‘Cat bonds’ may turn into dogs for investors

In recent years, cat bonds have enjoyed incredible growth in the United States as insurers seek a more affordable option than taking out a contract with traditional reinsurers.

Much like with a traditional bond, investors hand over a sum of money to obtain a cat bond, and are paid interest. They have been attractive to investors in the current low-rate environment as they often offer higher interest.

The catch is that if the natural disaster specified in the bond takes place the insurer may not pay back part or all of the bond and use the funds to cover its losses or replenish its capital.

However, without a major hurricane in recent years, investors have been snapping up cat bonds.

In 2016, the alternative reinsurance market was worth $81 billion, after expanding by nearly 13 percent for two straight years, according to data from British reinsurance broker Aon Benfield.

That put it at just under 14 percent of the size of the traditional reinsurance market.

– Testing times –

But the favourable winds may be over.

Hurricane Harvey, which lashed Texas and Louisiana with unprecedented rain last month, could end up costing insurers between -30 billion, experts suggest.

“Harvey and Irma are significant events for the sector… They will be a test for alternative capital,” said Torsten Jeworrek, a member of the management board at German reinsurance giant Munich Re, at an industry conference in Monaco this week.

Jeworrek also estimated Harvey, which lashed Texas and Louisiana with unprecedented rain last month, could end up costing insurers between $25 and $30 billion (21 and 25 billion euros).

Damage estimates for Hurricane Harvey, which made landfall in Texas on August 26 before returning out to sea to then lash Louisiana, vary from around $50 billion to well in excess of $100 billion.

However, not all property was insured or fully insured.

Nevertheless, with Harvey and Irma, certain “cat bonds will be triggered, the expected profitability won’t be there and there may even be losses,” said Claude Tendil, the organiser of the annual insurance conference known as September Rendezvous.

“The alternative finance market could experience a sudden stop,” he added.

Before Hurricane Irma struck Florida, ratings agency S&P Global Ratings identified 13 cat bonds that could get triggered, depending on its path and the severity of damage.

“Ever since the first catastrophe bond was issued, the question ‘How would the market react to a major event?’ has loomed, and Hurricane Irma could very well be that event,” the agency wrote in a recent report.

Some bonds could possibly see a loss on the investment principal, but S&P Global Ratings remained sanguine about the prospects for the cat bond market, even if some investors get burned by Irma.

“As to what happens post-Irma, even if bonds were to suffer principal reductions, we expect most investors would remain, as periodic losses are to be expected. So, one event, even a major one, should not result in a mass exodus,” said the agency.