It is a financial contract, read the fine print.
From The Economist, January 16:
The innovative form of insurance is reaching its limits
THE SCENES of devastation in Los Angeles were just the latest in a recent barrage. Last year hurricanes in the Atlantic, earthquakes in Japan and flooding in Europe all carried huge financial and human costs. Indeed, 2024 is set to be the year with the third-biggest insured losses, adjusted for inflation, in more than four decades.
Surely, then, it is a bad time to own catastrophe bonds? These are securities that protect issuers, mostly insurers and governments, from severe losses in the event of a natural disaster by paying out when certain conditions are met. In fact, across the asset class, such bonds returned 20% and 18% in 2023 and 2024, respectively—the strongest two years in recent decades. Instead of paying up, bondholders have reaped vast profits. Issuance has boomed and the market has doubled in size over the past ten years. It is now worth $50bn.
The gulf between the devastation and the rude returns available to bondholders is a stark demonstration of the limits of the asset class. Yet sometimes buyers and sellers of catastrophe bonds are a match made in heaven. Issuers hope to cover themselves against low-probability outcomes with costs that could overwhelm them. Investors are hungry for assets that do not move in tandem with the rest of their portfolio. This opportunity has become only more attractive since 2022, when bonds and stocks fell together, whacking investors who believed they had diversified by buying both. Viewed in such a light, catastrophe bonds are an example of financial markets at their very best.
Part of the reason for the lack of recent payouts is the exacting terms on which bonds are frequently issued. After Hurricane Beryl struck Jamaica in July, for example, the country’s GDP shrank by almost 3% in the third quarter of the year, driven by a 14% drop in agricultural output. Despite this painful decline in economic activity, a catastrophe bond issued by the Jamaican government and the World Bank did not disburse funds. The bond had so-called parametric triggers—ones based on measurable environmental conditions. In Jamaica’s case, the air pressure measured during the hurricane was a fraction higher than the maximum level allowed for the bond to pay out.
When it comes to California’s wildfires, catastrophe bonds face a different and more fundamental challenge. Since the 1990s, when such bonds first emerged, the market has mainly protected issuers against “peak perils”, or the largest and most damaging events such as earthquakes and hurricanes. However, it is the more common “secondary perils”—a bucket including everything from the current wildfires to hail and thunderstorms—that have expanded to take up a much larger share of total insured losses owing to the impact of climate change.
Some 61% of the catastrophe-bond market still covers only losses from a single major event, according to Artemis, a data firm. The other 39% of bonds in the market disburse funds when costs rise above an annual threshold, meaning that numerous secondary perils can add up to produce a payout. On top of this, investors are now demanding enormous returns in exchange for protecting issuers against losses from secondary perils. In the most extreme cases, spreads over the yield on Treasury bonds can be above 20 percentage points....
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