Why the Danish Red Cross put a volcano catastrophe bond on a blockchain

Last month, the Danish Red Cross drew mainstream news headlines for helping issue the first blockchain-based volcano catastrophe bond.

So-called “cat” bonds are a way to securitize insurance risk. Investors in cat bonds can earn a high yield for taking on this risk, but if the covered catastrophe actually happens, the money goes toward providing disaster relief.

The goal of the Danish Red Cross’s new cat bond is to provide insurance for communities vulnerable to active volcanoes. A total of 700,000 people live within 60 miles of one of the ten volcanoes — which span multiple continents — covered by the bond.

But why does it need a blockchain?

Volcano bonds

Before we go any further on the topic of blockchain-based cat bonds, let’s review cat bonds in general.

A cat bond is typically a way to transfer insurance risk to capital investors. Firms that provide insurance against natural disasters generally take out their own insurance policies, called reinsurance, to protect against the financial risk of the disaster actually happening. That insurance risk can also be securitized and turned into a tradable asset.

Investors in cat bonds stand to make money if the covered event does not happen during a specified timeframe. If it does happen, the money goes toward disaster relief.

There are two main reasons why investors find cat bonds attractive, says Rob Hoyt, a professor of risk management and insurance at the University of Georgia. First, cat bonds tend to have relatively high rates of return compared with corporate bonds. Second, “the risk that underlies this particular security is one that tends to be relatively uncorrelated with market risk — and that is very hard to find,” according to Hoyt.

A volcano erupting in Iceland won’t affect the Japanese economy, he adds, and a security whose risk is independent of market risk is valuable to some investors looking to diversify their portfolios.

As for the other side of the trade — the payout for relief in case of a disaster — cat bonds typically rely on a "parametric trigger," which means that a physical aspect of the natural event triggers the bond’s payout. For a bond that covers volcano eruptions, the trigger can be the height of the ash cloud.

The U.S. Geological Survey states that ashfall is “the most widespread and frequent volcanic hazard," as ash falling from a volcano eruption can damage buildings and debilitate critical infrastructure. Along with wind measurements, ash cloud metrics can be used to predict the location and extent of the damage the disaster will cause.

According to Alejandro Marti, CEO of Mitiga Solutions, a Barcelona-based risk management company that created the new bond’s parametric trigger system, the plume height threshold for each of the 10 volcanoes and was determined based on historical records of eruption frequency, intensity, and relative explosiveness.

“Each volcano has more than one ash plume trigger height associated with a percentage payout; the higher that trigger level, the higher the payout,” Marti says. Wind direction also factors into bond payout, he says.

Why blockchain?

The Danish Red Cross declined to comment for this article other than to confirm the news report about the blockchain-based cat bond. But in a YouTube video of a conference talk given in 2019, Adam Bornstein, who heads the Innovative Finance and System Change team at the Danish Red Cross, explained the thinking behind turning this bond into a digital asset.

The organization issued its first volcano cat bond in 2019 in an attempt to become more proactive in natural disasters. Bornstein explained in the talk that his organization was drawn to cat bonds because it wanted a better alternative to the “crisis, response, appeal for money, repeat” cycle. Cat bonds allow it to raise the cash beforehand so that it is available to pay out immediately.

According to a website maintained by Replexus, Mitiga, and the Danish Red Cross, issuing the $3 million volcano bond using a blockchain saves substantial amounts of cash that traditionally must be paid for clearing, documentation, custodial, and administrative services from third party securities settlement institutions like Euroclear or the Depository Trust Company.

“We applied the blockchain to it because we can actually cut out about $400,000 to $500,000 fees from banks,” Bornstein said during the 2019 talk.

The new bond will be issued to investors on a permissioned blockchain platform called ILSBlox developed by a startup called Replexus. Each bondholder will be responsible for the custody of their digital asset.

The advantages of using a blockchain are twofold, according to Replexus CEO and co-founder Cedric Edmonds. It makes issuing and holding custody of the bond much cheaper than it is to do so via conventional means. This approach also expedites the bond settlement and trading process for investors who want to buy or sell the asset on a secondary market. Instead of taking three days to settle a trade it only takes seconds, says Edmonds.

If during the three-year lifetime of the bond one of the covered volcanoes erupts and its ash cloud reaches a threshold height, Mitiga would trigger a payout of the relief funds. Replexus, as the bond’s paying agent, would then be responsible for getting the money to an appropriate bank account controlled by the Danish Red Cross.

Placing cat bonds on blockchain “is a unique transaction that we’ve been hearing about for a couple years now,” says Chris Grimes, a director in the insurance group at Fitch Ratings, a credit rating agency.

Now the idea behind the arrangement will have its first real-world test. “It's one thing to hear the theories around blockchain, but another to see how that actual process would flow through,” Grimes says.