Catastrophe Bonds

Financial markets are consistently changing as new opportunities arise and others die off. Catastrophe bonds are an example of a new market opportunity that had not been thought of before. Catastrophe bonds can be defined as 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 earthquake. One of the advantages of catastrophe bonds is that they are not linked to the stock market or the poor economic conditions occurring today. The emergence of catastrophe bonds occurred because of the large losses insurance companies suffered following Hurricane Andrew. A catastrophe bond deal occurs as; “an insurer will issue a bond whose returns are tired to the likelihood of one or more natural disasters over a certain period of time. If the event does not happen, investors earn a yield on the bond. But the principle can be wiped out if a devastating storm does strike,” (Ahmed). The catastrophe bond can be beneficial to the insurance company when a natural disaster occurs because they now have more money on hand due to the investors. It can also be very beneficial for investors when a natural disaster does not occur and they earn a relatively high yield compared to other securities. The main issue with the catastrophe bond as both an insurance company and an investor is that the likelihood of a natural disaster is entirely random and cannot be predicted through any mathematical formula.
The Japanese earthquake was the first large natural disaster to occur during the emergence of catastrophe bonds, excluding Hurricane Katrina. This earthquake will be revolutionary in the catastrophe bond market because of the large implications at hand. Investors will be reluctant to invest in the future if the claims cause huge losses. Because of the unknown implications, “we are seeing sellers willing to trade at more distressed prices in order to take the uncertainty away,” (Reuters). In a certain case, a Swiss Re mortality bond was given a negative credit watch, but is unlikely to have an impact unless a death toll of 50,000 is found. The reason catastrophe bonds were created was to “protect issuers against specific large natural disasters”, (Reuters) so it is not unexpected like the default on Lehman Brothers. The collapse of Lehman Brothers caused four bonds to default, creating a downward spiral for financial institutions. The worry has been and will continue to be whether the Japanese catastrophe bonds will default. A default will cause great losses to investors and will give them more chances to second guess buying into catastrophe bonds in the future. The catastrophe bond market can only thrive when investors believe they can make capital gains. The article written by Katy Burne gave a new perspective to the catastrophe bond market that I found very intriguing. As with every hurricane, there is a fair share of warning of a possible path predicted by meteorologists. This gives traders in the catastrophe bonds market some vital information and depending on the advice of the meteorologist; can change the marketability for a particular bond. “We were seeing opportunistic trading-some investors liquidating positions to avoid any exposure to a potential landfall in North Carolina, and others taking a view that they can buy in at attractive levels,” (Burne). Standard & Poor’s will not take action on any bond ratings until the event hits because “there is not guarantee those bonds will trigger,” (Burne). There is high uncertainty in general with catastrophe bonds and that shows in years of high occurrence of natural disasters against years of low occurrence of natural disasters. “Cat bonds have returned only 1.02% so far this year. That contrasts with 5.43% at this point a year ago and 4.3% each for 2004 and 2005, the most active Atlantic hurricane seasons on record,” (Burne). This should show some concern to investors looking into catastrophe bonds. The yields are very low compared to other years, and even years in which more natural disasters occurred. The catastrophe bond is considered the most uncorrelated financial instrument; however, it does not have immunity against a Eurozone breakup. The reason for this, according to Aon Benfield is that insurers “have direct exposure to sovereign debt and the weakening financial markets,” (ADMIN). The global recession that is occurring will affect nearly every type of financial market. One of the scares of a Eurozone breakup is “that this could lead to the introduction of an early redemption event which would allow a cedent to terminate a transaction if the Euro no longer existed as a currency in its own right,” (ADMIN). The currency issue is something that could become very troublesome in the future if the Euro were ever to collapse. With recent catastrophe bonds, some have included a new provision related to the currency issue. It states that “losses could be reported and determined in the new local currency and then converted into Euros at the rate established at the time of departure,” (ADMIN). The American economic crisis and the European debt crisis have put a damper on all markets and will continue to do so until an appropriate monetary and fiscal policy is instated. “Catastrophe bonds remain a very good diversifying asset class for investors,” (ADMIN). More investors are looking at catastrophe bonds because it is the least likely financial instrument to be affected by the poor economy. It helps diversify a