Avoiding Disaster with Catastrophe Bonds?

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Introduction

The global pandemic still remains a disaster for our civilization. Minimizing its impact: Few people were insured against it. Sure, Hollywood has churned out a lot of movies about infectious disease outbreaks over the years, but the topic appears to be—in the entertainment realm, not our neighborhood.

One institution that insured itself against such disasters was the tennis tournament Wimbledon. It paid out nearly $2 million annually for pandemic insurance in the 17 years before COVID-19 hit. The organization’s policy would cover approximately $142 million to cover the cost of canceling tennis tournaments in 2020. For Wimbledon, the policy was worth it financially. Of course, the pandemic means that the price of such protection has gone up, so Wimbledon will not renew it in 2021.

Buying security against disaster in the form of a disaster bond, or cat bond, is a relatively new development. Cat bonds were first issued in the 1990s. Hurricane Andrew and the Northbridge earthquakes, which primarily affected the US states of Florida and California, respectively. Prior to these two disasters, insurers were required by law to cover the loss of such events, in order to issue property insurance. But these two caused so much damage that many insurance companies went bankrupt by covering them. So cat bonds were developed in response.

From an investment perspective, since such catastrophes are not caused by the economy and capital markets, building a diversified portfolio of insurance policies can turn out to be an attractive investment opportunity.

So how have cat shackles fared over the years?

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insurance securities industry

The market for insurance-linked securities (ILS) is small. At the end of 2020, it measured $118 billion in bonds outstanding, compared to more than Rs. $3 trillion invested in hedge funds And $4 trillion in private equity funds. Although the ILS market also includes insurance policies for life and pandemics, disasters constitute more than 90% of risk.

The mechanics of a disaster bond are straightforward: the issuer builds a special purpose vehicle (SPV) for a specific disaster, such as a flash flood in South Texas. Investors contribute the principal, which is transferred to a collateralized account of the SPV, and receive coupon payments from the issuer until maturity, which is typically around three years. If the defined risk does not occur, the principal is repaid. If disaster strikes, the issuer will be used in whole or in part to cover the loss. Therefore, insurance and reinsurance companies issue CAT bonds to transfer risk to other investors.


Insurance-linked securities market: $118 billion (2020) outstanding bonds

Pie chart of the insurance-linked securities market: $118 billion (2020) bonds outstanding
Source: Lane Financial LLC, Factor Research

disaster bond structure

With its fault lines, hurricanes, and flood-prone rivers, the United States is more prone to natural disasters than Europe. This is reflected in the structure of the cat’s bonds. About 60% of these are focused on US wind and earthquakes. The term wind is used by the insurance industry and may sound mild, but it includes hurricanes and tornadoes that can devastate entire areas.

Situated between the Pacific and Asian tectonic plates, Japan is at serious risk of earthquakes, yet surprisingly few cat bonds have been issued there. As capital markets mature and countries prosper across Asia, more CAT bonds are likely to be issued because such developments bring higher rates of insurance for companies and citizens.

While disaster insurance can undoubtedly benefit many cities and regions, the potential for some to be at risk is very high, which makes policies very expensive. For example, many homes on the slopes of Mount Vesuvius near Naples, Italy, are deserted since the next major eruption of the volcano, which could happen in our lifetime, will damage or destroy them.


disaster bond structure

Chart showing the composition of the disaster bond
Source: Lane Financial LLC, Factor Research

Increasing damages from disaster insurance

An interesting data point: the number of man-made disasters peaked at 250 in 2005 and has fallen to just 85 in 2020. The two biggest in 2020 were civil unrest and riots in the United States, which affected 24 states, and the explosion in the port of Beirut, Lebanon, which destroyed a significant part of the city, causing more than $4 billion in damages. Happened.

In contrast, the number of natural disasters has increased from 50 in 1970 to 189 in 2020. This can be attributed to improved global catastrophe statistics, but also to increased urbanization, which creates greater population densities and higher property values. Climate change is another factor that may contribute to this trend.

The damage caused by catastrophes has been increasing over the past 50 years and has increased significantly since 2005. The insurance industry distinguishes between small and medium-sized disasters, or secondary perils, and large disasters, or primary perils. Combined losses of major devastation in 2005 (Hurricane Katrina, Wilma and Rita); 2011 (Japan and New Zealand earthquake and Thailand tsunami); and 2017 (Hurricane Harvey, Irma, and Maria) accounted for nearly half of all damage from secondary hazards since 1970. This pattern clearly raises significant concerns for the insurance industry.


