In today’s Finshots, we explain Catastrophe bonds and why their market has been on an overwhelming rise.

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The Story

In 1992, a deadly hurricane devastated parts of the United States. Nearly $30 billion vanished in a day — stores, jobs and lives had been lost. And entire cities had to be rebuilt.

But it also hurt another set of entities — insurance companies!

These folks were liable to pay for a large portion of the damages. And 8 insurance companies went bankrupt because of the unprecedented compensation requirements.

And this got other insurance firms thinking about how such incidents could completely devastate them. They needed to find a way to protect themselves. So in 1997, a novel idea was born — Catastrophe bonds.

Here’s how this worked. Imagine that an insurance company has committed to insuring property worth $100 million. But when a storm strikes you don’t know how much damage it will create. It could exhaust all of the insurance company’s resources. So it issues bonds worth $50 million to make up for this uncertainty. Yup, a bond which people like you and me can buy. And one which pays out interest.

But unlike other bonds, CAT bonds came with one tiny difference.

Typically at the end of the tenure of the bond, you’d expect to get paid back the money you invested. And it would be pretty much the same in the case of a CAT bond too. Unless disaster struck — say if there was an earthquake that registered over a predetermined level or the losses from a flood exceeded a certain monetary value. In that case, the insurance company can use all the money it raised via the bonds to meet the claims from the disaster. They wouldn’t have to pay a penny back to the investors in the bonds.

But why on earth would anyone invest in such a bond, you wonder?

Well, to make up for the risk of such a scenario, CAT bonds do offer a higher interest rate than regular bonds And investors who are also betting on this will be hoping and praying that Mother Nature stays kind to them.

In this manner, insurance companies protect themselves. And investors make a bit of extra money if everything goes well.

Now initially, it took some time for the markets to warm up to this idea. Between 1997 and 2005, CAT bond issuance only averaged $1.2 billion annually. But then, another massive hurricane struck the US in 2005 — one that resulted in damages of a whopping $62 billion in insured losses. And insurance companies realised they couldn’t sit back and get hammered anymore. CAT bond issuances soared through the roof in the next couple of years.

But why are we talking about them now, you ask?

Well, a couple of days ago, Bloomberg pointed out that 2023 was an exceptional year for CAT bonds in the US. While regular bonds delivered returns of roughly 5%; hedge funds returned 8% on average; and an index made up of these catastrophe bonds was up by nearly 20%!

Now hold on…

We know that climate change is only getting more and more intense. We keep seeing reports of wildfires, floods, earthquakes and a whole host of other disasters in the news all the time. Heck, 2023 was the hottest year on record. So we’re potentially looking at even more problems in the future.

And it makes sense why insurers would rush to issue a record-high of $16.4 billion worth of CAT bonds in such an environment. They know the risks are multiplying and they need protection now more than ever. So they’re in a hurry to cover their losses.

But the real question is — shouldn’t all this make investors more wary? Shouldn’t they be worried about losing all their money?

Well, this wariness might have actually contributed to the high returns in 2023.

For starters, investors worried about what disasters lay in wait and they didn’t think getting a 2-3% higher return than a regular government bond justified the risks. So last year, they forced insurance companies to open up their purses and pay a premium of over 10%! They knew insurance companies didn’t have too many alternatives and ensured they squeezed the firms as much as they could. And luckily for the investors, 2023 was quite a light year for hurricanes in the US. So it didn’t trigger big payouts either.

Also, the yields (interest payouts) on many CAT bonds are linked to what the US Federal Reserve does with interest rates. Think of it as a ‘floating’ rate. If the central bank hikes interest rates — which they did last year — it triggers a higher payout for CAT bonds too.

But there’s one more thing for investors. Just because disaster strikes, it doesn’t mean it’s all over for CAT bonds. For instance, as an earlier Bloomberg report highlighted:

Hurricane Harvey hit Texas [in 2017] and was the second costliest storm in U.S. history — however — there were no losses for catastrophe bonds other than the initial mark-to-market impact of the storm. … Part of the reason that investors are willing to take on these risks is that the bonds insure for very specific events. A bond may only cover wind damage for a Carolina Hurricane, but not flooding.

So yeah, all these specific clauses mean that at the end of the day, it’s often the investors who’re laughing all the way to the bank while insurers are still left holding the bag.

Will the bull run for CAT bonds continue in 2024 or will it fizzle out? We’ll have to wait and see.

Until then…

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