Huge Profits Catastrophe Bond Investors Raise Eyebrows

Enjoy free access to the best ideas and information – selected by our editors.

(Bloomberg) –A strategy that has provided specialist investors huge profits are now facing scrutinized attention amid concerns that the risk-reward dynamic may be skewed against some issuers.

Catastrophe bonds, which are issued by insurers, reinsurers and governments looking for an extra layer of coverage in the event of disasters, have given investors double-digit returns. Meanwhile, issuers have seen their costs rise.

Grievances arose in July after it was found that Jamaica’s disaster link had not been triggered by the devastation caused by Hurricane Beryl. Although the entire Caribbean island was officially declared a disaster areathe carefully calibrated terms of the bond meant that its holders were protected from losses. In this case, it was decided that the precise level of air pressure required for a payment was not made.

For cat bond investors – who are now earning an average return of around 15% after hitting 20% ​​in 2023 – the result in Jamaica underpins the appeal of a strategy that has attracted some of the brightest minds in finance. For others, it sparked a difficult debate.

Caribbean heads of government within the group known as Caricom recently discussed the financial ramifications of Beryl. This month, the group said it would seek “a review” of bonds as well as other insurance-related securities and wants the region’s finance ministers to look more closely at which markets governments should choose and which they should avoid. .

“We recognize that at the end of the day, investors need to make a profit,” Jwala Rambarran, a former governor of Trinidad and Tobago’s central bank, said in an interview. “But at the same time equity and fairness say that it can’t be all the time when investors get profits. It’s a one-way street.”

Jamaica’s Ministry of Finance did not respond to requests for comment.

The country’s $150 million cat bond – arranged by the World Bank and bought by private investors – was issued this year to replace bonds due in 2021. The new bond costs the government 60% more per coverage unit, which reflecting the greater risks posed by climate change, as well as “harder” ILS market conditions, according to Conor Meenana venture finance specialist in London Center for Disaster Protection.

Cat bonds make it possible for issuers (also called sponsors) to transfer some of their risk to the capital markets. Sales of the instruments have skyrocketed in recent times, with factors such as climate change, population density and inflation adding to their appeal. Investors face potentially substantial losses if a bond is triggered, but can generate market returns if a predefined catastrophe does not occur.

For the $47 billion cat bond market, Beryl has proved an early win for investors navigating what is expected to be an unusually active hurricane season.

Zurich-based Plenum Investments AG, one of the private market buyers of Jamaica’s cat bonds, said it was attracted by the opportunity to diversify outside the US market. “We like it too parametric trigger structure, which minimizes post-event uncertainty,” Plenum said in an emailed response to questions.

Issuers using cat bonds obtain a very specific type of coverage whose terms should be clear to all interested parties at the point of purchase, according to the World Bank.

Cat bonds are “for tail events,” which are rare disasters outside the norm, he said Michael Bennetthead of derivatives and structured finance at the World Bank treasury. “The setting is not the small print, but the print.”

At Swiss Re, a common issuer of cat bonds, those dynamics are well understood. The instruments “are usually remote hedges that don’t pay per event,” said Jean-Louis Monnier, global head of ILS at the Zurich-based reinsurer. “It takes an extreme event for them to be triggered.”

In Jamaica’s case, Beryl fell far short of hitting the benchmark that would have triggered the bond payment. The pressure reading “was one or two millibars too high in one or two areas,” said Robert Muir-Wood, director of insurance solutions research at Moody’s. “It was a very close call.”

Rambarran, the former central banker of Trinidad and Tobago, recently co-authored a report by Vulnerable Group Twenty — or V20 — which represents the countries that are among the most exposed to climate change in the world. V20 says it’s time to review the triggers that determine whether a cat bond investor will be called upon to cover losses. The group’s concern is that, thanks to savvy financial engineering, such triggers are becoming increasingly narrow and rigid.

In the case of Jamaica’s cat bonds, investors were protected because the conditions for triggering a payout “are tough and specific,” the V20 report said. “This rigidity protects investors, but leaves Jamaica vulnerable to catastrophic risks.”

The parameters that determine payouts for cat-bonds are unlikely to get any weaker in the future, according to analysts who monitor the market.

“We expect cat bonds to adjust the trigger criteria for a payout to cover only the most severe types of storms,” ​​said Morgan Stanley strategists, including Carolyn L Campbell. “Today’s parametric margins may become all too common in 10 years; the cat links of the future are likely to cover only those rarest and most damaging storms, with a constantly evolving frame of reference.”

Sara Jane Ahmed, managing director and financial advisor of the V20 Group and lead author of the report, says “it is clear that we need many more financial protection triggers that are reliable and timely.”

The “disappointing” outcome of Jamaica’s cat bond payment underscores the need for the World Bank to “reassess the utility of this complex and costly financial instrument, and perhaps even for Jamaica to renegotiate the terms of its bond,” the report concludes.

But designing cat bonds with lower trigger thresholds would only increase the price, according to the World Bank.

“If you want these bonds to pay more often, you’re going to be charged more in premiums,” said George Richardsondirector of capital markets and investments at the World Bank treasury. “There is a trade-off to consider.”

Apart from Jamaica, investors were spared losses on cat bonds in Mexico and Texas, which were also hit by Beryl. However, other forms of disaster insurance have paid out. The Caribbean Catastrophe Risk Insurance Facility, or CCRIF, paid a register $44 million to Grenada due to destruction of Beryl. CCRIF also delivered smaller payments to other Caribbean countries, including Jamaica.

And with a total disaster safety net of $1.6 billion, Jamaica is particularly well insured against the threat of hurricanes, according to Meenan. “They take their risk very seriously,” he said.

The Philippines chose not to renew its cat bond when it expired in 2022, favoring a indemnity insurance program. The World Bank’s Bennett, who helped arrange the country’s catastrophe risk insurance, says the government in Manila still “views cat bonds as part of their broader insurance strategy.”

The V20 group’s Ahmed says that “as development partners think about their role in this climate crisis, part of that is really taking a hard look at some of these products.” And then “we thought about how to make them right,” she said.