Last weekend’s tropical storm Fay, which brought heavy rain and high winds to much of the U.S. East Coast, was a record-breaker.
It’s not that Fay was particularly fierce—although six people were killed in flooding and rip tides and the weather system caused an estimated $400 million in damage. But Fay was the sixth named Atlantic storm of the 2020 and the third to make landfall in the U.S.
The hurricane season only began on June 1 and this is the first time there have been so many tropical storms so early in the year.
Fay seemed to confirm a series of predictions, put out by government, academic and private weather forecasters, that 2020 will be a busier-than-usual Atlantic hurricane season. For many, those prognostications are further evidence that 2020 is a cursed year: with the Covid-19 pandemic still raging, did we really need more Biblical plagues?
But for a special breed of investor in an obscure corner of the market, the confluence of catastrophes spells opportunity: welcome to the cat bond market, where the risk of calamity is finely weighed and parceled out in tranches, and where a wildfire in the San Gabriel Mountains or a Category 5 beast churning up the Gulf Stream towards Miami, coming on top of a global pandemic, can make for a very profitable year—or a complete wipeout.
Catastrophe bonds, or cat bonds for short, have been around since the early 1990s. They were created after the insurance industry experienced debilitating losses from 1992’s Hurricane Andrew, and were designed so that insurers could further hedge their risk.
In essence, cat bonds are an alternative form of reinsurance. Insurance companies—or sometimes reinsurance companies, themselves looking for a backstop—issue a bond to cover the risk from one kind of catastrophe in a particular location for a certain number of years: a named tropical storm hitting Florida, California wildfires, U.S. earthquakes or European wind storms.
If that event occurs during the life of the bond and—importantly, for most cat bonds—if the insured losses are above a pre-specified threshold, the creditors forfeit their principal, which the insurance company can use to pay claims. In exchange for taking on that risk, the investors earn an unusually high interest rate—between about 7% and 12% for many bonds. Investors also like that cat bonds aren’t correlated to other financial markets—after all, movements in the S&P 500 don’t move the San Andreas Fault—so they were good for portfolio diversification. What’s more, the investments are actually less risky than say, junk bonds, or many equities, Kumar says. Expected loss ratios generally average in the low- to mid-single digit percentages, and the cases in which investors have lost their entire principal are relatively rare.
A banner year
Cat bond issuance was at record levels prior the COVID-19 pandemic. In all of 2019, $11 billion worth of cat bonds and related securities were issued. So far this year, $9.2 billion have been sold in 34 different transactions, according to data from Artemis, a company that tracks the market for what are known as “insurance-linked securities” (or ILS), of which cat bonds are one type. That puts 2020 on track to exceed the $13.8 billion issued in 2018, which the industry’s biggest year so far.
The start of the pandemic saw a flurry of cat bond trading, with more than $2 billion in bonds trading hands in March as hedge funds sought to take profits and use them to cover losses elsewhere in their portfolios, says Shiv Kumar, the CEO of MMC Securities and president of reinsurance broker Guy Carpenter, both of which are part of insurance services firm Marsh & McLennan Companies.
Cat bond values held up well—an index of cat bonds was down just 1% in the second quarter of 2020 compared to a 20% decline in the S&P 500—and the market is supported by a number of specialized money managers, backed by pension funds and endowments, that only invest cat bonds and other ILS instruments, Kumar says. Issuance of new bonds has also remained strong since the pandemic began, with 17 bonds coming to market since March. This includes a $100 million bond issued by the New York City Metropolitan Transport Authority to cover the risk of severe flooding from a storm surge, like 2012’s Hurricane Sandy, or an earthquake.
Maren Josefs, a credit analyst at S&P Global Ratings who covers the cat bond market, says the large number of new bonds on offer reflects two factors: insurance and reinsurance companies needed to replace about $4.6 billion worth of existing bonds that matured in the second quarter of 2020. Additionally, losses—both in terms of business interruption coverage and life insurance from COVID-19, plus a fair number of natural disasters over the past few years—have left insurers and reinsurers with less capacity to absorb additional losses, so they’ve had to turn to the cat bond market.
Location, location, location
An unusually busy hurricane season is not, cat bond experts say, something to spook a market dedicated to wagering on disaster. “We do not expect a drop in new issuance due to the hurricane season forecast,” S&P’s Josefs says.
