Climate change and natural disasters aren’t only a concern for the natural environment and scientific community. They’re also a major challenge for business, with impacts on investment markets, the insurance and risk management fields, the job market, and even fiscal and monetary policy, as more frequent and extreme catastrophes and the cost of preparedness take their toll.
Carolyn Chang, a professor of finance at Cal State Fullerton’s Mihaylo College of Business and Economics, notes that in the past, the federal government took the lead in bailing out people, organizations and local governments impacted by disasters.
But that’s becoming untenable with the twin threats of climate change and more Americans living in at-risk places, such as Atlantic coastlines or fire-prone Western hillsides.
“Now the cost of these disasters has become so large that the government is strained to absorb the risk. Climate change-induced disasters are a threat to governments and the insurance industry,” says Chang.
The Birth and Growth of Cat Bonds
Chang notes that this new era in disaster response and impact began in the 1990s in the aftermath of a rash of multibillion-dollar losses tied to Hurricane Andrew in South Florida in 1992, the Midwest floods of 1993 and the Northridge earthquake of 1994.
Demand for derivative financial instruments called catastrophic bonds (or “cat bonds”), which allow investors to take on the risk of natural disasters, became even more frequent after Hurricane Katrina and a series of other major hurricanes in the mid-2000s.
Today, cat bonds cover individual risks, such as earthquakes, hurricanes and even agricultural harvests that might be impacted by drought, floods or other planting disruptions.
“Disasters are high-risk propositions, so taking on that risk delivers a high return,” says Chang. “Investors seeking high returns have been hard pressed to find them in traditional corporate bond markets, as interest rates have remained very low since the 2008 financial crisis. So they’ve turned to instruments like cat bonds.”
Derivatives – financial products with a value based on the value of something else – has always been a research interest for Chang.
Right now, she’s particularly looking at cat bonds for hurricanes and other tropical cyclones (such as East Asian typhoons), which are derived from such physical measures as wind speeds, rainfall amounts and the physical size of storm conditions.
Using AI to Prepare the Financial World for Hurricanes
Hurricane forecasts, officially issued by the National Hurricane Center in Miami, but also available from a crop of private meteorological firms, are the information source that cat bond traders rely on to plan for risk and returns.
In addition to plotting the path of storms from their genesis in the open Atlantic to eventual landfall, forecasters also provide pre-season insights into likely storm activity (based on such variables as tropical atmospheric conditions and sea surface temperatures), helping financial markets prepare.
Chang’s new market-consensus hurricane forecasting model uses market transaction price changes for cat bonds to predict a given storm’s landfall and destruction, factoring in such variables as population and the strength of building construction in the impacted areas.
She argues that since transaction prices represent a consensus of all models, a market-based forecast would have an advantage over models only based on meteorology, due to the added benefits of in-house models that provide added insights and better financial-related data.
Looking at the five costliest natural disasters in the U.S. in the past generation, four have been hurricanes. Scientists aren’t certain if hurricanes will become more frequent in the future, but they do expect stronger intensities and greater rainfall rates for those storms that do form, which combined with higher sea levels and a population of more than 150 million in hurricane-prone regions, will make hurricanes a major threat in the U.S. in the 21st century.
Therefore, Chang recognizes the acute importance of her research and is looking forward to continued study to help the financial sector prepare for the winds of change.
Historically, the S&P 500, often considered the widest measure of U.S. stocks, has declined 0.2% the month after the 15 most expensive hurricanes have hit. But there’s a risk that things might be different with future storms, especially considering the increasing damage tolls and where the economy is in the business cycle at the time of landfall.
For More on Chang’s Research
Chang’s first study on hurricanes and financial markets, “Global Warming, Extreme Weather Events, and Forecasting Tropical Cyclones: A Market-Based Forward-Looking Approach,” was published in ASTIN Bulletin in 2012 and tests out the methodology in the aftermath of Hurricane Irene, which struck the Eastern Seaboard in 2011.
In her 2014 follow-up study, “Optimum Hurricane Futures Hedge in a Warming Environment: A Risk-Return Jump-Diffusion Approach,” Chang and her co-authors further develop an optimum risk-return hedge model, based on hurricane strength. That study appeared in The Journal of Risk and Insurance.
“Hedging the impact of climate change in the catastrophe space,” a 2017 study appearing in the Journal of Risk Management in Financial Institutions, further develops the hedging model in light of the latest disaster and climate change realities.
If you’re a Cal State Fullerton student or faculty or staff member, you’ll be able to access the entire text of these studies for free using your Pollak Library access.
Or read more about Chang’s research in this CSUF News article.