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Courting Disaster: This Is Why Catastrophe Bonds Critics Are All Wet

By Igor Greenwald on August 31, 2017

When natural disasters take lives and ruin property, money can become a touchy subject. Link an emotionally charged word like “catastrophe” with a financial instrument like a bond, and you’re liable to trigger some people without a basic understanding of the important role financial markets play in redistributing risk.

That’s what happened last week when an inexperienced advocacy journalist seized on a story about catastrophe bonds to curse “capitalism.”

The truth is that catastrophe bonds are merely another way for insurers to obtain reinsurance. Insurers sell them to lay off some of the risk of damage claims after massive natural disasters. Parceling out the risk allows them to sell more insurance, which benefits the homeowners seeking coverage. So a cat bond should be about as controversial as an insurance policy, which is really what it represents.

The way it works is that catastrophe bond investors reap yields higher than what a plain-vanilla bond of the same duration and credit quality might offer, but stand to lose some of the principal if a disaster meeting pre-agreed conditions triggers a payout to the issuer.

The tricky part is setting out the trigger. It can be based on an objective storm attribute like maximum wind speed or minimum barometric pressure, on actual or modeled industry losses or on the claims faced by the issuer.

The even trickier part is estimating the probability that a particular cat bond’s payout will be triggered and the extent of potential losses, which is what determines how much extra yield investors should demand for the added risk. The complexity of the such estimates limits the market for such securities to the most sophisticated investors such as  hedge funds.

Nevertheless, demand for cat bonds has been stoked by the chase for higher yields amid low interest rates. Another contributing factor, surely, has been the decade-long lull in U.S. hurricane losses, before Harvey. Cat bonds sales set a record during the second quarter in and demand for the securities frequently outstripped supply, according to industry publication Artemis.

In addition to the commercial insurers and private buyers, nations and multinational institutions are also players in catastrophe reinsurance. For example, earlier this month, a World Bank affiliate sold $360 million in catastrophe bonds insuring the Mexican government against earthquakes and cyclones.

And in June the World Bank debuted a ‘pandemic bond’ offering payouts to the world’s poorest countries in case of a deadly epidemic caused by some of the world’s most virulent diseases. The facility will provide up to $500 million of coverage over the next five years, with payouts based on the scale and the growth rate of an outbreak as well as the number of countries affected.

This is not about profiting from death and sickness but rather about ameliorating their cost. Buyers of catastrophe bonds profit if the worst-case scenario fails to materialize. The principle should be about as controversial as buying life insurance or health insurance.

Buyers take on a lot of risk for the extra yield. For example, the highest-yielding tranche of the Mexico catastrophe bond went off at a yield of 9.3%, despite the risk of losing as much 75% of the principal.

The social benefit of catastrophe bonds is indisputable. They increase the availability of insurance coverage and allow communities, regions and nations to recover faster from a calamity. (We’ll leave the discussion of the moral hazard inherent in all insurance transactions for another day.)

The current value proposition of cat bonds to yield-hungry investors is more controversial. I can get something close to an annualized 9% from the preferred shares of a large, diversified energy pipeline operator. And I’d be willing to bet the odds of a catastrophic loss are lower than on many varieties of cat bonds.

But I’m glad there are sophisticated buyers of large and difficult-to-calculate risks out there. As a  society, we’re better off as a result.  

 


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