## Online Boxes 5.1–5.3 — Physical Risk and Equity Prices

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### Online Box 5.1: Insuring against Climate Change Physical Risk: The Role of Catastrophe Bond Markets
- Definition and market role:
  - Catastrophe (CAT) bonds transfer natural disaster risk to capital markets; typically short- to medium-term, high-yield instruments with low turnover, issued primarily by insurance and reinsurance companies.
  - "Alternative reinsurance capital" accounted for 16 percent of the total amount insured by global reinsurance capital in 2019 (Aon 2019).
- Peril coverage and concentration:
  - Most important single peril: hurricanes and other storms (cyclones, typhoons, windstorms), followed by earthquakes.
  - Almost 75 percent of CAT bonds issued between 2009 and 2018 were exposed to hurricane risk.
  - More than one-quarter of CAT bonds insure against multiple perils, most of which also cover hurricane risk.
- Market size, maturities, and trends:
  - Annual issuance grew from about $3 billion in 2008 to a peak of nearly $12 billion in March 2018.
  - As of February 2020, more than $41 billion in CAT bonds were outstanding (Artemis 2020).
  - Most CAT bonds have maturities between two to four years.
  - Primary market spreads have been declining since the global financial crisis, even though expected losses from CAT bonds have been increasing on average over the past 20 years.
- Pricing and climate uncertainty:
  - In a sample of 656 CAT bonds, controlling for expected losses and other factors, exposure to hurricane disasters was associated with around a 90 basis points higher premium on average, relative to CAT bonds with no exposure to hurricanes.
  - CAT funds and institutional investors comprise 75 percent of total buyers in the CAT bond market (Aon 2019).
  - Premiums increase in the immediate aftermath of natural disasters; magnitude of this effect has decreased over time.
- Policy relevance and sovereign use:
  - Given high insurance costs and large protection gaps in developing countries, greater use of CAT bonds could benefit vulnerable countries.
  - Colombia, Chile, and Peru issued sovereign CAT bonds equivalent to $1.1 billion in 2018 alone.

### Online Box 5.2: Assessing the Impact of Climate Change Physical Risk on the Equity Risk Premium with a Long-Run Risk Model
- Model approach:
  - Builds on a stylized long-run risk (LRR) macrofinancial model and incorporates temperature-induced climatic disasters.
  - Calibrated using consumption, equity prices, market dividends data, discount rates from literature, a future temperature scenario until 2100, and a reduced-form mapping between temperature and disasters.
  - Model estimated for the United States and a representative advanced economy; simulations run using bootstrapped simulated data until 2100.
- Scenarios analyzed:
  - No warming scenario: climatic disasters remain at their current level.
  - Low warming scenario: corresponding to the RCP 2.6 scenario, in which climate change mitigation actions are implemented forcefully.
  - Medium warming scenario: corresponding to the RCP 6.0 scenario, in which some climate change mitigation actions are undertaken but emissions rise quickly up to 2060.
  - High warming scenario: corresponding to the RCP 8.5 scenario, in which no mitigation action is implemented.
- Quantitative results:
  - Model simulations, based on mean temperature projections, deliver equity risk premiums (ERPs) of 5.9 percent, 8 percent, 11.6 percent, and 13.4 percent respectively across the scenarios.
  - Under the high warming scenario, the model delivers ERPs that are on average more than twice as large as under the no warming scenario.
- Interpretation and policy relevance:
  - Climatic disasters could be a key source of long-run economic risks for equity investors.
  - Results suggest equity markets may not currently price climate change physical risk, given the lack of apparent relationship between current market-implied ERPs and model-implied ERPs under the high warming scenario.
  - Underscores importance of timely policy action to mitigate climate change and avoid possible market dislocations.

### Online Box 5.3: The Pricing of Climate Change Physical Risk into Sovereign Bonds
- Data and definitions:
  - Global sample includes 41,211 bonds, issued in 121 economies from 1990 to 2019; sample dominated by advanced economies with more than half of observations pertaining to the United States.
  - Long-term bonds defined as bonds that mature after 2040; very-long-term bonds discussed as those maturing after 2040 and another group maturing between 2025 and 2040.
  - Climate indices: indices range from 0 = low risk to 10 = high risk.
- Main empirical findings:
  - Projected changes in the occurrence of individual climate hazards (extreme heat and precipitation, heat waves and droughts, sea level rise) are not associated with higher issuance costs for long-term bonds compared to short-term bonds.
  - A rise of the Climate Change Hazard Index by 1 point increases spreads by about 8 basis points.
  - A 1-point increase in the Climate Change Physical Risk Index (range 0–10) is associated with an increase in spreads by 11 basis points.
  - When differentiating by maturity, both long-term bonds (maturing between 2025 and 2040) and very-long-term bonds (maturing after 2040) are issued at a discount when issued by countries with low climate change risk, with the effect larger for very-long-term bonds—suggesting markets expect risks to materialize over the very long term.
- Caveats:
  - Results are sensitive to the choice of climate change risk proxies.
  - Further research is required to better understand the sensitivity of sovereign bonds to climate change physical risk.

