The State of Catastrophe Bonds

by: Felix Salmon

Catastrophe bonds make a huge amount of sense, in theory. The cost of Hurricane Katrina was over $65 billion in insured losses alone. And that's a fraction of potential damages: coastal property in Florida is worth $1.9 trillion, compared to just $66 billion in Louisiana and Mississippi, where Katrina hit. Values in earthquake-prone California are, if anything, even higher. What's more, uninsured losses, especially in areas of the world which have recently been hit by hurricanes and the 2004 tsunami, are higher still: globally about 25% of catastrophe risks are insured, and in the emerging markets it's 7%.

The problem is that the risk of bearing the costs of catastrophes tends to be borne either by private reinsurers, whose capacity tends to top out at about $150 billion, or else, ultimately, by national governments, many of whom in places like Honduras or Sri Lanka simply don't have the fiscal capacity to recover from a major disaster.

Where to turn? Capital markets: They should have much more ability to provide extremely large amounts of money than do reinsurers and other traditional risk takers. But although the issuance of catastrophe bonds has been growing, it's still tiny. From a newly released Milken Institute report on the topic (click on chart to enlarge):

Click to enlarge

In 2007, which was a record year for cat bond issuance, the total fell just shy of $7 billion. Dan Ozizmir of Swiss Re talked about these numbers growing exponentially in the future, especially if catastrophe bonds expand to include not only earthquakes and hurricanes but also catastrophic mortality risk. Life insurers often have $1 trillion of face value in written life insurance policies, and a major wipeout of human life, like a big terrorist attack or a bird flue pandemic, could destroy the life-insurance industry.

Even bigger sums could be in play with drought insurance - something which Swiss Re has already started offering to Jeff Sachs in conjunction with his Millennium Villages project. There, satellite imagery is used to measure total vegetation, which is an excellent proxy for crop yields. So far, this kind of risk hasn't been securitized, but there's no reason in theory why it shouldn't be.

All of these trillions of dollars in potential catastrophe bonds, then, not to mention associated derivatives, which could be even bigger, have yet to appear. Some of the obstacles to growth in this market are slowly falling away: one, for instance, is the fact that most of these bonds are written and structured by reinsurance companies, and investors are worried about adverse selection: the risk that reinsurers are selling off their worst risk. Slowly independent catastrophe risk rating agencies are appearing, which should help assuage such concerns, although clearly quantifying the risk of future catastrophes is very difficult indeed.

But more profoundly, the market in these bonds at the moment is dominated by hedge funds, who generally require much higher returns than do reinsurance companies. It shouldn't be that way: Pimco's
John Brynjolfsson pointed out that total catastrophe exposure globally of about $4 trillion pales in comparison to the $100 trillion in global debt and equity markets. According to his study, on average global markets are a bit higher after a natural disaster than they were before the disaster, which means that catastrophe bonds really are completely uncorrelated to global markets - something very valuable to any institutional investor.

On the other hand, there are some spillovers between capital markets and catastrophe bonds. Catastrophe bonds need to put their principal into collateral, for instance, which needs to be liquidated in the event of a catastrophe, and during a credit crisis there can be concerns over the quality of that collateral.

That said, there does seem to be more demand for catastrophe bonds than there is supply. Right now, the market isn't clearing very well, partly because the transaction fees on these bonds can be very high. I've been hearing a lot of hopeful projections of how fast the catastrophe bond market is going to grow for many years now, and so far it hasn't really happened. This issue was addressed by Jose Siberon of Merrill Lynch, who called for government to help: the state of Florida, he said, should lead the way by insisting on using capital-market structures to help insure its hurricane risk.

One big issue seems to be endemic, however, and that's the difference between parametric risk and indemnity risk. Bond investors want to pay out based on science: earthquakes as measured by the Richter scale or amount that the ground moved; hurricanes as measured by wind speed and the like. Insurers and insured, by contrast, want their payouts based on losses. The basis risk between the two is large: Everybody can think of large losses from relatively small events, or small losses from relatively large events. And it's not easy how that basis risk can be reduced.