portfolio by having different types of financial instruments affected by completely different factors. There are many strong opinions on whether or not to invest in catastrophe bonds. As a new market, there is always skepticism on whether it can continuously return positive yields. In an article written by Randy Diamond, titled “Catastrophe bonds offer diversification, but a lot of risk, too”, he tried to explain the large risks involved with investing in catastrophe bonds. The main risk with these is that simply, the risk is random and a natural disaster could occur at any point in time. Hurricanes occur relatively frequently in the southeast, and investing in a catastrophe in Florida can be extremely risky. There are potential for “losses – even a total loss,” (Diamond). On the other hand, a catastrophe bond reduces the risk for insurance companies. This means that insurance companies will be more likely to give out higher yields to keep investors happy and to increase the total amount of investment. Many private hedge funds have used catastrophe bonds to diversify their portfolio, but in recent years two public pension plans have invested money into these bonds. If the weather is clear, these pension plans will see hefty gains, but if the weather is harsh, the losses will be just as harsh. While Mr. Schauble states that “insurance-related securities offer a true diversifier for institutional investors looking to find an alternative to lock-step drop of many asset classes during the financial crisis,” (Diamond) he also states the complexity. “His firm does not recommend them to clients because of the difficulty in understanding the risk level being taken and the potential for loss,” (Diamond). The Japanese earthquake was a total loss for investors, the first total loss to investors in the cat bond market. Overall, the rewards from catastrophe bonds are ideal, but the risk involved with them should keep many investors away from them. For the year 2012, catastrophe bonds are expected to perform very well according to an article written by Rodd Zolkos. “New catastrophe bond issuance hit a record during the first quarter amid signs that the market may be poised for continued growth,” (Zolkos). The first quarter in 2012 was the most active since GC Securities started tracking the market with a record of $1.34 billion in risk capital. “Among characteristics that issuers are finding attractive are that cat bonds are fully collateralized and that multiyear cat bond programs can stabilize risk transfer pricing,” (Zolkos). After the 2008 financial crisis, catastrophe bonds have increased in issuance. Investors look at catastrophe bonds as a safe haven against the financial crisis that is occurring in today’s age, however, there is no legit safe haven in a time with so much uncertainty. “Investors continue to like assets that have low correlation with their other assets. In the fixed-income sector, these are relatively high yielding assets,” (Zolkos). Another reason for the boom in catastrophe bond activity is the decoupling from reinsurance market pricing. “(Investors) are looking at a completely different set of pricing drivers than are reinsurers with portfolios full of global catastrophe risks,” (Zolkos). The continued growth of the catastrophe market has uniformly helped out both its’ investors and the insurance companies that issue these bonds. Investors have gotten yields that are pleasing and insurance companies have gotten aid when a natural disaster does hit and payments are needed. Overall, according to the author of this article, catastrophe bonds have a bright future and investment in this market is a great decision for any investor looking to diversify his portfolio. When a predicted quiet hurricane season is announced, investment in catastrophe bonds seems to be the right choice for investors. “Cat bonds have rallied since the earthquake and tsunami in Japan,” (Burne). The recovery of catastrophe bonds was very dependent on the Japanese earthquake and how the insurance payments were covered and used. The news of cat bonds recovering is warming to hear for investors all over the world. Sales of cat bonds have doubled from last year, showing enormous interest in the acquisition of cat bonds. “Total returns as measured by a benchmark index from Swiss Re have hit 2.14% year to date, a turnaround from their negative 1.53% return to this point in 2011 after the cat-bond market was rocked by the disasters such as the Japan earthquake,” (Burne). The concern of recovery from the devastating hit of the earthquake on Japan has now been lifted because of this great turnaround. It is interesting to see how well catastrophe bonds did compared to other bonds, such as the Barclays BB U.S High Yield and the S&P 500. The cat bond performed immensely better than the S&P 500, having a return 9.3% higher. What interests me the most is the comparison between Barclays and cat bonds. The Barclays BB US High Yield is a more well-known and respected fund, that performs well and the cat bonds performed 2.1% higher. Investor demand can be shown by “the Travelers deal, rated double-B-plus by Standard Poor’s, priced to yield six percentage points over yields on Treasury money-market funds- one of the narrowest risk premiums for coverage this year,” (Burne). From reading this article, I feel it would be wise for every hedge fund to invest some of their portfolio into cat bonds.

