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KIM: ‘CAT’ bonds ease financial pain of nature’s fury

September 9, 2017

KimThe images of the devastation caused by Hurricane Harvey are fresh and draw comparisons to Katrina, which was just one of four major hurricanes to hit the United States in 2005 (preceded by Dennis and followed by Rita and Wilma).

Before Harvey, the most recent notorious hurricanes to hit the United States were Matthew (2016) and Sandy (2012). In fact, according to the NOAA National Centers for Environmental Information, the United States has sustained 212 weather and climate disasters since 1980 in which damages exceeded $1 billion, with cumulative damages in excess of $1.2 trillion. Harvey was the 10th such disaster of 2017.

Weather forecasting and investing are both probabilistic endeavors. Floods are sometimes referred to as “100- or 500-year events,” but it’s important to understand these terms refer to the chance of a flood happening in a given year, not the timing. A 100-year flood theoretically has a 1 percent chance of happening in a given year, but that doesn’t mean it will happen only once a century or can’t happen in consecutive years. When you flip a coin, heads and tails have the same 50 percent probability, but it’s certainly possible to have a string of five or 10 in a row.

According to Vox, from August 2015 to August 2016, there were eight 500-year flood events recorded by the National Weather Service and three 1,000-year flood events in each of 2015 and 2016. Harvey will likely be the Houston area’s third 500-year flood in three years.

Whether climate change is increasing the probabilities of weather disasters or we’re just having a run of bad luck, the need for protection is obvious.

Property owners typically purchase an insurance policy from Company A, which in turn lays off a portion of the risk by purchasing “reinsurance” from Company B. Catastrophe, or CAT, bonds were invented in 1994 after Hurricane Andrew (1992) created $25 billion in insured losses in Florida, leading to the bankruptcy of numerous insurers.

CAT bonds enable insurers to transfer risk to bondholders. With traditional bonds, the issuer defaults when it becomes insolvent and is unable to pay scheduled interest and principal. With CAT bonds, the issuer defaults when 1) a specified catastrophe 2) hits a particular place 3) before the bond matures (typically three years). In essence, CAT bondholders are betting catastrophe won’t strike.

Four types of triggers can cause a CAT bond to default:

Indemnity trigger: covers claims paid by the issuer over a threshold amount.

Industry loss trigger: based on claims paid by all insurers on the extreme event.

Parametric trigger: based on occurrence of a specific extreme event (i.e. category 5 hurricane).

Modeled trigger: based on claims estimated by a computer model.

CAT bonds are popular, as they offer relatively high returns that are also uncorrelated to the economy or stock/bond markets. The issuer invests the principal received from the bondholders in ultra-safe securities. The income earned is combined with premiums received from policyholders to pay above-market rates to the bondholders. If no default is triggered, the principal is returned at maturity.

With tightly defined triggers, there have been relatively few defaults for the 230 CAT bonds issued since 1994, but only time will tell if CATs have nine lives.•

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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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