The Rise of the CAT Bond.
In late August of 1992, tens of thousands of passengers sat in their cars in what was one of the worst traffic jams the country had ever seen. Miles of cars lined up along the Interstate 95 highway in Miami-Dade county desperately trying to escape the destruction behind them. As hurricane Andrew made landfall, the governor of Florida warned South Florida residents to either evacuate their homes or board their windows and prepare for the worst hurricane the state had ever experienced. Starting in the southern Atlantic, Hurricane Andrew grew to become one of only 4 known category 5 hurricanes on earth, with wind speeds reaching upwards of 170 miles per hour.
In a matter of days the storm caused extreme damage across Southern Florida, Louisiana, and the Bahamas. Over 65,000 homes were destroyed and more than 120,000 were severely damaged. Across the entire state, over 1.4 million people lost electricity for weeks. After all the damage was accounted for the result was far worse than any meteorological expert could have imagined.
Previous to Andrew, experts expected that the losses to insurance companies from a worst case hurricane would result in $4-5 billion in total insured losses. The actual amount was more than 3 times that amount. For years, Hurricane Andrew held the record for causing more insured damage than any other storm in history, with a total of $27.4 billion in losses according to the Insurance Information Institute.
Hit almost as hard as the citizens of Southern Florida were the balance sheets of insurance companies who for years had been drastically underestimating their loss exposure for the insurance policies they had underwritten for Florida real estate. So much so that eight insurance companies went bankrupt from the losses incurred from Andrew. The bankruptcy of these eight insurers, as well as the realization that they were getting grossly underpaid for the risk they were incurring, caused hundreds of insurers to exit the Florida property & casualty insurance market.
The result of this exodus of insurance companies was a severe imbalance in the capitalist equation as demand for home and property insurance grew sporadically but the supply virtually evaporated. When such imbalances occur regulation is only inevitable, particularly when it comes to a necessity such as insurance. To try and fix this imbalance, Florida regulators created the Florida Residential Property and Casualty Joint Underwriting Association (FRPCJUA) to make it easier for Florida residents to attain home insurance. The organization, with its overly long name, had yet a simple goal of either underwriting the insurance policies itself or serving as an intermediary to help homeowners find coverage with a private insurer willing to write the risk. The organization at its peak had written a total of 487,000 policies. In 2012, a combination of Florida's two largest state run insurers were combined to form Citizens Property Insurance Corp., which at the time had roughly $500 billion in loss exposure.
However, even with government assistance, insurers still felt that the risk of major catastrophes were too widely concentrated on insurance companies and set out to find a method to spread the risk further. The solution was to spread the risk of major catastrophes such as hurricanes to investors willing to bear part of the risk in exchange for a potential return on their investment. The investor’s return would be in the form of a premium paid to them in a similar manner as a corporate or government bond, leading the new insurance product to be called a catastrophe bond; commonly known as a CAT bond.
The conventional way of spreading risk within an insurance company is to spread it among numerous different policy holders purchasing similar insurance and price the insurance premiums accordingly based on the odds of a loss occurring, and the potential amount of capital to be lost. In many instances, insurers are not willing to bear the entire risk of a certain possible loss, which drives them to the reinsurance market.
Reinsurance, simply put, is insurance for insurance companies. The purpose of which is to pass some of the loss exposure to another company. If an insurance company, for example, writes a policy to cover $2 billion in losses, but is only wanting to take the responsibility for losses up to $1.5 billion, it can pay a reinsurance company a premium to incur the responsibility for losses above $1.5 billion. The process is known as ceding risk to a reinsurer and has become a larger part of the insurance market due to the growth of some of the world’s largest reinsurers including Swiss Re, Munich Re, and Berkshire Hathaway.
The concept of the CAT bond took this idea one step further by ceding part of the risk to investors rather than reinsurance companies. In order to set up a CAT bond an insurance company has to go through the process of setting up a special purpose vehicle (SPV) which holds the capital to cover the possible loss. The capital that is put into the SPV is almost always invested in short term treasury bonds or some sort of money market instrument, which involves almost no risk.
