The hurricane season this year is shaping up to be particularly severe.
Wildfires in California are intensifying, and floods are causing widespread damage.
Who will bear the costs?
Surprisingly, an increasing number of investors are willing to take on this risk.
Sales of catastrophe bonds, a form of insurance used to transfer part of the risk of the costliest disasters to the capital markets, are on the rise.
In the first half of 2024, a record $12.6 billion worth of bonds were issued — mainly covering properties — by reinsurers and governments from Mexico, Jamaica, and Puerto Rico, according to data provider Artemis.
The investor base for this $48 billion market is expanding, involving more funds of funds, family offices, and wealth managers investing through UCITS funds.
Investor interest has been spurred by attractive returns.
The Swiss Re Global Cat Bond Total Return index posted a 19.7% return last year, the highest since 2002.
This result is attributed to lower-than-expected costs for 2022, higher risk premiums, and increased returns on collaterals typically invested in money market funds.
The catastrophic bond market yield — a mix of collateral return and insurance risk premium — more than doubled in three years, reaching 13.7% at the end of June, according to Artemis.
However, there are significant risks involved.
One issue is that investors’ capital can remain locked up after a disaster due to payment delays, which can occur if there are uncertainties regarding compensations.
Another concern is that investors might be taking on more risk than anticipated.
So far, the average cumulative losses for bondholders have represented 2.7% of capital over the 26 years until 2023, according to Swiss Re.
Factors limiting compensations include a growing preference for covering specific events rather than aggregates, thus protecting against rising costs of low severity but high-frequency storms and fires.
Additionally, bonds only pay out when costs exceed a certain threshold.
Despite 2023 being a record year for disasters, few catastrophe bonds paid out.
Catastrophe bonds offer diversification along with high returns.
Natural disasters are not tied to economic cycles.
However, this is a sector reserved for sophisticated investors.
They should be aware that these bonds are by no means a risk-free choice.
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