Bob Tannahill, our resident bonds expert and part of our discretionary investment team, writes this week’s update.
You can if you have cats…
While hurricanes are a fact of life for people living around the Gulf of Mexico, it is impossible not to be shocked by the pictures and stories of those worse affected by these dramatic events. Another emotive and related subject is how people who live in these regions can get access to affordable insurance cover. I think we can all sympathise with the desire to be protected against natural disasters, however, when you see images like the below the question that springs to my mind is, what insurance company can possibly afford to insure a high-risk region like Florida?
Source: The Independent
The answer is that no insurance company can. Insurance works on the premise that many people pay into a pot but that only the minority will ever have to claim on the pot at the same time. So, a small Florida insurer might insure 10,000 homes and as long as only a few claim at a time they can afford to cover those claims. But what happens if a large number of those homes in the same region are damaged at the same time? In the case of many smaller regional insurers, paying out in full to all households is out of the question.
This is where reinsurance comes in. The “frontline” insurer agrees to take the more likely but smaller risk of a small number of claims and then takes out their own insurance policy to insure them against the less likely but very expensive case of a wave of related claims. It was major disasters such as the Great Fire of Hamburg in 1842 that pushed many insurers to the brink of collapse and inspired the development of the reinsurance industry.
Source:Wikimedia
The creation of firms such as Munich Re was the result, and this worked well for a long time. Eventually, however, high-value metropolitan areas started to develop in high-risk regions. Be that cities like Miami, which sits in a hurricane region, or Tokyo, which sits in a seismically active zone. Even for the mighty re-insurers, these risks are simply too big for any one firm to take on and this creates a serious problem. If the re-insurers can’t manage this highly unlikely but potentially ruinous catastrophic risk, then they can’t re-insure the frontline insurers. And if the frontline insurers can’t get re-insurance, then they can’t provide policies to people in high-risk regions such as Florida. This reality was hammered home by Hurricane Andrew, which struck the south end of the Miami area in 1992 and caused an estimated $27bn of damages. So, what entity can stomach such enormous losses in a short period of time? There is probably only one place: the global financial markets.
Source: Wikimedia
Every time you hear on the news that global stock markets are up or down by 1%, something that can happen by lunchtime, you are talking about the values of those stocks rising or falling by hundreds of billions of dollars. So $30bn to clean up a hurricane, amazingly, is something of a drop in the ocean. No pun intended!
But how do markets provide insurance? Well, this is where cats come in. Or to give them their full title, catastrophe bonds.
Cat bonds, which are a type of insurance-linked security, might sound strange, but they work very much like other types of bonds. Investors hand over money up front, they get paid while the money is lent, and they get it back at the end provided something bad hasn’t happened. The only real difference is that the “something bad” for cat bonds is an insured event, such as a natural disaster, while the “something bad” for normal bonds is the default of the borrower, such as a company or government. This allows the big re-insurance firms to effectively get insurance against these otherwise uninsurable events and ultimately for people in regions like Florida to get insurance.
On the investor side, provided there is prudent portfolio management and diversification to limit the risk, we can be paid well for providing the capital. At present a lack of money available to the insurance market means cat bonds are paying investors in excess of 13% per annum. We access this space through a specialist house called Fermat, which is a name some clients may have seen in their portfolios. And to put the risks in context the recent hurricane Milton, which hit the Tampa region last week, is expected to cost the Fermat portfolio less than 3% in claims. This gives you some feel for why we think the current balance of risk and reward in cat bonds is highly appealing. It is important to note that even a diverse fund of cat bonds carries a small chance of a big loss and as such they need to be carefully blended into broader portfolios. With this caveat in mind however, at current prices we can be paid well for providing caprital to the space. And by doing so, we are helping people in high-risk regions access essential insurance cover. In a highly uncertain world this is for us a win/win scenario.