The frequency of storms, and even their severity, matters far less to cat bond investors than whether a storm strikes a populated area with high property values. “Catastrophes are like real estate, it is location, location, location,” Karen Clark, the co-founder and CEO of Karen Clark & Company, a firm that licenses sophisticated loss models to insurers who issue cat bonds and funds that invest in them.
John Seo, co-founder and managing director Fermat Capital Management, a $7 billion fund that invests in cat bonds and other insurance-related instruments, notes that a busier-than-normal hurricane season has been forecast every year since 2006. The models cat bond investors use to gauge risk already “bake that in,” he says.
But COVID-19 actually increases the risks from hurricanes: fear of moving people into crowded shelters that could become breeding grounds for the infection might make it difficult to evacuate people from the path of storms.
As importantly, concerns about infection may make it more difficult for insurance companies to send loss adjustors into an area after a disaster or for clean-up and construction crews to come in and repair the damage. Past experience has shown that delays in processing claims can result in a big bump in overall losses. Clark says this could push insured losses past the thresholds at which they “attach” to a cat bond, causing investors to begin to lose their principal.
A bull market for cat bonds
Seo says that cat bond investors are demanding an extra .5% to 1% in coupon rates to compensate for this added risk. But what’s curious about the market at the moment, he says, is that cat bond yields have risen well past these levels. Josefs notes that Lane Financial’s index of cat bonds and other ILS security rates is up 25% in the first half of 2020.
The reason, he says, is more about simple supply and demand rather than concerns about impending Armageddon. With so many bonds coming to market, issuers are having to offer high coupons to fill their order books.
Those outsized yields, coming at a time when interest rates for almost everything else are at historic lows, are drawing more and more asset managers into cat bonds. Demand for cat bonds is especially strong in the secondary market, where existing securities trade hands, Seo says. Every morning he gets an email—the cat bond market is conducted entirely over-the-counter, with no centralized exchange—listing those offering to buy or sell bonds, and buyers currently exceed sellers by about 10-to-1, he says.
There are nascent signs the market might be starting to adjust. Christopher Grimes, an analyst who covers cat bonds for ratings agency Fitch, says that the coupon rates being demanded for some catastrophes—like a major hurricane hitting South Florida—have gotten so high that insurance companies are starting to pull out of the market. He notes that Florida Citizens Property Insurance pulled the issuance of a $200 million cat bond tranche in May citing investors seeking “irrational returns.”
Memories of Fay are already fading fast. But if the storm does wind up becoming a harbinger, and the forecast proves correct, expect plenty of action in the cat bond market this year. Trading in and out of particular cat bonds usually heats up in the day or two before storms make landfall, as investors use proprietary forecasting models to try to predict exactly where a storm might hit and what kind of losses it could cause.
The Covid-19 pandemic has hit insurance companies hard, with many unresolved issues over business interruption claims—and, with the tragic number of deaths, higher-than-expected life insurance claims.
The World Health Organization did issue a special kind of cat bond back in 2016 to help it deal with a future pandemic. That bond was triggered—wiping out the principal for some bond holders—by the year’s COVID-19. (The bond was what is called a parametric cat bond: it pays out if a certain event, defined in the bond’s terms, occurs, as opposed to having a trigger set to a dollar value of insured losses.) But for the most part, cat bonds have not been issued for pandemics. Kumar says this because, as COVID-19 makes clear, pandemics are not uncorrelated with other financial market losses and so the diversification advantage isn’t there.
But Seo, who says he lost money on the WHO pandemic bonds, thinks there could be a thriving market for cat bonds linked to pandemics and other unusual risks not currently covered by the market. The reason? He says investors already implicitly bear the risk of such catastrophes—whether it be a pandemic or a major volcanic eruption— tanking financial markets, but they aren’t receiving any compensation for it. What a cat bond does, he says, is make that risk explicit and allow investors to collect on it. So, for sophisticated institutional investors like pension funds and endowments, it bolsters their portfolio optimization metrics, Seo says.
Clark says that while cat bonds might be useful for mitigating future pandemic risk, the difficulty of modeling disease outbreaks and understanding the extent of losses, might cause problems for structuring the investments. They would almost certainly have to be parametric bonds, triggered by the event itself, rather than actual losses, she says.
In addition to pandemics, parametric cat bonds have been issued from time to time to cover unusual events—volcanic eruptions and even meteor strikes, Fitch’s Grimes says.
Why not? After all, futurist Barbara Marx Hubbard once said catastrophe and creation are twins. She wasn’t talking about the bond market, but she might as well have been.
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