(Bloomberg Businessweek) -- The year 2017 turned out to be a big test for one of the odder financial assets on the market: catastrophe bonds. They’re essentially a way for insurers to protect themselves against high costs from natural disasters—and for investors to bet on earning a steady return as long as those disasters don’t happen.
Recent hurricanes across the Atlantic are estimated to have caused more than $200 billion in damage. Through early October 2017, the U.S. was hit by 15 weather events that cost $1 billion or more each, according to the National Centers for Environmental Information. That’s one short of the record set in 2011 and doesn’t include the costs of the recent wildfires in California. By and large, the $90 billion catastrophe bond market survived intact.
Investors who owned the bonds suffered losses, to be sure. The Stone Ridge Reinsurance Risk Premium Interval Fund, which owns catastrophe bonds, tumbled more than 11 percent in 2017. The Swiss Re Cat Bond Total Return Index, a widely used gauge of the market’s performance, lost more than 15 percent in one bad week, then recovered to end the year basically unchanged. The pain was a sign of health. If investors don’t take a hit in bad years, the bonds probably aren’t doing their job providing protection to the issuers.
Here’s a simplified model of how a cat bond works: If an insurer wants to protect itself against insurmountable losses—generally for risks expected to happen once in 50 or 100 years—it can issue a cat bond to investors. The proceeds are set aside to help pay future disaster claims. If there’s no disaster, the bondholders get interest payments and their principal back when the bond matures. But when a so-called trigger event occurs, the bond issuer gets to use some or all of the money to pay for damages, and investors eat the cost in the form of a lower payout.
At the beginning of the hurricane season, about 13 catastrophe bonds were considered to be at risk of being downgraded by S&P Global Ratings. So far, only one has been. Some chalk this up to smarter underwriting by insurers. “The industry has gotten a much better grasp on risk management,” says David Havens, an analyst at Imperial Capital LLC who tracks insurers. In the almost 20-year history of the market, there have been very few instances in which a cat bond has been completely wiped out.
“The market has exceeded my expectations as far as resiliency this year,” says Michael Millette, former head of structured finance at Goldman Sachs Group Inc., who helped the bank develop a market for cat bonds in the 1990s. He now helps run Hudson Structured Capital Management, which makes some catastrophe-related bets. “Losses were consistent with the losses that investors felt should have occurred from events like these.”
Hedge funds, pensions, and high-net-worth individuals are drawn to cat bonds by the yields, which are higher than those available on conventional corporate or government bonds. Another appealing feature is diversification: The value of cat bonds usually doesn’t rise and fall in lockstep with other assets; the risk of a hurricane doesn’t have much to do with, say, the pace of corporate earnings. KKR & Co. has bet on the market by taking a stake in hedge fund Nephila Capital Ltd., which oversees more than $10 billion mostly invested in cat bonds. The development of the market has led investment bankers and brokers to envision more complicated offerings. Underwriters are considering bonds for pandemics, terrorism, and cyberrisks.
The caveat is that the market may have had a bigger loss this year if the wind had blown in a different direction. A large swath of existing bonds helps insure weather risks in Florida, which was spared the worst of Hurricane Irma when its path swerved. Before Irma made landfall in Florida, some analysts said it could have caused as much as $200 billion in damages. After the storm changed direction, forecasts of damages slipped to a quarter of that.
And then there’s the question of whether investors have accounted for the potential long-term risks of climate change. Millette says there’s one thing that could ultimately crush investors’ faith in the market: “If we had year after year after year like this, and investors would say, ‘Look, this is not a bad year. This is normal.’ ”—With Brian K. Sullivan and Jim Efstathiou Jr.
Updates with the name of Michael Millette’s firm in the sixth paragraph.
To contact the authors of this story: Sonali Basak in New York at sbasak7@bloomberg.net, Brandon Kochkodin in New York at bkochkodin@bloomberg.net.
To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net.
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