introduction
The global pandemic continues to be a catastrophe for our civilization. Making matters worse is that few were insured against it. Sure, Hollywood has produced plenty of flicks about infectious disease outbreaks over time, but that is where the topic looked as if it would belong – within the realm of entertainment, not in our neighborhoods.
One organization that insured itself against such disasters was the Wimbledon tennis tournament. Before the COVID-19 outbreak, the corporate paid about $2 million annually for pandemic insurance for 17 years. The organization’s policy can pay out about $142 million to cover the prices of canceling the tennis tournament in 2020. For Wimbledon, the policy has paid off financially. Of course, the fee of such protection has skyrocketed as a consequence of the pandemic, so Wimbledon is not going to renew it in 2021.
The purchase of disaster protection in the shape of catastrophe bonds or cat bonds is a comparatively latest development. Cat bonds were first issued within the Nineteen Nineties after Hurricane Andrew and the Northbridge earthquake, which mainly affected the US states of Florida and California. Before these two disasters, insurers were required by law to cover the damages of such events so as to issue property insurance. However, the damages from these two disasters were so severe that many insurance firms became insolvent as a consequence of the coverage of those damages. In response, catastrophe bonds were developed.
Since such disasters are typically not attributable to the economy and capital markets, constructing a diversified portfolio of insurance policies could possibly be a horny investment opportunity.
How have catastrophe bonds evolved over time?
The insurance-linked securities industry
The insurance-linked securities (ILS) market is tiny. At the tip of 2020, outstanding bonds amounted to $118 billion, in comparison with greater than 3 trillion dollars invested in hedge funds And $4 trillion in private equity fundsAlthough the ILS market also includes life and pandemic insurance, catastrophes account for greater than 90% of the chance.
The way a catastrophe bond works is simple: The issuer creates a special purpose vehicle (SPV) for a selected disaster, akin to a flash flood in South Texas. Investors contribute capital, which is transferred to a collateral account within the SPV, and receive coupon payments from the issuer until maturity, which will likely be about three years. If the defined risk doesn’t occur, the capital is repaid. If the disaster does occur, all or a part of the capital is used to compensate the issuer for losses. Therefore, insurance and reinsurance corporations issue catastrophe bonds to transfer risk to other investors.
Insurance-linked securities market: $118 billion in outstanding bonds (2020)
The composition of catastrophe bonds
With its faults, hurricanes and rivers susceptible to flooding, the USA is more in danger from natural disasters than Europe. This can also be reflected within the composition of catastrophe bonds. Around 60 percent of them are focused on US wind and earthquakes. The term wind is utilized by the insurance industry and should sound somewhat harmless, but it surely includes hurricanes and tornadoes that may devastate entire regions.
Japan lies between the Pacific and Asian tectonic plates and is due to this fact at high risk of earthquakes. Yet surprisingly few catastrophe bonds have been issued there. As capital markets mature and countries in Asia turn into more prosperous, more catastrophe bonds are prone to be issued, as such a development tends to guide to higher insurance premiums for corporations and residents.
While many cities and regions may benefit from disaster insurance, some risks are just too likely and due to this fact too expensive. For example, many homes on the slopes of Mount Vesuvius near Naples, Italy, are abandoned because they can be damaged or destroyed by the volcano’s next major eruption, which could occur in our lifetime.
Composition of catastrophe bonds
Increasing losses as a consequence of catastrophe insurance
An interesting data point: The number of synthetic disasters peaked at 250 in 2005 and has dropped to simply 85 in 2020. The two largest disasters in 2020 were the social unrest and riots within the United States, which affected 24 states, and the explosion on the Port of Beirut in Lebanon, which destroyed a significant slice of town and caused over $4 billion in damage.
In contrast, the variety of natural disasters has increased from 50 in 1970 to 189 in 2020. This is partly as a consequence of higher global disaster data, but additionally as a consequence of increasing urbanization, which brings higher population density and better property values. Climate change is one other factor that would contribute to this trend.
