Market is booming for insurance-linked securities known as catastrophe bonds.
John Seo sells an investment labeled “catastrophe” – and people cannot get enough.
The mounting cost of natural disasters, including extreme weather events fueled by a warming climate, has insurers and public agencies looking to share the financial burden with Wall Street.
That’s where Seo, managing director of Fermat Capital Management in Westport, Conn., comes in. From a one-story brick building adjacent to the town’s railroad station, he transforms the risk of multibillion-dollar natural disasters into securities that pay off for investors – so long as they make the right bet on exactly how bad things will get.
Some of the market’s savviest participants – including hedge funds, pension plans and the ultrarich – are increasingly putting their money into these “catastrophe bonds,” the most prominent type of insurance-linked securities. After record sales so far this year, the total cat bond market now exceeds $41 billion, almost double its 2013 level, according to Artemis, an investment data firm.
For insurers, and others such as Amtrak, Florida’s state retirement system, Google, the New York City transportation authority and the World Bank, tapping financial markets is a way to limit worst-case damage bills from hurricanes, wildfires, earthquakes and other threats. Only individuals worth at least $100 million typically are able to buy cat bond funds.
“I’m not renting out a room at the local Ramada and pitching a mass audience. It’s still an investment for sophisticated investors,” Seo said. “Our job is to answer the phone.”
With Hurricane Idalia slamming into Florida as a Category 3 hurricane on Wednesday – just weeks after wildfires ravaged Maui and record rainfall swamped Southern California – Seo’s phone is ringing.
The cat bond market has been growing, despite a recent flurry of climate-linked storms and fires, as some investors rush toward risks that most would shun. The frequency of unusual weather events, including hot-tub temperatures in the ocean off Florida, has made natural disasters a staple of newspaper and television coverage, sparking investor awareness in this sliver of the financial world.
Insurers unload some of their risk by selling cat bonds, which require investors to pay damages resulting from a natural disaster, if specific conditions are met. The bonds offer fat returns, but carry the risk of total loss of principal if the worst happens.
Investors, for example, that bought a $200 million catastrophe bond from PG&E, the California utility, in August 2018 lost their entire stake when the devastating Camp Fire erupted just three months later.
Seo, 57, who describes himself as a cat bond evangelist, has a PhD in biophysics from Harvard and a physics degree from the Massachusetts Institute of Technology. He worked for Lehman Brothers years before its collapse in the financial crisis and co-founded Fermat, which employs about three dozen people, with his brother Nelson in 2001.
Potential investors call him, usually after researching the cat bond market for years. Contrarian by nature, those who manage pension plans, sovereign wealth funds or university endowments are prepared to wager a small portion of their holdings on an alternative investment that to the uninitiated seems saturated in danger.
“All these people understand intuitively that insurance has always been important. It may be boring, but it’s always important, and that with climate change and an awareness of climate risks, insurance only rises in importance,” he said.
Fermat manages more than $9 billion in cat bonds for investors, who are attracted to this financial niche by prospective returns of more than 10 percent at a time when super-safe treasuries pay half that. Even better, cat bonds typically do not rise and fall in value along with other investments, making them a good way to diversify a portfolio.
In March, when Silicon Valley Bank set off a banking panic, the Dow Jones Industrial Average fell by 5 percent in one week. But cat bonds were unscathed.
Whenever they sell coverage against property damage, insurers typically unload some of the risk to other companies known as reinsurers. Issuing cat bonds is essentially another way to achieve the same de-risking.
Reinsurance companies provide more than 80 percent of the capital that backstops insured risks. But over the past decade, most of the new money devoted to guarding against risk has come from the capital markets, not traditional reinsurance companies, according to Aon Securities, a Chicago-based investment bank.
Reinsurance firms earlier this year raised rates and reduced underwriting of new policies, following several years of losses. Several insurance companies have exited risky markets such as California and Florida or limited their business there. For the insurance industry, keeping pace with the rising cost of more frequent climate-related disasters could depend on its ability to continue wooing Wall Street.
“It’s a great investment,” said Florian Steiger, an investment manager with Twelve Capital in Zurich. “But it is by no means risk free. It is a very risky asset class. You get the big Cat 5 [hurricane] in Miami, we’re talking about double-digit losses.”
