With Hurricane Irma expected to make landfall in Florida sometime on Sunday according to the latest NHC forecast, investor attention is shifting to Catastrophe Bonds, which at least in some cases already, have lost as much as 50% of value in the past few days.
For those unfamiliar, Catastrophe bonds (or CAT bonds) are a major category in the security class known as insurance-linked securities or ILS. Their purpose is to securitize, or crowd-source in the parlance of our times, reinsurance coverage, in order to reduce reinsurers’, insurers’, and self-insurers’ reserve requirements and reduce their cost of coverage. At the same time they are attractive to investors, because the risks they cover are virtually uncorrelated with other risks such as equity market risk, interest rate risk, and credit risk, and effectively offer a “prop bet” on catastrophic events taking place over a given time horizon, usually three years.
Catastrophe bonds – which are typically used by insurers as an alternative to traditional catastrophe reinsurance – emerged from the need by insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not cover by the premiums. An insurance company issues CAT bonds through an investment bank, which are then sold to investors. These inherently risky bonds are usually rated BB, and have maturities less than 3 years. If no catastrophe occurs, the insurance company pays a coupon to the investors. However, if a catastrophe does occur, then the principal would be shaprly reduced or forgiven and the insurance company would use this money to pay their claim-holders. Traditional investors in CAT bonds include hedge funds, catastrophe-oriented funds, and various other return starved asset managers.
This post was published at Zero Hedge on Sep 6, 2017.