LONDON - As the world wrangles over how to fight climate change, with national leaders to meet in Copenhagen early next month, capital markets are gearing up to handle the consequences if the effort fails.

The insurance industry, including reinsurers, who distribute risk around the sector, has traditionally been the main way to hedge against hurricanes, floods and other natural disasters.

But climate change could increase the scale and frequency of these disasters so drastically in coming years that traditional insurance might become unable to handle the burden.

Much of the risk would have to be shifted into the capital markets, where financial instruments such as catastrophe bonds and hurricane futures may boom, and increasingly exotic instruments are being developed to spread the burden further.

In a more volatile risk landscape, as might be produced by climate change, the need for risk transfer instruments quickly increases, said John Seo, managing principal at Fermat Capital Management.

If we look 10 years ahead, we will see an acceleration of the need for newer, or at least more evolved, forms of insurance-linked securities (ILS) to manage reinsurer risks.

Nobody can predict with certainty the costs of climate change, but a consensus is building in financial markets that the insurance burden is likely to rise substantially. Even a successful meeting in Copenhagen might only slow global warming and an increase in violent weather patterns over coming decades.

Climate change could cut gross domestic product in countries at risk by up to a fifth by 2030, a study by the U.N.-backed Economics of Climate Adaption Working Group found this year. The hurricane-prone U.S. state of Florida could see weather-related costs knock 10 percent off its GDP each year.

A report by catastrophe modeling company AIR Worldwide, in partnership with the Association of British Insurers, said the general insurance industry might not be able to cope with the increased frequency and severity of floods and typhoons brought about by climate change.

CATASTROPHE BONDS

Ten years ago, a natural disaster that could be expected to occur once in a hundred years would have cost insurers $55 billion, Seo said. Ten years from now, it might cost $220 billion, he estimated.

One result may be rapid growth in issuance of catastrophe bonds. These are ILS which insurers use to pass on potential losses from natural disasters to investors; the bonds pay interest but if a disaster occurs and results in a specified amount of damage, the investors have to pay part of the cost.

An estimated $27 billion of cat bonds have been issued since the first such instrument was launched in 1994 -- a tiny part of the burden carried by traditional insurance. Issuance almost ground to a halt after last year's collapse of Lehman Brothers, which played a counterparty role in several cat bonds.

But issuance has rebounded dramatically in the past several months and is on track to total about $3-4 billion this year. It is expected easily to reach $5 billion in 2010, closing in on its record annual peak of $7 billion, hit in 2007.

The Lehman crisis may in fact have helped prepare the cat bond sector for growth by encouraging issuers to experiment with new collateral provisions aimed at reassuring investors.

This could eventually help cat bonds become mainstream investments, expanding the pool of active buyers beyond adventurous ones such as hedge funds to include diversified asset managers.

Another way to spread the risks of climate change is hurricane futures, which pay out to investors if the size of insurance losses exceeds a trigger level.

The Chicago Mercantile Exchange and U.S.-British insurance futures exchange IFEX have been trading hurricane futures since 2007; IFEX had its busiest-ever month for the futures in April this year, with $41.1 million in notional trades.

In June this year, Eurex became the first continental European exchange to offer the futures. They have not yet traded because of a quiet U.S. hurricane season, but Eurex is launching new contracts for 2010, aiming to attract investors who want to diversify beyond traditional asset classes such as equities.

EXOTIC INSTRUMENTS

Demand for more exotic insurance-linked instruments may also rise in coming years. They include industry loss warranties, which are derivatives triggered by the size of losses caused by an event to the entire insurance industry, and sidecars, which capture the risk of a sub-portfolio of an insurance or reinsurance company's business.

Other exotic products being developed include temperature futures, and catastrophe-linked instruments that bear a resemblance to equities.

Some governments and international organizations, looking ahead to the burden of climate change, are encouraging development of new financial instruments to cope with it.

One example is the Caribbean Catastrophe Risk Insurance Facility, which the World Bank helped to set up in 2005. It is owned and operated in the Caribbean for Caribbean governments, selling windstorm and earthquake cover to them.

The facility said in October that it was developing an excess rainfall weather derivative that might eventually be repackaged into a cat bond to spread the risk through the international capital markets.

The World Bank estimates only 3 percent of potential losses from natural disasters in developing countries are insured, against 45 percent in developed countries, and says the capital markets are important to changing this.

Societies are becoming more vulnerable as the risks they face become more interconnected, said Martin Bisping, head of non-life risk transformation at Swiss Re.

The transfer of catastrophic risk should be a key element in the financial strategy of every disaster-prone country.

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