This is the world where high risk investors meet high risk insurance companies, and in recent years it has been a win-win scenario for both. This is an investment vehicle you probably won’t find on TDAmeritrade or the like, as it is beyond the risk/reward profile of all but the very well-funded and those who live on antacids during hurricane season. However, there aren’t many other places where you will find a 5 percent return either.
So what is a catastrophe bond? A catastrophe bond (CAT) is a high-yield debt instrument that is usually insurance-linked and meant to raise money in case of a catastrophe such as a hurricane or an earthquake. It has a special condition that states if the issuer, such as the insurance or reinsurance company, suffers a loss from a particular pre-defined catastrophe, then its obligation to pay interest and/or repay the principal is either deferred or completely forgiven. The following exhibits the mechanics behind the bond.
The question looming now is should CAT bond investors be nervous with Hurricane Florence et al. making a B-Line toward the U.S. coast with potentially billions of dollars of claims to come. The answer to date is a resounding “no.” In fact, the bonds have gained 4.3 percent this year as measured by the Swiss Re Cat Bond Total Return Index. They’re up a remarkable 20 percent from 12 months ago. And what’s more, 2018 could be the biggest year of CAT bond issuance ever.
One of the key elements of any catastrophe bond is the terms under which the securities begin to experience a loss. Catastrophe bonds utilize triggers with defined parameters which have to be met to start accumulating losses. Only when these specific conditions are met do investors begin to lose their investment.
According to Brendan Grady at KeyBanc Capital Markets, “it’s not as simple a calculation as “storm = losses” and “no disaster = profit.” Grady continues, “Part of the reason that investors are willing to take on these risks is that the bonds insure for very specific events. A bond may only cover wind damage for a Carolina Hurricane, but not flooding.” The other upside for buyers is that these bonds have little to do with the overall economy and business cycle. That makes them a strong candidate for diversification among the typical “sophisticated investor” crowd. Buyers can be pensions, endowments, family offices and hedge funds.
Risk is mitigated somewhat by the short maturity of the bonds, which is typically three to five years. In the approximately 20-year history of the security, there have been 10 transactions that have resulted in a loss to investors as of April 2016, according to the National Association of Insurance Commissioners (NAIC). Traditionally, pension funds have been the major buyers of CAT bonds. While insurance companies are the issuers of the securities.
Catastrophe modeling is vital to catastrophe bond transactions to provide analysis and measurement of events which could cause a loss as well as to define the exposed geographical region. No one wants to see damage and devastation to life or property as the result of a natural catastrophe. CAT bonds fill this niche in times of economic damage done by nature. One would imagine they are here to stay.