The effects of a ruinously expensive 1992 Florida storm, Hurricane Andrew, led to the creation of cat bonds. Andrew caused more than $58 billion in property damage in today’s dollars, with only $33 billion of that amount covered by insurance. The costliest storm to hit the United States at the time, Andrew caused eight insurance companies to fail.
The storm prompted government officials, businesses and homeowners to reassess Florida’s vulnerability to natural disasters and demand additional protection beyond what the traditional reinsurance market could handle.
In response, insurers seeking new ways to attract capital created the catastrophe bond, according to a 2018 Federal Reserve Bank of Chicago note.
Along with more frequent weather-related disasters, insurers also face mounting damage bills from historic inflation and supply chain headaches that have driven up rebuilding costs, said Steve Evans, editor in chief of Artemis.
“What’s been driving the growth in catastrophe bonds has actually been a need for capital and capacity in the insurance industry generally,” he said. “So the majority of catastrophe bonds are providing reinsurance protection to insurance companies.”
Here’s how the bonds work: An insurer that wants to unload a particular risk sells a bond that requires investors to pay damages resulting from a particular type of disaster, if specific conditions are met.
The investor puts up collateral, which earns interest and will be used to pay the damages if the disaster occurs. The investor receives periodic interest payments, just like with a regular corporate bond, and gets its collateral back if no qualifying disaster occurs during the bond’s term.
Each bond is written to cover a particular risk or “peril” affecting a specific geography, such as a named storm in Massachusetts or an earthquake in Japan.
Cat bonds typically operate like a high-deductible health insurance plan, guarding against the worst outcomes rather than paying the first bills. Most bonds are in effect for multiple years.
In the wake of Hurricane Sandy in 2012, the superstorm that flooded the Manhattan subways, the New York Metropolitan Transport Authority issued a catastrophe bond to protect it from a similar event in the future. The protection would kick in only if a tidal gauge in the Battery, at the southern tip of Manhattan, detected flooding of at least 8.5 feet. One inch less and investors would not be on the hook.
The appeal of these investments is obvious. In June, the California Earthquake Authority sold $425 million in cat bonds to investors in two batches. Investors who buy the less risky ones will be on the hook to pay damages if annual earthquake-related losses top $5.651 billion. In return for accepting that risk, they can expect to earn a return of about 12 percent.
Investors who purchase the riskier batch can anticipate a higher 15 percent return. But they start making payments as soon as annual losses exceed $2.994 billion.
It’s too soon to tell whether any investors will be called upon to pay for any of the estimated $5.5 billion in damages from the recent Maui wildfires.
But so far this year, investors have escaped responsibility for the most costly U.S. disasters.
A series of severe thunderstorms in the United States were responsible for 68 percent of global insured losses in the first six months of 2023, according to an Aug. 9 report from Swiss Re, the Zurich-based reinsurance firm. The $34 billion bill in the United States was the highest for any half-year period.
Insurers paid heavily. But investors were untouched.
“The losses we’ve seen over the last number of years, a lot of it has to do with these smaller events like thunderstorms, hailstorms, tornadoes. It’s not one of the named perils,” said Tracy Benguigui, an insurance equity analyst at Barclays.
Only a few corporations each year issue their own cat bonds, because it’s easier to buy insurance, Evans said. Google has gone to the market three times, most recently in late 2021, to obtain protection against the risk of a California earthquake.
Governments also issue cat bonds to protect taxpayers. Earlier this year, the Federal Emergency Management Agency issued $275 million of cat bonds to backstop the National Flood Insurance Program.
Under the terms of its 2022 cat bond, a storm comparable in flooding damage to Hurricane Katrina would cause bondholders to lose their entire investment, according to the Congressional Research Service. A storm akin to Sandy would cause investors to lose some of their principal.
The Florida state pension plan has about 2 percent of its $48.5 billion portfolio invested in insurance-linked securities, including $95 million in cat bonds, according to Paul Groom, deputy executive director of the state board of administration.
In March, the World Bank, one of the largest participants in this market, provided Chile with financial protection against earthquake and tsunami damage, including $350 million in catastrophe bonds, the bank’s single largest such transaction.
“Chile is one of the most seismically active countries in the world, experiencing some of the largest earthquakes ever recorded,” said Carlos Felipe Jaramillo, the bank’s vice president for Latin America. “This cat bond allows Chile to transfer major earthquake risks to the capital markets, while allowing the authorities to respond quickly to the needs of citizens when calamities strike.”