Risk Management

Cat Bonds: A Way to Hedge Corporate Risk?

Few corporations have shown an interest in buying catastrophe bonds to protect their assets against natural disaster. But plummeting prices may lur...
David KatzMay 16, 2013

Slowly but surely, pricing for catastrophe bonds is inching to a point at which at least one broker thinks a corporation with a huge, concentrated risk — a $500 million facility on the San Andreas fault, say — may find the bonds a useful way to hedge against a natural disaster.

To be sure, such a risk might be better managed via a natural hedge: Don’t build the darned thing in such a perilous geological spot. But the example, supplied by Chi Hum, a broker who puts together cat-bond deals, succinctly illustrates his notion of how CFOs might soon be using such bonds to manage their companies’ financial exposure to hurricanes, earthquakes and other natural perils.

Given the severity of recent natural catastrophes — SuperStorm Sandy is a case in point —corporations might be less likely than ever to find traditional property and casualty insurers to back such risks. In that event, a finance chief might buy a cat bond that would pay off if a storm hit. And if the CFO’s company had facilities damaged by the storm, the company would then have cash to repair them.

Although the bonds are not insurance, they can, theoretically, cover some of the same risks that property-casualty insurance does. The problem until now is that cat bonds have been outlandishly priced for such purposes. But Hum, a managing director of GC Securities, says he sees the emergence of a “leading indicator” that prices might soon be low enough for CFOs and corporate risk managers to take an interest in cat bonds. His metric? The number of calls he’s been getting from corporate executives outside the insurance industry has risen exponentially.

That’s as much consolation as a broker/dealer working in the under-populated field of cat bonds has been able to expect during the long “adolescence” of the security, according to a GC first-quarter 2013 update. The bonds, which have been around since 1997, have found only a handful of corporate sponsors (corporations that use it to provide financial protection against their own risks) outside the insurance industry.

It’s a niche so narrow that it can report the closing of a mere two natural-peril-exposed bond deals, for a total issuance of $520 million, in the first quarter, according to GC. In practically every deal so far, an insurance company or a pooled self-insurance arrangement (in which a group of cities, say, pool their capital to insure themselves against windstorms) buys cat bonds in lieu of reinsurance.

And relative to reinsurance, the bonds have been a pricey way to manage risks — applicable mostly only to what Hum calls “lumpy risks,” or large concentrations of assets crammed into a small geographical area. Since reinsurers carry large portfolios of risks of diversified sizes, they have been able to price their coverage lower than the bonds.

But the cost of insuring a risk via cat bonds has been dropping to the point where it’s cheaper than reinsurance in some cases, according to Hum. One reason the prices have been dropping is that the current low interest-rate environment has made the yields on cat bonds more attractive than those of other investments, the broker says.

Indeed, in the first quarter of 2013, institutional investors offered a price 40 percent lower on a bond covering Florida hurricanes than the one they offered for a similar bond last year. Perhaps fueled by the low prices, total risk capital outstanding (the amount of coverage supplied to buyers) in the natural-peril cat bond market hit a record $15 billion at the end of the first quarter and should reach $17 billion to $19 billion by the end of 2013, according to GC Securities.

With an eye toward building the market for long-term investors, no doubt, the brokerage insists that it’s “unfair to characterize this demand as a ‘bubble’ or assume that institutional money is chasing risks at returns that are necessarily too low.”

Rather, it claims that a pool of capital-market investors will have a lower cost of capital than a reinsurance company would. Such bond investors can, “on a sustained basis,” charge less than traditional reinsurers to provide coverage for such risks as peak winds, according to the first-quarter update from GC. (Reinsurers, they contend, have “capital constraints” on covering such exposures, and have traditionally gone to the cat bond market for coverage. Hence the higher cost of capital.)

To Hum, the fact that the cost of insuring such extreme risks via cat bonds has dropped below that of reinsurance marks the passing of an inflection point for corporate participation. “Very soon, we’ll be getting to a place that should make it interesting for corporates,” he hopes. Especially if another superstorm causes traditional insurers to flee the market.