A flooded street running parallel with the River Neckar in Heidelberg, Germany, on June 3.Photographer: Alex Kraus/Bloomberg
LONDON: A strategy that’s delivered specialist investors huge returns is now facing scrutiny, amid concerns that its risk-reward dynamics might be skewed against some issuers.
Catastrophe bonds, which are issued by insurers, reinsurers and governments seeking an extra layer of disaster coverage, have been handing investors double-digit returns. Issuers, meanwhile, have seen their costs soar.
Grievances surfaced in July, after it emerged that Jamaica’s catastrophe bond wasn’t triggered by the devastation wrought by hurricane Beryl.
Though the entire Caribbean island was officially declared a disaster area, the carefully calibrated terms of the bond meant its holders were shielded from losses.
In the event, it was decided that the precise level of air pressure required for a payout wasn’t achieved.
For cat bond investors – who are currently reaping an average return of around 15% after raking in 20% in 2023 – the outcome in Jamaica underpins the appeal of a strategy that’s attracted some of the brightest minds in finance. For others, it’s set off 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 will be seeking “an examination” of cat bonds and other insurance-linked securities, and wants the region’s finance ministers to take a closer look at which markets governments should choose and which they should avoid.
“We recognise that at the end of the day, investors need to make returns,” Jwala Rambarran, a former governor of the central bank of Trinidad and Tobago, said in an interview.
“But at the same time, fairness and equity says it can’t be all the time that the investors are making the returns. It’s a one-way street.”
The Jamaican Finance Ministry didn’t respond to requests for comment.
The country’s US$150mil cat bond –arranged by the World Bank and bought by private investors – was issued this year to replace a 2021 bond.
The new bond costs the government 60% more per unit of coverage, which reflects the heightened risk posed by climate change as well as higher reinsurance costs, according to Conor Meenan, a risk finance specialist at the London-based Centre for Disaster Protection.
Cat bonds make it possible for issuers (also referred to as sponsors) to pass part of their risk over to capital markets. Sales of the instruments have soared lately, with factors including climate change, population density and inflation adding to their appeal.
Investors face potentially substantial losses if a bond is triggered, but can generate market-beating returns if a predefined catastrophe doesn’t occur.
For the US$47bil cat bond market, Beryl proved an early win for investors navigating their way through a hurricane season that’s expected to be unusually active.
Zurich-based Plenum Investments AG, one of the private-market buyers of Jamaica’s cat bond, said it was drawn to the opportunity to diversify away from the US market.
“We also like the parametric trigger structure, which minimises uncertainty post-event,” Plenum said in an emailed response to questions.
Issuers turning to cat bonds get a very specific type of coverage whose terms should be clear to all stakeholders at the point of purchase, according to the World Bank.
Cat bonds are “for tail events,” which are rare disasters outside the norm, said Michael Bennett, head of derivatives and structured finance at the World Bank treasury. “The parameter isn’t the fine print, it is the print.”
In the case of Jamaica, Beryl very narrowly missed hitting the parameter that would have caused the bond to pay out.
The pressure reading “was one or two millibars too high in one or two zones,” said Robert Muir-Wood, chief research officer in insurance solutions at Moody’s. “It was a very close call.”
Rambarran, the former Trinidad and Tobago central banker, recently co-authored a report by the Vulnerable Twenty Group – or V20 – which represents countries who are among the world’s most exposed to climate change.
V20 said it’s time to overhaul the triggers that determine whether a cat bond investor will be called on to cover losses. The group’s concern is that thanks to skillful financial engineering, such triggers are becoming increasingly narrow and rigid.
In the case of Jamaica’s cat bond, investors were protected because the conditions for triggering a payout “are hard and specific,” the V20 report said.
“This rigidity protects investors but leaves Jamaica vulnerable to catastrophic risk.” — Bloomberg
