Delete

The top banks are basically Guy Carpenter, Aon, Swiss Re, Goldman, CS. There are a number of big hedge funds/asset managers that have specialty funds that invest in these too. It is a relatively small market still.

To answer your question about the risk, it is not very different than traditional insurance risk. Hurricane happens, company has a loss, and then they draw down on the proceeds from the issuance of the bonds to indemnify themselves. Basically investors principal isn’t at risk from a credit standpoint, the principal is in MMFs in a trust and doesn’t leave, but if a covered event triggers a payout the trust will release funds to the insurer/gov/corporate causing a loss to investors. I can’t speak much to your other questions as I don’t have any experience on that side of banking.

Used to work for the woman who ran the Insurance structured finance desk at GS after Mike Millette left to found Hudson Structured Capital. Nephila is a big player in the cat bond investing space - by far. There are a couple of other funds that invest heavily in ILS. Career path for an analyst is in the Structured Finance group, not FIG capital markets, although at Goldman they were both run by this woman. Reinsurance and captive reinsurance etc. is not a recent innovation. Munich Re, Swiss Re Gen Re. etc. have been around for a long time.

What are the risks of these cat bonds? Take a look at Cal Phoenix Re (CALPHO Corp on bbg if you have it) - this was a cat bond insuring PG&E against California wildfire risk.....

You lose money by hurricanes, wildfires, earthquakes, floods (it's mostly hurricanes that are the root tbh) that exceed certain parametric thresholds or dollar loss amounts. 

Yes that is absolutely possible just relatively uncommon. Players in the space (both insurers and funds who invest in these products) buy products that pay out when certain losses are exceeded ($10bn Florida Hurricane trigger, $50bn aggregate cover that covers Hurricane, Earthquake, Wildfire, over the USA, or worldwide, etc.) as a purpose of hedging losses against their own insurance portfolio. I'm not aware of investors that do buy these instruments similar to how naked CDS' were purchased in the past but they certainly may exist. My guess is that there are very few to none because the industry is just so esoteric to anyone who is not a catastrophe modeling or insurance expert.

You make some good points, however, I disagree with most of what you wrote.

To answer your first statement, yes. These securities are incredibly risky and you can lose your entire investment quite literally overnight. But so is traditional insurance/reinsurance, cat bond or not PGE needed to insure themselves against wildfire risk. The loss happened regardless of who ended up paying it, unfortunate for those investors, but it is the reality of the market. If traditional reinsurance agreements were traded and a catastrophe occurs, anyone holding that paper would be wiped as well. It says nothing about cat bonds as a security, just the risks they cover. I’ll add too many hedge funds are already heavily involved in the reinsurance/insurance industry outside of cat bonds through sidecars, joint ventures, and other structures so they are already well aware of the risks.

Secondly, you’re right. This likely won’t be a massive highly liquid market ever, but there has been significant increases in trading activity as well as investor demand for cat bonds. In fact something like 75% of issuances this year have priced well below initial guidance and have also upsized. They’re little known securities with a lot of nuance which absolutely hampers the speed at which investors will get drawn into the market, but certainly investors are increasingly finding value here. Catastrophic events are random and very difficult to predict, however, this doesn’t necessarily make cat bonds inherently more risky. It all depends on the underlying risks covered and the structure of the bond, many would be rated investment grade if they were rated by the agencies if you compare probabilities of loss. In many cases they are priced at a premium to traditional bonds given a specific probability of loss.

Sure, when rates go up investors purely chasing high yield instruments might take their money elsewhere, but that’s not necessarily the largest benefit of allocating a portion of your portfolio to cat bonds. They are diversifying by nature. They are a near zero beta asset, hurricanes and the financial markets don’t have a large correlation. Even in the event of default on premium payments, your principal is safe as the coverage is automatically canceled and you are still entitled to receiving the coupon payments that weren’t paid.

COVID-19 is a tough example and frankly a lot of litigation is happening around the issue to determine if insurers should have to pay regardless of the language in their policies. That said, the World Bank successfully issued a pandemic cat bond, so it is certainly being used to cover that risk.

I think it will be interesting to see how the market develops, but I stand by my belief that the market will only continue to expand and gain traction. They change the way insurance works, of course it won’t replace the traditional insurance industry, but there are many areas where I think you’ll see increased use in the future.

Not at all related. BH underwrites risk, collects premiums, and invests in securities (money on the float). This is capital intensive, they still wear the insurance risk. What we're talking about here is risk transfer - actually securitizing that insurance risk and selling it to capital markets investors like you or me. So now even though we are not licensed insurance companies, we are still backing the insurance risk. We are effectively stepping into the shoes of reinsurers.

What I've never understood is why investors in this space think they can get an edge. The risk is being underwritten by an insurance / reinsurance company that presumably has access to advanced pricing and analytics engines, as well as public data sets and their own internal actuarial experience. What edge does some 'to the moon' Reddit clown have in pricing the risk of relative to, say, Travelers? The answer is they don't. Buyers of these securities are still a pretty small group who are highly specialized - AlphaCat, Nephila, Hudson Structured....these are not institutionals anyone outside P&C insurance nerds have heard of. Trying to build a book for these deals isn't a 4 week process, it's a 6 month roadshow and requires jetting all over the damn world.

They dabble in this space but their reinsurance strategy by and large is providing an ample source of float for the broader BH investment franchise.

They don't. It was a simplification, I apologize for the miscommunication. The payout structure is very stratified, you can have a total loss, but in most cases this is not what occurs. Basically a map of the company's exposure is created and catastrophe events are modeled on top of it to give an idea of what losses would like in a given are for a given event. If the bond covers the entire state of Florida and a hurricane only clips the southern tip and only triggers a loss in that location, the bond will pay only a fraction of the original principal. There is often a balance between severity and location in the payout structure. And to answer your first question, no. Each SPV can issue multiple classes of notes in multiple series which cover as many perils as needed

Yes, for example when storms start to approach land you will see specific transactions start to get marked down. Traders at funds can then speculate on whether they like the pricing and speculatively trade them.

They can certainly be very volatile during times of trading. As Hurricane Katrina approached New Orleans, some of these bonds were being traded internationally at 10 cents on the dollar from what I remember. 

There are some hedge funds who do this stuff. Fermat and RMS come to mind first, they've got a lot of math guys working for them, and they hire the services of meteorological experts, oceanographers, etc. 

PGGM, a Dutch pension fund, has a insurance linked investment team that managed a $4bn portfolio back in 2018.