County Level Cat Bonds Offered

As reported in the Financial Times, Blue Coast, a unit of the German insurer Allianz, is now selling catastrophe bonds that break down losses from hurricanes by the county in a state, instead of at the state level itself. The $120 million issue is the first to bring the event down to the county level. Whether this will encourage local municipalities along with states themselves to cover their catastrophe risk is difficult to tell. It will no doubt certainly allow investors more transparency as to the exact risk they are taking, at least from a location perspective, and could facilitate pricing and valuation.

For those unfamiliar with catastrophe bonds, they are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. As with other bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. Cat bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. After Hurricane Katrina one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. An additional benefit of cat bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.

A little over a month ago I wrote a post discussing a Barron's article on the subject. At the time a reader who worked in the industry made some interesting comments, one of which discussed the recent growth of cat bonds. It was mention that over the last 10 - 15 years the market for cat bonds had went through some abrupt growth periods which typically followed weather events like Hurricanes Katrina and Andrew, and other events like 9/11, but then growth usually stagnated in between. What is interesting now is that the current growth is not really being triggered by recent events. What could be driving the growth? As it turns out, hedge funds are initiating funds that invest in cat bonds given their low beta risk, high yield, and attractive Sharpe Ratios. Since both supply and demand has been strong, even without events increasing, the cat bond yields have stayed attractive.

The worry is that higher yields will cause more hedge funds to enter this asset class without really understanding the nature of the risk, driving down yields and increasing exposure. Furthermore, unlike for bankruptcy, or even credit risk, investors will have a more difficult time evaluating something like a catastrophe which can be both severe and unexplainable. This usually leads to a post-event attempt to assign blame to others with no hand in the event. Investors who put their toe in the water during the year of the event could lose their entire principal before they ever earn the high yields. The fear is that when the event does happen, the product, and those that offer it, may end up being the scapegoat, thereby forcing the government (and John Q taxpayer) to cover the losses. Imagine. A scenario where investors buy something they don't fully understand, capture the benefits of attractive terms, but have the government and taxpayers cover the risk when things go bad. Never mind. That would never happen.