Did Cat Bonds Take a Hit from the Hurricanes?

This article recently appeared in "What's Hot" in Knowledge at Wharton.

When weather forecasters predicted a severe hurricane season early this year, analysts began wondering whether investors in catastrophe bonds would bolt. So far, according to risk management experts associated with Wharton, that hasn't happened.

"It turns out that investors did not fare too badly" from Hurricane Floyd, which struck the east coast of the U.S. in September, says Robert H. Litzenberger, a Goldman Sachs managing director and Wharton alumnus. Goldman Sachs helped lead a bond issue in the Florida area by the automobile insurer, United Services Automobile Association (USAA) in 1997 and each year since. In addition, Goldman Sachs is one of several sponsors funding Wharton research into modeling systems that estimate the risk of catastrophes.

"There was exposure in eastern Florida, when it was thought Hurricane Floyd might hit there, and the price of the bonds came down substantially," Litzenberger notes. "But once it passed that area, the price of the bonds recovered substantially."

Catastrophe securities are a recent development in investing. By floating such bonds for specific risks over limited time periods in defined geographic regions, insurers and reinsurers reduce risk by transferring it to investors. Investors (usually hedge funds or other major institutional financiers) get a high rate of return, often around 11% annually, in return for the possibility of losing much of their principal or interest, or both, in the event of disasters.

Catastrophe bonds have been used, for example, to mitigate the insurance and reinsurance risks of hurricane damage to property in Florida during the hurricane season. Once a disaster occurs, and its dollar cost surpasses, say, $500 million, then the investors lose substantial portions of their investment, and the insurer uses the cash to help pay off on policies.

Although the hurricane season this year still has two months to go, Floyd's effect on insurers' and large investors' attitudes toward securitizing risks may have even been salutary, says another Goldman Sachs managing director, Andrew Kaiser.

"Last year, the concern was how do we make people realize this is a good vehicle that makes sense because of the nature of the return," and the fact that it allows investors to diversify outside of the stock market, Kaiser observes. "What you want in such a circumstance is for there to be a small number of hurricanes, so people understand the variations, but not so large that they find they can lose substantial amounts of money."

Neil Doherty, professor of insurance and risk management at Wharton, also shrugs off Hurricane Floyd and the other big storms that have recently been raging around the Atlantic. "There was some movement [in USAA cat bond prices] before Floyd hit," he says. "These bonds do trade, and an impending hurricane of the [projected] intensity of Floyd was frightening people." In the long run, however, it had no effect on the way investors look at these bonds, he says.

Meanwhile, Wharton's project to investigate the effectiveness of the three major catastrophe-modeling efforts is going well, says finance professor Anthony M. Santomero, director of Wharton's Financial Institutions Center. As part of that project, researchers are looking at competing disaster models offered by Applied Insurance Research, EQECAT and Risk Management Solutions.

They are also trying to find out how much capacity the insurance and reinsurance markets must have to be able to sustain losses. "Losses have become bigger, but capacity is up substantially, so for things like Floyd this was not a problem," Santomero says. "On the other hand, the potential for large losses can be enormous. That's where securitization instruments come into play, because the capital market is so much larger than the insurance and reinsurance market."

Doherty thinks cat bonds are just the advance wave of an approach that is going to become increasingly commonplace for managing many kinds of risks.

"There are signs now that these types of instruments are being taken out of the cat risk area to cover other weather-related risks and maybe environmental risks," Doherty says. "I think eventually you are also going to see non-insurance companies issuing instruments like this to cover, say, liability risks."

The essence of cat bonds is that they are "forgivable debt," Doherty observes. That idea can also be applied to other types of disasters, including financial ones. He notes that one of the ideas that has been tried recently is reverse convertible debt. In this approach, debtholders can convert their bonds into stock if the company fails to meet certain specified financial objectives.

"There's always a perverse incentive [for corporate executives] when you have a lot of debt," he notes. "If things go well, the shareholders do very well; if things go badly, they can declare bankruptcy and walk away from the debt. Now, what you can do with some of these new types of instruments--putting some forgiveness in the debt should something go wrong--is you change some of the incentives so that the shareholders get stuck with some of the downside risk. That should be very comforting to bondholders. Once the company gets into trouble, the bondholders get paid off in equity. It's subtle, but I think the message is starting to get across that these types of approaches might make sense. They address the firm's need to finance everything, plus they manage risk as well."

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