Catastrophe bonds shake up insurance industry

By added on 08/08/2016

Catastrophe bonds were invented in the early 1990s to help insurance companies mitigate the risk of disasters such as hurricanes and earthquakes. Today, like the very storms they protect against, catastrophe bonds are upending the insurance business, reports MarketWatch.

The oddball securities have exploded in popularity, driven by pension plans, sovereign-wealth funds and wealthy families seeking better returns. Investment banks and insurers’ own securities-brokerage operations churn out billions of dollars a year in catastrophe bonds.

There are “cat bonds” that pay off if too many people die in a pandemic. Others cover the opposite problem of people living beyond their expected lifetimes. An American International Group Inc. AIG, +2.59%   unit sold cat bonds this spring to insure itself against a potential rash of foreclosures. A Credit Suisse Group AG CS, +0.71 per cent   bond sale in May insured the Swiss bank against the risk of rogue traders, cyber hacking and accounting fraud.

Traditionally, insurers raise capital and use it to back policies that are priced by the companies’ actuaries. To unload some of their risk, insurers pay premiums to companies known as reinsurers, a low-profile corner of the industry that serves as insurance for insurers.

Catastrophe bonds have disrupted this way of doing business. The bonds are sold by insurers or the entity itself seeking insurance, like a local government or transit agency. An independent risk-modeling firm calculates the odds of a particular disaster occurring. Investors are paid relatively high interest rates but lose their principal if disaster hits.

As a result, the price of reinsurance is falling, as are profits. These bonds have also injected a new source of volatility into the otherwise staid insurance world, since money flows are driven by broader forces in the bond market.

In all, there are $72 billion of cat bonds and similar investments outstanding. The total is equivalent to 12 per cent of the $565 billion in capital in the reinsurance business. The volume of cat bonds and related investments is widely expected to double in the next several years, a sign that the transfer of risk from the insurance industry to capital markets has opened up access to a seemingly limitless source of funding.

That means this new fixed-income market “is acting like one giant insurance company,” says John Seo, a biophysics Ph.D. and former insurance-risk trader who co-founded Fermat Capital Management LLC in 2001 to invest in cat bonds and other securities.

The surge is partly an unintended consequence of economic-stimulus efforts by central banks. Low interest rates are pushing investors such as pension funds to seek out higher returns.