When setting up the SPV for each CAT bond the terms are laid out to state the different aspects of the CAT bond. Each term, in Wall Street fashion, is given an specific name, each specifying a certain aspect of the bond. The attachment point specifies the level at which the bond is set to pay out. If the issue is to pay out on losses between $2 billion and $2.5 billion, the attachment point would be the point at which losses exceed $2 billion. When losses rise above $2.5 billion, in this example, the bond reaches its exhaustion point at which point the bond will no longer pay out.
In exchange for covering the possible loss, the insurance company pays the purchaser of the CAT bond annual premiums which the investor may consider their return on their investment, assuming no loss occurs. If the insured event does occur, the funds put into the SPV go towards covering the loss, and the investor in the CAT bond has the potential to lose the entire “principle” of their investment.
As one can expect, the coupon paid out on a CAT bond is dependent on the risk the purchaser is taking on. Lower risk bonds pay out somewhat attractive rates compared to the risk-free treasury bonds that investors can purchase from the government. The majority of CAT bonds issued over the past year have ranged between 2% and 6%. The higher risk CAT bonds, though, can yield upwards of 10% but are issued very infrequently. The highest coupon issued over the past year, according to the analytics firm Artemis, had a coupon of 17.25%, covering Herbie Re.
The risk of losing the entire amount of principal may thwart off more conservative investors, but as hedge funds and pension funds go searching in desperation for higher yield these sorts of alternative investments begin to call their name, and call it loudly.
Since the introduction of the CAT bond in 2005, tens of billions of dollars have been sold to investors of all kinds. The biggest customer by far, though, for these newly created products are institutional investors who are employed solely to invest billions of dollars on behalf of others.
Like all new financial products that make their debut on Wall Street, CAT bonds have taken many different iterations and have been modified by countless firms to fit specific needs. And each firm, undoubtedly, comes equipped with a book of sales points to explain the merits of this “wonderful new product.” Perhaps the biggest selling point being the noncorrelation between the yield of a CAT bond and the returns experienced by the broader economy. The yield of a CAT bond in many cases is more correlated to the rising of global temperature than to the Federal Reserve’s prime rate.
The key for these financial products to prove profitable is for the investors to receive an appropriate return in relation to the likelihood of the catastrophic event occurring. Few fund managers, though, have the necessary experience to determine these rates. As the CAT bond becomes more popular the likelihood of investors mispricing the risk goes up. Such experience in determining risk lies mostly with insurance underwriters who for decades have been estimating these risks and gathering mountains of actuarial data on when their estimates have been right and when they have been wrong.
These underwriters, incidentally, are the ones who have been hurt most by these new products as they previously were competing only with other insurance companies to underwrite these risks. Underwriters now are competing against institutional money managers (with trillions to throw around), who may be, without knowing it, offering a foolishly low rate.
The extreme dangers that will result from these products will come about from extended periods in which there are not any major catastrophes. These long periods of catastrophic docility cause investors, and inexperienced underwriters, to price their insurance as if this period of stasis will continue into the future. A misconception that all experienced underwriters know isn’t true.
Making matters worse is that the clients of these institutional funds, who the actual money belongs to, certainly are not aware of the risks that are being taken with their money. And only until a massive loss occurs will their interest be peaked.
Roughly $30 billion is currently invested in CAT bonds set to be paid out if any number of catastrophic circumstances occur. While this number is miniscule compared to the amount of money invested in stocks and bonds, if the amount of money put into CAT bonds continues at a similar pace the risk could rapidly get out of hand. To prevent risk growing beyond what the market can handle, underwriters experienced in the risks of catastrophes will need to be given a bigger role at the institutional investment houses that are purchasing the CAT bonds; otherwise, the industry risks mispricing premiums in the same manner as insurers did in South Florida previous to Andrew, which could bring about losses just as damaging.
Resources: Insurance Information Institute.
