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The small group of people betting $45bn on natural disasters

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Fink Money
October 11, 2024 • Estimated Reading Time: 7 minutes

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Hurricane Milton ended up being a bit of a damp squib in the end.

Expected to be a category 5 hurricane at landfall, it actually landed at cat 3 and quickly dissipated into a cat 1…

Which is great for the super rich lady who didn’t want to leave her home because her husband built it to commercial grade…

But also for the managers of Cat Bond (catastrophe bond) funds.

These guys were squirming at the potentially huge losses from Milton.

Cat bonds are a very niche part of the market, and a relatively new invention and even today, there are probably less than 30 globally.

They came to life in 1997, a full five years after Hurricane Andrew wiped out eight insurance companies in in 1992.

Many others were pushed to the edge of insolvency too.

That situation couldn’t be repeated!

Cat bonds were launched as a solution. They exist to help both insurers and investors have exposure to, or hedge risk against natural disasters.

That sentence is kinda insane if you stop and think about it.

Here’s how they work…

Benefits for Insurers

  • Reduced Counterparty Risk: CAT bonds are fully collateralized, eliminating the risk of reinsurer default.

  • Multi-Year Coverage: Unlike annual reinsurance contracts, CAT bonds can offer multi-year commitments, allowing insurers to lock in prices for extended periods.

  • Cost-Effective Diversification: By attracting alternative capital sources, CAT bonds increase competition and exert downward pressure on reinsurance prices.

Appeal for Investors

  • Low Correlation: CAT bond returns are largely uncorrelated with other financial instruments, providing portfolio diversification.

  • Strong Historical Returns: CAT bonds have historically offered attractive returns, drawing in alternative capital sources.

And yes, this industry is now worth $45bn… a drop in the ocean compared to some assets, but for a niche vehicle it is significant and likely to grow as alarm over the climate (rightly or wrongly) grows.

Etienne Schwartz, an expert in cat bonds, was asked in July if climate change is affecting the market…

Significantly! We have seen a clear increase in the frequency and severity of catastrophic events over the last few years, notably with respect to wildfires and tornadoes in the US, as well as European wind and flood.

A sudden increase in event frequency, particularly where the change seems to be accelerating, is challenging for the insurance industry to deal with because they are forced to rely on historical datasets when modelling these risks for regulatory reasons.

As a result, they have tended to structurally underestimate some of the risks associated with climate change. We incorporate more forward-looking assumptions into our own risk modelling and are starting to see growing discrepancies with industry risk assessments.

For investors, it just means that having your own in-house analytics capabilities is more important than ever.

More broadly, an increase in the frequency and severity of catastrophic events has increased losses for the insurance and reinsurance industries, eating into the amount of insurance capital available and driving the premiums paid by underlying customers up. 

If climate change continues to accelerate losses, we could well see insurance for certain risks in certain areas become unaffordable for the majority of people; we are already seeing the beginnings of this for California wildfires and Florida wind, but it will likely get worse.

So perceived threat of climate change and the effects of it are indeed changing how things are priced — we care about these things because others care and it could affect the price of assets and how people trade even the stock market!

Now there’s something called ‘net asset value’ (nav) in finance.

In short, nav is the value of an asset minus its liabilities.

In this case, fund managers are looking at potential losses from Milton versus the funds they have in the product.

Astoundingly, for such a hyped up hurricane (do better next time, climate!), Artemis reports…

Now, the average (NAV) decline on hurricane Milton for mutual catastrophe bond funds is almost -1.80%, while for the two interval style ILS funds that invest more broadly across reinsurance and ILS the average decline is almost -2.20%.

That’s a LONG way from the worst case estimates, where we were looking at triple digit billions in some cases…

Now estimates are at between $10-50bn.

The biggest factor to take away from this is really that if there are varied beliefs on something, SOMEONE is going to make a product to try and monetise the divergent beliefs…

I mean, take Polymarket or Kalshi for instance!

Should you try and bet on cat bonds?

Well, you probably can’t since they are an institutional only product…

What you could and should do with information like the existence and function of cat bonds is look at aspects of the market where returns might be uncorrelated to market conditions…

Sometimes this can be the key behind making super returns annually and, well, not.

At Fink, we aim to extract beta while managing risk.

We don’t pretend to be alpha kings!

This means we want to be able to extract profit from returns that are greater than a benchmark like the SP500.

Rinse and repeat.

What do you think though — is it moral to effectively be betting on natural disasters, even if it’s for insurance purposes (sort of)?

Drop us a reply with your thoughts, and your X handle for a shout out.