Losses from disasters have been increasing over the past 50 years, and have increased significantly since 2005. The insurance industry distinguishes between small and medium-sized disasters, or secondary perils, and enormous disasters, or primary perils. Losses from major disasters in 2005 (Hurricanes Katrina, Wilma and Rita), 2011 (earthquakes in Japan and New Zealand and tsunami in Thailand) and 2017 (Hurricanes Harvey, Irma and Maria) together accounted for nearly half of all losses from secondary perils since 1970. This pattern is clearly of great concern to the insurance industry.
Insured losses from catastrophes (billions of US dollars)
Performance of catastrophe bonds
There are two publicly available cat bond indices that allow us to research the returns of this unique asset class. The Eurekahedge ILS Advisers Index consists of greater than 30 equally weighted fund managers who mainly deal with cat bonds. The SwissRe CatBond Index is a diversified portfolio of cat bonds weighted by market capitalization.
The performance of the 2 indices was an identical. The SwissRe CatBond Index returned significantly more over the period 2005-2021, but that is partly as a consequence of the incontrovertible fact that it was calculated before fees and transaction costs. Cat bond returns have been exceptionally consistent, leading to Sharpe ratios of around 2. This is significantly higher than another asset class. The largest decline occurred in 2017, however the SwissRe index recovered its losses relatively quickly, although its Eurekahedge counterpart didn’t perform as well.
Of course, these indices should be viewed with caution: each overestimate their returns. The SwissRe index excludes costs and the Eurekahedge index allows fund managers to import their track records. This promotes survivorship bias: fund managers are inclined to import their track records only when it has a positive impact on them.
Performance of catastrophe bond indices
Correlation to traditional asset classes
We imagine that the Eurekahedge ILS Advisers Index higher represents the realized returns of this asset class, as these are net of fees and transaction costs, and we due to this fact limit the rest of our evaluation to this index.
Uncorrelated returns in comparison with traditional asset classes: This is the predominant marketing argument for investing in catastrophe bonds. According to our calculations, the correlation of the Eurekahedge index with the S&P 500 and US bonds from 2005 to 2021 was 0.2 and 0.1, respectively.
Many hedge fund strategies promise uncorrelated returns. But that is never the case when equity markets crash. However, catastrophe bonds offered attractive diversification advantages through the global financial crisis in 2008 and the COVID-19 crisis in 2020: Correlations to the S&P 500 remained relatively low.
Correlation of the Catastrophe Bond Index with S&P 500 and bonds
Catastrophe bonds: The diversification advantages
With high risk-adjusted returns and low correlation to stocks and bonds, catastrophe bonds have been a superb diversification strategy for traditional portfolios. Even though a 20% allocation to a stock and bond portfolio would have barely reduced annual returns by 0.3% from 2005 to 2021, the Sharpe ratio would have increased from 0.90 to 0.95 and the utmost drawdown would have decreased from 29% to 26%.
Diversification advantages of catastrophe bonds, 2005 to 2021
Further considerations
Capital allocation has rarely been as difficult because it is today. Fixed income, one of the crucial essential asset classes, has turn into structurally unattractive as a consequence of low to negative yields. However, investors trying to shift capital from fixed income to alternative investments could also be pleased by the unique characteristics of catastrophe bonds. Consistent yields, low volatility, few drawdowns and low correlation to equities – what’s not to love?
Well, perhaps catastrophe bonds have been mispriced previously. Before 2005, there have been fewer major disasters. But now, as more horrific disasters turn into more common and property prices rise around the globe, insurance costs are also rising. The Eurekahedge ILS Advisers Index has not returned since 2017.
In addition, future disasters could have a greater impact on the worldwide economy, making catastrophe bond yields less uncorrelated. A hurricane in Florida could severely damage the local economy, but a significant earthquake within the San Francisco Bay Area could have truly global implications.
Investing in catastrophe bonds is unlikely to end in catastrophe, but it surely might not be as attractive as portfolio insurance because it has been previously.
Further insights from Nicolas Rabener and the FactorResearch Team, join on your Email newsletter.
If you liked this post, don’t forget to subscribe.
Photo credit: ©Getty Images / Monticello
