A Quantitative Model for Climate Change Adaptation Resilience Bonds

This paper introduces a model designed to support green transition and climate change adaptation, focusing on the role of insurance companies and public authorities. As climate change accelerates, climate risks are seen as uninsurable, unless alternative risk transfer methods are employed. One such method is the issuance of Catastrophe (CAT) bonds, which allow insurers to transfer risks to financial investors. However, these instruments alone do not guarantee a reduction in climate risk or foster a green transition. Our model assumes that firms (policyholders) are exposed to catastrophic risks, which can be mitigated by adopting green technologies (which we assume to include, by extension, any form of climate change adaptation). To encourage this transition, insurance companies, with support from a public authority, periodically issue resilience bonds, similar to CAT bonds. If a sufficient number of "virtuous" firms adopt green technologies, the risk - and thus interest rates - on these bonds decrease, allowing the bonds to finance the green transition, such as offering premium discounts to the adopting firms. This creates a dynamic interaction between bond rates and the proportion of firms using green technologies.The model outlines two scenarios: one where all trajectories converge to an optimal equilibrium (where all firms adopt green technologies and bond rates are minimal), and another where a sub-optimal equilibrium occurs with fewer firms adopting green technologies and higher bond rates. The paper's main contribution is the development of a quantitative model for a green transition supported by financial instruments and public intervention, with a specific application to mitigating flood risk in Italy.