Risk Management

Ports and Storms

Retail investors bet that nature will be calmer than the markets.
Economist StaffAugust 13, 2007

With the planet warming and the weather doing outlandish things, it is odd to think that bets on natural disasters might turn out to be a safe haven for investors. But that is how they may be marketed as turmoil grips global financial markets. Correlations between asset classes are appearing in unexpected ways, but are unlikely to reach holders of catastrophe bonds, the securities issued by insurance companies that pay tempting yields but can lose their value in the event of floods, earthquakes and the like. Investors in “cat” bonds can shrug off the subprime mortgage mess, the price of oil, or any other misfortune that might arise—except those caused by an act of God.

In the past, cat bonds were available only to large institutions, which typically acquired them directly from insurance companies. But recently, Pioneer Investments, an American fund-management firm, opened the first mutual fund to give individuals exposure. If the fund is a success and spawns copycats, even insurance-policy buyers could reap rewards; the greater appetite may lower yields, making them cheaper than reinsurance—a saving that could be passed onto consumers.

Until recently, the market for cat bonds was minuscule. Thanks to a decade without major natural disasters following the 1994 Northridge earthquake, property and casualty insurers were awash with capital and had little need to hunt for more. But after hurricanes Katrina, Rita, and Wilma caused over $60 billion in claims and sopped up much of the world’s available reinsurance capacity, insurers have increasingly sought to share their risk with the markets. Last year, they more than doubled their issuance of cat bonds, from under $2 billion in 2005 to $4.7 billion.

This increased supply has made cat bonds more attractive to investors. According to Charles Melchreit, a portfolio manager of the Pioneer fund investing in them, a typical cat bond pays a coupon of 12%, nearly twice as much as the non-investment-grade sovereign debt of an emerging market like Brazil. On average, he argues, losses are likely to be minimal—lower, at least, than from the risk of default on high-yield corporate debt. Only once, during the exceptionally bad hurricane season of 2005, has the value of the bonds been wiped out entirely.

The securities’ main drawback is illiquidity: there is virtually no secondary market for cat bonds, as they tend to be gobbled up by buy-and-hold investors eager for the yield. But Pioneer is seeking to expand the pool of buyers. “Traditionally, they have been a little closed club for hedge funds, which have served the needs and interests of high-net-worth people,” says Ken Taubes, director of fixed income at Pioneer. “We’re trying to democratise them.” Currently, the exposure of the fund’s investors to cat bonds is small and part of a broader portfolio. But Pioneer hopes to launch a larger, pure cat-bond vehicle if the first fund is a success.

It will not be easy. Barring another mega-disaster like Katrina, reinsurance capacity is likely to continue recovering over the next few years, giving insurers fewer reasons to issue cat bonds. Investors, meanwhile, might like an alternative to tempestuous markets. But betting on the natural environment is a highly unpredictable strategy, too.