There are, however, many people who do not believe in catastrophe bonds and believe that there is too much risk involved. When a large natural disaster happens such as Hurricane Katrina or the Japan earthquake, insurance payments are extreme and investors will now lose millions of dollars due to investment in cat bonds. However, the “cat bond market won’t be much help in covering Japan-related insurance losses,” (Keogh). Most cat bonds were issued with the area of Tokyo, but the earthquake occurred far away from the capital. Cat bonds have specific locations and to be triggered, it must be in that exact location. For this reason, cat bonds are very complex and specific to certain areas. Investors are betting against a natural disaster occurring in a specific area and receive interest on the bond. The real risk is when a disaster does occur and the investor then loses some or all of the principle. Luckily for those who had invested in bonds during the Japan earthquake and Hurricane Katrina, the investors did not lose much because of how narrow cat bonds are. What is astonishing is that “the securities have returned 60 percent over the past five years,” (Keogh). Very good returns have encouraged more investment and the insurance companies “show no signs of abandoning the cat bonds, even though the market failed to deliver a big payout for the Japan disaster,” (Keogh). Pension funds have increased investment in cat bonds, creating record highs for the amount of bonds issued. The long term successes of cat bonds are very uncertain. Will insurance companies be able to continually make money off investments and will investors get ‘lucky’ and miss a large natural disaster. These are things that both investors and insurance companies need to ask to continue the cat bond market. The riskiness of catastrophe bonds is the main concern for me and I am sure every other investor looking into them. There is essentially no calculated risk, because natural disasters, and the damage caused by them can be entirely random and sporadic. Investing in a cat bond for a large city when a storm comes through can be catastrophic and can lose you millions and millions of dollars. While investing in the stock market has its fair share of riskiness, the risk can be reduced by doing research on the company and finding out how well the company is performing, where there money is coming from and going, and how sturdy their management is. It is hard to make an educated guess on the chances of a storm occurring in a certain area. The best strategy is finding out what weather normally occurs in what specific area and how harsh it usually is during a certain time period. I cannot see myself investing in cat bonds anytime soon. As a beginner investor I don’t think I have nearly enough knowledge to even consider investing in such a complex market. I believe that returns are very probable and can outperform many other markets, but I think a vast amount of knowledge is required to start investing in this market. Currently, I only have a savings account with my local bank and just recently invested in a Vanguard mutual fund that has continually thrived throughout the financial crisis. My next step is going to be getting more involved with the stock market, but I need to do much more reading and studying before I get in the middle of it. I believe that after I get involved and get a good hold of the stock market and investing in general, I may look into cat bonds. But at the time being, I am nowhere near investing, let alone thinking about investing into cat bonds. As stated several times in my paper, I believe that investing in catastrophe bonds is a great way to diversify a portfolio. Since cat bonds are the least correlated financial instrument, it is a good way to ensure some diversity. The cat bonds depend on factors not related to the financial markets and is only slightly affected by an economic crisis. Compared to the stock market, cat bonds have almost no relation to an economic crisis. Every large hedge fund should have some involvement in cat bonds to create a truly diversified portfolio. If I were to invest in cat bonds today, firstly the amount of research I would have to do is immense. Secondly, there are several things I would want to look at before investing. What I want to look at first is finding a good location to have my bond issued to. Learning about the area you are investing in is very important. I would want to find out what type of major weather problems they have, if that’s hurricanes, tornados, blizzards, etc.. Next I would want to know when this weather is most likely to occur and what specific months. There will be areas, such as in Florida, where hurricanes are more likely to hit than others and this is important news. After I have found out all of the information about the certain area I want to invest in, I want to find out how bonds in this area performed in recent years. I want to find out what a typical yield would be and for what reason it was given. I personally don’t think catastrophe bonds are essential for insurance companies because from what has happened in the past, it has shown that the insurance companies have no benefitted besides for the Japanese earthquake. I think that in the long term, and if more and more investment is made into this market, that it will be much more beneficial for the insurance company and will help cover costs due to natural disasters. Overall, catastrophe bonds look to be something that will be more well-known and invested in in the future.
Works Cited:
ADMIN, . "Eurozone breakup could impact catastrophic bonds and insurance-linked securities." (2012): n. page. Print.
Ahmed, Azam. "Investors Bet on Catastrophic Bonds." New York Times 6 January 2011, n. pag. Print.
Burne, Katy. "Hurricane Irene Whips Up Trading In 'Catastrophe Bonds'." Wall Street Journal 26 August 2011, n. pag. Print.
Burne, Katy. "A Safe Haven in 'Cat' Bonds." Wall Street Journal 6 June 2012, n. pag. Print.
Diamond, Randy. "Catastrophe bonds offer diversification, but a lot of risk, too." Pensions&Investments. (2012): n. page. Print.
Keogh, Bryan. "The Trouble with Catastrophic Bonds." Bloomberg Businessweek Magazine. 21 April 2011: n. page. Print.
Reuters, Thomson. "Japan quake set to trigger catastrophic bonds." (2011): n. page. Print.
Zolkos, Rodd. "Big year expected for cat bonds." Investment News. (2012): n. page. Print.