### Section 2 — Key finding and figure elements
- Key finding:
  - "Risk is priced" (label appearing twice in figure).
  - Climate change physical risks are reflected in equity prices across maturities (figure context: "Climate Change Physical Risk Index" and "By maturity structure").
- Figure numeric elements and exact textual labels:
  - Vertical axis ticks: -10, -5, 0, 5, 10, 15
  - Secondary numeric axis/ticks: 0, 2, 4, 6, 8, 10, 12
  - Additional numeric sequence shown: 20 2520 40
  - Horizontal/textual indicators: "E xt r em e heat", "E xt r em e precipitation", "Heatw ave liklihood", "Drought liklihood", "Sea level rise index", "Climate Change Ha z ar d Index"
  - Report header text: "GLOBAL FINANCIAL STABILITY REPORT—Climate Change: Physical Risk and Equity Prices"
  - Publication imprint line: "8 International Monetary Fund | April 2020"

*Source: Global Financial Stability Report—Climate Change: Physical Risk and Equity Prices, April 2020 (Online Boxes 5.1–5.3).*

### Section 1

### Online Boxes 5.1–5.3 — Physical Risk and Equity Prices

### Online Box 5.1: Insuring against Climate Change Physical Risk: The Role of Catastrophe Bond Markets
- Definition and market role:
  - Catastrophe (CAT) bonds are specialized securities that allow issuers to transfer natural disaster risk to capital markets; typically short- to medium-term, high-yield instruments with low turnover, issued primarily by insurance and reinsurance companies.
  - CAT bonds are a major component of “alternative reinsurance capital,” which accounted for 16 percent of the total amount insured by global reinsurance capital in 2019 (Aon 2019).
- Peril coverage and concentration:
  - The most important single peril covered is hurricanes and other storms (cyclones, typhoons, windstorms), followed by earthquakes.
  - By volume, almost 75 percent of CAT bonds issued between 2009 and 2018 were exposed to hurricane risk.
  - More than one-quarter of CAT bonds insure against multiple perils, most of which also cover hurricane risk.
- Market size, maturities, and trends:
  - Annual issuance grew from about $3 billion in 2008 to a peak of nearly $12 billion in March 2018.
  - As of February 2020, more than $41 billion in CAT bonds were outstanding (Artemis 2020).
  - Most CAT bonds have maturities between two to four years.
  - Primary market spreads have been declining since the global financial crisis, even though expected losses from CAT bonds have been increasing on average over the past 20 years.
- Pricing and climate uncertainty:
  - In a sample of 656 CAT bonds, controlling for expected losses and other factors, exposure to hurricane disasters was associated with around a 90 basis points higher premium on average, relative to CAT bonds with no exposure to hurricanes.
  - CAT funds and institutional investors now comprise 75 percent of total buyers in the CAT bond market (Aon 2019).
  - Premiums also increase in the immediate aftermath of natural disasters; magnitude of this effect has decreased over time.
- Policy relevance and sovereign use:
  - Given high insurance costs and large protection gaps in developing countries, greater use of CAT bonds could benefit vulnerable countries.
  - Colombia, Chile, and Peru issued sovereign CAT bonds equivalent to $1.1 billion in 2018 alone.

### Online Box 5.2: Assessing the Impact of Climate Change Physical Risk on the Equity Risk Premium with a Long-Run Risk Model
- Model approach:
  - Builds on a stylized long-run risk (LRR) macrofinancial model and incorporates temperature-induced climatic disasters.
  - Calibrated using consumption, equity prices, market dividends data, discount rates from literature, a future temperature scenario until 2100, and a reduced-form mapping between temperature and disasters.
  - Model estimated for the United States and a representative advanced economy; simulations run using bootstrapped simulated data until 2100.
- Scenarios analyzed (four):
  - A no warming scenario, in which climatic disasters remain at their current level.
  - A low warming scenario corresponding to the RCP 2.6 scenario, in which climate change mitigation actions are implemented forcefully.
  - A medium warming scenario corresponding to the RCP 6.0 scenario, in which some climate change mitigation actions are undertaken but emissions rise quickly up to 2060.
  - A high warming scenario corresponding to the RCP 8.5 scenario, in which no mitigation action is implemented.
- Quantitative results:
  - Model simulations, based on mean temperature projections, deliver equity risk premiums (ERPs) of 5.9 percent, 8 percent, 11.6 percent, and 13.4 percent respectively across the scenarios (preserving the scenario ordering in the source).
  - Under the high warming scenario, the model delivers ERPs that are on average more than twice as large as under the no warming scenario.
- Interpretation:
  - Climatic disasters could be a key source of long-run economic risks for equity investors.
  - Results suggest that equity markets may not currently price climate change physical risk, given the lack of apparent relationship between current market-implied ERPs and model-implied ERPs under the high warming scenario.
  - Underscores importance of timely policy action to mitigate climate change and avoid possible market dislocations.

