certain market events wouldn’t affect a cat bond,” Adesanya advised. “That low correlation gives a good mix to a portfolio.”

At CAD $150 million, TD Insurance’s three-year bond is a small portion of the roughly USD $7 billion in cat bonds that have been issued thus far in 2025. Insurers based in the United States, such as Allstate, USAA, California Earthquake Authority and State Farm, have been among the most active sponsors.

“Most of the cat bonds issued are for U.S. perils,” Adesanya affirmed. “It’s understandable because the U.S. has a big exposure to catastrophe risk. They’ve got hurricane season, earthquakes in California and wildfires.”

Russell suggests the Canadian bond now offers a new element of diversification within the alternative asset class since it is tied to different perils. He reported “overwhelming positive response from investors and reinsurance partners” to the first bond placement. Notably, the risk premium could be set at the low end of the initial price guidance on the risk spread — 3.25 to 3.75 per cent — based on investor willingness.

The European Bank for Reconstruction and Development (EBRD) provides the backing for the collateral trust account, representing the financial institution’s first Canadian-denominated debt security, or maple bond. This ticked some key boxes, including the stature to attract global investors’ interest and meet the criteria for high-quality collateral, while also giving TD Insurance access to new reinsurance capital with no exposure to currency exchange risk. In turn, EBRD gained entrance to a new market.

“While the likelihood of reaching this level of catastrophe is very low based on the expectancy of a catastrophic event of this magnitude of event occurring, this investment gives us options to diversify our protection sources,” Russell said. “I’d say with the increasing frequency and severity of climate-related events, we’ll continue to explore options toward more resilient ways to manage our financial impacts.”

“On the Canadian side, we may see more companies follow what TD has done in terms of issuing a cat bond,” Adesanya added. “I think the demand for cat bonds in the future will grow.”

Efforts to manage and mitigate physical climate risk are also necessary to fill out this picture. Losses related to natural catastrophes climbed to a record high, surpassing CAD $8 billion in Canada last year, with about half of that total attributed to hailstorms and wildfires in Alberta. Russell underscored the importance of embedding climate risk management into infrastructure strategies, development planning and building codes.

“If we think about more resilient reconstruction of properties and mitigation in catastrophic-prone areas like flood zones and other things, there are ways to actually reduce costs and the impact of catastrophes on claims,” he said. “It’s really important that good behaviour by clients is rewarded to prevent losses.”