Investors’ Bets on Mother Nature Are Paying Off Big

livemint.com:

How much would you need to be paid to cover the risk of the next massive hurricane or earthquake? Investors in the insurance market have a new answer: Way more than they were before. That is the message coming from a key part of that market, catastrophe bonds. “Cat bonds" emerged roughly a quarter century ago as insurance companies scrambled for ways to manage their most extreme risks after Hurricane Andrew’s shocking losses put several out of business.

They found a taker of the risk of major earthquakes or hurricanes on Wall Street: In exchange for a high annual yield, hedge funds, pensions and wealthy individuals were willing to put up cash that they might lose in the event of a specified weather event or insurance loss. Some bonds have had losses over the years. In an example described by a Federal Reserve Bank of Chicago research paper, a private home-and-auto insurer sold a $100 million bond back in 2010 that was designed to compensate the insurer for industry-wide losses from thunderstorms and tornadoes across the U.S.

beyond $825 million. When it was determined that industry losses were $954.6 million in 2011, investors had to give up the cash. The decision was litigated for several years.

Overall, though, this arrangement has worked out for investors over time. Even in 2017, when a trio of major hurricanes hit the U.S., the Swiss Re Global Cat Bond Total Return Index still was positive that year. But then last year, cat bonds produced a negative 2.16% return, according to Swiss Re.

It was the first annual loss in the index’s history. What happened? It wasn’t just about interest rates, since the cash put up by investors earns a floating market yield that rises with rates. And it wasn’t even just about loss events,