What the heck is happening with cat bonds?

Lessons in correlation from Bangladesh

Want to earn 14%-18% on your money? Consider the booming catastrophe (CAT) bond market, fast becoming a favorite of hedge fund investors. But watch out: a key assumption behind these bonds is that their performance isn't strongly correlated with the broader financial markets. In the years ahead, that assumption will most likely cease to be true. 

What are cat bonds? Cat bonds, invented by the insurance industry in the early 90s, are a sub-category of insurance-linked securities. They're designed to give insurance companies access to the capital markets when they want to de-risk their exposure to natural disasters. Basically, an insurer worried about extreme weather putting it on the hook for unsustainable payouts creates a special-purpose entity that then issues a security. The security, the cat bond, is designed to pay for losses that go beyond some high threshold. 

In a 2018 primer, the Chicago Fed described a sample three-year cat bond issued to provide a thunderstorm/tornado damages insurer with up to $100 million in compensation in the event estimated losses to the property and casualty insurance industry exceeded $825 million in a given year. If that threshold of losses was reached, the insurer would receive $1 in compensation for every $1 of additional covered losses up to $100 million. The investors in the bond would get a high rate (6.25%) of annual interest on their investment over the three-year term of the bond, to compensate for the higher risk they were taking on. The investors dutifully provided the SPV with $100 million in cash, which was then invested in U.S. Treasury bonds, and the insurer sent annual premiums of $6.25 million to the SPV as well. If the threshold of losses hadn't been reached, the treasury account would have been liquidated and returned to investors. As it turned out, the trigger happened (it was a bad time for tornadoes), and the investors' principal was completely wiped out. 

You can see why insurers wanting to shift some risk off their books might want to issue cat bonds. They're backed up by those Treasury accounts, so the insurer is confident of being paid if the trigger or threshold is met—better than a deal with a reinsurance company, which might become insolvent. They last for a few years rather than having to be renegotiated every year. Investors like them too, because the spread—the premium over a risk-free interest rate that investors are paid to take on a catastrophic risk—can be great. Investors noticed that even though other investment instruments swooned during the 2008 financial crisis, cat bonds stayed strong. Cat bonds can be a source of diversification, the reasoning goes, because natural disasters are random and unconnected to larger financial trends.

Well, 2023 was the best year ever for cat bond investors. According to Sheryl Tian Tong Lee and Gautam Naik of Bloomberg, hedge funds reaped enormous profits betting on cat bonds last year—as much as 19.7% in gains. Many more cat bonds were issued than ever before, and spreads were the highest they have ever been. Why? There was a "relatively benign" hurricane season in the US at the same time that inflation-fueled construction costs made insurers fear much greater losses following storms.

Enthusiasm for cat bonds is high, particularly for the new-growth cat bond area of wildfire damages, so inflows are tightening spreads a bit. (In other words, investors are really interested in these bonds, so the supply of capital available to soak up the bonds is increasing. Bond issuers, as a result, don't have to offer as much of a risk premium to attract investment.) But spreads remain near historic highs.

Here's what should be troubling to cat bond investors: A key assumption behind their popularity is that they represent largely uncorrelated risk—an "opportunity to earn an attractive return on investment uncorrelated with the returns of other financial market instruments," in the language of the Chicago Fed, as a tradeoff for taking on the burden of losing the entire investment should an identified catastrophic threshold be crossed. 

Surely that assumption will cease to be true in the years to come. The US coastline is home to nearly a third of the country's population, and there has been enormous growth in these areas (particularly along the Gulf of Mexico) over the last 60 years. Forty million additional people moved to coastline counties between 1960 and 2008, and that number has continued to increase since then. If American coastal counties were a country, it would have the third-highest GDP in the world. The warming oceans along those counties are posing country-wide economic risk.

Just ask the Senate Budget Committee, whose chairman, Sen. Whitehouse, said the other day:

The market will have to adjust abruptly to a new realization that the useful life of billions of dollars in property will end way sooner than expected, setting off dangerous economic cascades. We saw in 2008 how trouble in the mortgage market cascaded out into the broader economy; the writing is on the wall for a climate-fueled repeat. We are seeing the early stages of such a trajectory in the Florida insurance market. The thing about economic crises is that they come on slowly, until they come on fast.

I've been reading this week about the cataclysm that struck what was then East Pakistan on November 12, 1970. The Bhola Cyclone made landfall at high tide, during a full moon, and brought with it a storm surge some said was 33 feet high. Unclear and delayed information about the ferocity of the coming storm left hundreds of thousands of people in harms' way, and between 300,000 and 500,000 people died. The response from the central government of Pakistan, in what was then West Pakistan, was feeble, even though most of the country's population lived in East Pakistan. Corpses were floating everywhere and entire villages had vanished. (Gary Bass's authoritative 2013 book, "The Blood Telegram," tells this story vividly.) This failed response to the storm led directly to deep losses for West Pakistan in an election held a month later, which in turn led to a bloody genocide carried out by Gen. Yahya Khan's West Pakistani forces. (More about this another time. Another recent book, "The Vortex: A True Story of History's Deadliest Storm, an Unspeakable War, and Liberation," by Scott Carney and Jason Milkman, ties these immoral threads together.) The independent country of Bangladesh emerged from this storm and these conflicts.

It's a simple point: Even absent a military regime using mass killings to crush a majority that wins a fair election (which is what happened following the Bhola Cyclone), this story should make us reflect on the role intensifying, frequent, widespread storms and flooding that cripples coastal financial areas and activities will have on our overall economic and political picture.

These rapidly intensifying events will surely be correlated with larger financial trends. It's a brittle picture of correlated risk.