### Online Box 5.3: The Pricing of Climate Change Physical Risk into Sovereign Bonds
- Data and definitions:
  - Global sample includes 41,211 bonds, issued in 121 economies from 1990 to 2019; sample dominated by advanced economies with more than half of observations pertaining to the United States.
  - Long-term bonds defined as bonds that mature after 2040; very-long-term bonds discussed as those maturing after 2040 and another group maturing between 2025 and 2040.
  - Climate indices: indices range from 0 = low risk to 10 = high risk.
- Main empirical findings:
  - Projected changes in the occurrence of individual climate hazards (extreme heat and precipitation, heat waves and droughts, sea level rise) are not associated with higher issuance costs for long-term bonds compared to short-term bonds.
  - A rise of the Climate Change Hazard Index by 1 point increases spreads by about 8 basis points.
  - A 1-point increase in the Climate Change Physical Risk Index (which captures hazard, exposure, and vulnerability; range 0–10) is associated with an increase in spreads by 11 basis points.
  - When differentiating by maturity, both long-term bonds (maturing between 2025 and 2040) and very-long-term bonds (maturing after 2040) are issued at a discount when issued by countries with low climate change risk, with the effect larger for very-long-term bonds—suggesting markets expect risks to materialize over the very long term.
- Caveats and implications:
  - Results are sensitive to the choice of climate change risk proxies.
  - Further research is required to better understand the sensitivity of sovereign bonds to climate change physical risk.

*Source: Global Financial Stability Report—Climate Change: Physical Risk and Equity Prices, April 2020 (Online Boxes 5.1–5.3).*

### Section 2

### onlinebox51 - Section 2

### Key finding: Risk is priced
- "Risk is priced" (label appearing twice in figure)
- Climate change physical risks are reflected in equity prices across maturities (figure title/context: "Climate Change Physical Risk Index" and "By maturity structure")

### Figure elements and exact numeric labels
- Vertical axis ticks: -10, -5, 0, 5, 10, 15
- Horizontal/textual indicators: "E xt r em e heat", "E xt r em e precipitation", "Heatw ave liklihood", "Drought liklihood", "Sea level rise index", "Climate Change Ha z ar d Index"
- Secondary numeric axis/ticks: 0, 2, 4, 6, 8, 10, 12
- Additional numeric sequence shown: 20 2520 40
- Report header text: "GLOBAL FINANCIAL STABILITY REPORT—Climate Change: Physical Risk and Equity Prices"
- Publication imprint line: "8 International Monetary Fund | April 2020"

### References listed in the section
- Aon Benfield. 2019. “ILS Annual Report 2019 - Alternative Capital: Strength Through Disruption.”
- Artemis. 2020. Catastrophe Bonds, Insurance Linked Securities, Reinsurance Capital & Investment, Risk Transfer Intelligence. https://www.artemis.bm/wp-content/uploads/2020/01/q4-2019-cat-bond-ils-market-report.pdf?utm_source=ReportsPage&utm_medium=Link&utm_content=Q42019Report&utm_campaign=Report
- Bansal, Ravi, and Amir Yaron. 2004."Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles." The Journal of Finance 59: 1481-1509.
- Bansal, Ravi, Dana Kiku, and Amir Yaron. 2016 "Risks for The Long Run: Estimation with Time Aggregation." Journal of Monetary Economics 82: 52-69.
- Beeler, Jason, and John Y. Campbell. 2012. “The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment.” Critical Finance Review 1 (1): 141–82.
- BlackRock. 2019. “Getting Physical. Scenario Analysis for Assessing Climate-Related Risks.” BlackRock Investment Institute. https://www.blackrock.com/ch/individual/en/insights/physical-climate-risks.
- Cebotari, Aliona, and Karim Youssef. 2020. “Natural Disaster Insurance for Sovereigns: Issues, Challenges and Optimality.” Working Paper 20 (3). International Monetary Fund, Washington DC.
- Froot, Kenneth A., and Paul G. J. O'Connell. 1999. "The Pricing of US Catastrophe Reinsurance." in the Financing of Catastrophe Risk 195-232. University of Chicago Press.
- Melecky, Martin, and Claudio Raddatz. 2011. How Do Governments Respond after Catastrophes? Natural-Disaster Shocks and the Fiscal Stance.” Policy Working Paper WPS5564, World Bank, Washington, DC.
- Moody’s. 2017. “Evaluating the Impact of Climate Change on US State and Local Issuers.”
- Painter, Marcus. 2020. “An Inconvenient Cost: The Effects of Climate Change on Municipal Bonds.” Journal of Financial Economics 135 (2): 468–82.
- Standard and Poor’s. 2014. “Climate Change Is A Global Mega-Trend for Sovereign Risk.”
- Tomunen, Tuomas. 2019. "Failure to Share Natural Disaster Risk." Working Paper.

*Source: onlinebox51 - Section 2 (onlinebox51 - Section 2, https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/onlinebox51.pdf)*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/onlinebox51.pdf_