Investors’ Bets on Mother Nature Are Paying Off Big | Mint

Investors’ Bets on Mother Nature Are Paying Off Big

In exchange for a high annual yield, hedge funds, pensions and wealthy individuals were willing to put up cash that they might lose in the event of a specified weather event or insurance loss.
In exchange for a high annual yield, hedge funds, pensions and wealthy individuals were willing to put up cash that they might lose in the event of a specified weather event or insurance loss.

Summary

Thanks to turmoil in the insurance market and a repricing of risk, catastrophe bonds are earning more while covering more remote events.

How much would you need to be paid to cover the risk of the next massive hurricane or earthquake? Investors in the insurance market have a new answer: Way more than they were before.

That is the message coming from a key part of that market, catastrophe bonds. “Cat bonds" emerged roughly a quarter century ago as insurance companies scrambled for ways to manage their most extreme risks after Hurricane Andrew’s shocking losses put several out of business.

They found a taker of the risk of major earthquakes or hurricanes on Wall Street: In exchange for a high annual yield, hedge funds, pensions and wealthy individuals were willing to put up cash that they might lose in the event of a specified weather event or insurance loss.

Some bonds have had losses over the years. In an example described by a Federal Reserve Bank of Chicago research paper, a private home-and-auto insurer sold a $100 million bond back in 2010 that was designed to compensate the insurer for industry-wide losses from thunderstorms and tornadoes across the U.S. beyond $825 million. When it was determined that industry losses were $954.6 million in 2011, investors had to give up the cash. The decision was litigated for several years.

Overall, though, this arrangement has worked out for investors over time. Even in 2017, when a trio of major hurricanes hit the U.S., the Swiss Re Global Cat Bond Total Return Index still was positive that year.

But then last year, cat bonds produced a negative 2.16% return, according to Swiss Re. It was the first annual loss in the index’s history.

What happened? It wasn’t just about interest rates, since the cash put up by investors earns a floating market yield that rises with rates. And it wasn’t even just about loss events, as potential payouts triggered by Hurricane Ian are turning out to be smaller than initially feared.

Instead, cat bonds’ prices were caught up in the insurance industry’s broader turmoil. Several recent years of $100 billion-plus industry losses have spurred a radical rethinking of the price of risk. Hurricane Ian last year, with insurance losses expected at around $50 billion—second only to 2005’s Katrina, adjusted for inflation, according to the Insurance Information Institute—might have been the final wake-up call.

Now, cat bond investors are demanding much higher payouts relative to the risks they are taking on. That pushed down the value of older bonds, which contributed to last year’s price decline. But the upshot is that investors are now getting paid more than they have in 20 years to take on extreme catastrophe risk.

A key way to measure the price of this risk is the multiple of the yield investors earn to the loss rate projected by catastrophe models. In 2023, the average coupon paid on cat bonds has been over five times the average expected loss, according to Artemis, a catastrophe-bond and insurance-linked-security news and data provider.

That is a big step up. Back in 2017, cat bonds’ coupons on average were less than two times the expected loss rate. The ratio in 2023 is so far the highest it has been since 2002, when the market was far smaller and newer, and issuers were trying to entice investors to the esoteric products.

Usually in markets, investors’ higher demands for return result in fewer willing sellers. But insurance is a different beast: Cat bond sales in 2023 are on pace to surpass the prior record of $12.5 billion, according to AM Best, a credit agency specializing in insurance.

Companies can delay going public until the price is right, but insurers and some companies can’t go without coverage for major catastrophes. Traditional reinsurers are also right now charging a lot more to cover more common losses and providing less overall coverage, sometimes leaving cat bonds as the only alternative.

Buyers are reaping the benefits. The total return on the Swiss Re index in the first half of 2023 was a record-breaking 10.3%. “Investors are basically getting more money, on a risk-adjusted basis. They’re doing better than they ever were," says Emmanuel Modu, managing director and head of insurance-linked securities at AM Best.

Of course, one should always be skeptical of the proverbial free lunch: Is it really more return for less risk? One major question is whether the market is actually right in what it expects for future losses.

Cat bonds on average in 2023 have carried an expected 1.7% loss rate, according to Artemis. That is more remote than what investors were covering a few years ago, when bonds in 2019 had an expected loss rate of 3.5%.

Still, what were thought to be incredibly rare occurrences or sky-high loss levels might be less so now, particularly if climate change is altering the underlying frequency or severity of some catastrophes. Already, industry losses can reach high levels even without major earthquakes or hurricanes, due both to general inflation in claims and how costly other disasters have become. Major thunderstorms in the U.S., known as severe convective storms, have generated more than $50 billion in insured losses for the first time ever in 2023, according to Gallagher Re.

So the current extremely high ratio of yields to losses might be illusory. However, the relatively short lifespan of cat bonds, typically a couple of years, also means that pricing and terms on new bonds have time to catch up to longer-term shifts as they become more pronounced.

Another risk is that cat bonds’ recent performance will bring in a flood of not-so-sophisticated money, depressing pricing. Yet due to those rising-loss pressures, the demand for coverage might just keep up with the supply of capital. Urs Ramseier, chief investment officer of Twelve Capital, which specializes in insurance investments, expects the cat-bond market to double from its roughly $40 billion size today over the next five years.

One big driver of future cat-bond issuance could be state or federal insurers of last resort. These pools sometimes rely on cat bonds to help backstop coverage in markets that don’t have private options—increasingly the case for homeowners in places like Florida and California.

Some day, people might start to move away from places exposed to catastrophes, reducing the need for extreme-risk coverage. But so long as Americans are willing to keep betting on Mother Nature, Wall Street will be there to take the other side.

Write to Telis Demos at Telis.Demos@wsj.com

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