Insured damages from disasters

Bar chart of insured losses from disasters (US billions)
Source: Swissray, Factor Research

disaster bond performance

There are two CAT bond indexes in the public domain with which we can analyze the returns of this unique asset class. The Eurekahedge ILS Advisors Index includes more than 30 equally-weighted fund managers focused primarily on disaster bonds. The Swissray Catabond Index is a diversified portfolio of cat bonds weighted by market capitalization.

Both indices had similar performance trends. The Swissray Catabond Index achieved significantly higher returns in the period from 2005 to 2021, but this is partly explained by fees and transaction costs being gross. Cat bond returns were exceptionally consistent and resulted in a Sharpe ratio of around 2%. This is much higher than any other asset class. The biggest fall came in 2017, but the SwissR index recovered its losses relatively quickly, although its Eurekahase counterpart did not do well either.

To be sure, these indices require careful consideration: both tell more than their returns. The SwissRE Index does not involve costs and the Eurekahedge Index allows fund managers to import their track records. This encourages survival bias: Fund managers only import their track records if they reflect well on them.


Performance of Disaster Bond Indices

Line Chart of Performance of Disaster Bond Indices
Sources: Eurekahenge, SwissRay, Factor Research

Relationship to traditional asset classes

In our view, the Eurekahedge ILS Advisors Index provides a better representation of the true returns of this asset class because they are net of fees and transaction costs. Thus, we will confine the rest of our analysis to that index.

Uncorrelated returns relative to traditional asset classes: This is the major marketing pitch for investing in CAT bonds. According to our calculations, the correlation of the Eurekahedge Index to the S&P 500 and US bonds from 2005 to 2021 was 0.2 and 0.1, respectively.

Many hedge fund strategies claim to deliver disproportionate returns. But this rarely happens when the stock market crashes. However, CAT bonds provided attractive diversification benefits during the global financial crisis in 2008 and the COVID-19 crisis in 2020: the relationship with the S&P 500 remained relatively short.


Correlation of the S&P 500 and the Catastrophe Bond Index to Bonds

Line chart showing the correlation of the S&P 500 and the Catastrophe Bond Index to bonds
Sources: Eurekahenge, SwissRay, Factor Research

Disaster Bonds: Diversification Benefits

With high risk-adjusted returns and low correlation to stocks and bonds, CAT bonds were an excellent diversification strategy for traditional portfolios. Even though adding a 20% allocation to equity and bond portfolios would have reduced annual returns by 0.3% from 2005 to 2021, the Sharpe ratio would have increased from 0.90 to 0.95 and the maximum drawdown would have fallen from 29% to 26%.


Diversification Benefit from Disaster Bonds, 2005 to 2021

Bar chart of diversification benefits from disaster bonds, 2005 to 2021
Sources: Eurekahenge, Swissray, Factor Research

further thoughts

Allocating capital has rarely been as difficult as it is today. Fixed income, one of the main asset classes, has become structurally unattractive due to lower negative returns. But investors who want to reallocate capital from fixed income to options may be pleased with the unique features of cat bonds. Consistent returns, low volatility, few downsides, and low correlation to equities – what’s not to like?

OK, maybe cat shackles have been misrepresented historically. There were fewer major disasters before 2005. But now as more catastrophic disasters are occurring more frequently and amid rising property values ​​around the world, insurance bills are on the rise. The Eurekahedge ILS Advisors Index has given zero returns since 2017.

In addition, future disasters could impact the global economy to a greater extent, making CAT bond returns less disproportionate. A hurricane in Florida could seriously damage the local economy, but a major earthquake in the San Francisco Bay Area could have a truly global impact.

Investing in CAT bonds may not spell disaster, but it may not be as attractive a portfolio insurance policy as it has been in the past.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credits: © Getty Images / Monticello


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Nicholas Rabner

Nicolas Rabner is the Managing Director of Factor Research, which provides quantitative solutions for factor investing. Prior to that he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Prior to this, Rabner worked at GIC (Government of Singapore Investment Corporation), which focused on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100 km ultramarathon, Mont Blanc, Mount Kilimanjaro).



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