Avoiding Disasters with Catastrophe Bonds?

The hedge fund strategy that never was one

June 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Catastrophe bonds offered exceptionally high risk-adjusted returns since 2005
  • These were uncorrelated to equities, making cat bonds attractive for diversification
  • However, cat bonds might have underpriced risk historically, raising concerns going forward

INTRODUCTION

The global pandemic continues to be a catastrophe for our civilization. Compounding its effect: Few were insured against it. Sure, Hollywood has churned out plenty of movies about contagious disease outbreaks over the years, but that is where the topic seemed to belong — in the realm of entertainment, not in our neighborhoods.

One organization that insured itself against such disasters was the tennis tournament Wimbledon. It paid about $2 million annually for pandemic insurance over 17 years before COVID-19 hit. The organization’s policy will pay out approximately $142 million to cover the cost of cancelling the tennis tournament in 2020. For Wimbledon, the policy was financially worth it. Of course, the pandemic means the price for such protection has spiked so Wimbledon won’t be renewing it in 2021.

Buying protection against disaster in the form of catastrophe bonds, or cat bonds, is a relatively new development. Cat bonds were first issued in the 1990s after Hurricane Andrew and the Northbridge earthquake, which primarily affected the US states of Florida and California, respectively. Prior to these two disasters, in order to issue property insurance, insurers were required by law to cover the damages of such events. But the damages from these two were so severe, that covering them rendered many insurance companies insolvent. So cat bonds were developed in response.

From an investment perspective, since such catastrophes tend not to be caused by the economy and capital markets, creating a diversified portfolio of insurance policies might constitute an attractive investment opportunity (read Black Swans, Major Events & Factor Returns). 

So how have cat bonds performed over the years?

THE INSURANCE-LINKED SECURITIES INDUSTRY

The market for insurance-linked securities (ILS) is tiny. At the