After all, insurance and reinsurance can only absorb so much risk and their capacity is both cyclical and correlated. It is difficult to find diversification and natural hedges in catastrophic events.
It is in precisely this environment that catastrophe bonds have flourished, offering a new source of risk absorption outside of traditional markets.
And yet, even amidst the reports of catastrophe bond growth, one key question remains. If natural catastrophes are increasing in their frequency and impact, who is buying the increasing issuance and why?
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There are two answers. First, cat bonds offer risk diversification in investment portfolios.
The conventional wisdom that bond yields and equity returns move in opposite directions increasingly does not hold true and investment managers find the income-generating, diversified risk of cat bonds an attractive third leg to their investment strategies.
Of course, there are specialised funds that invest exclusively in weather and catastrophe, and these can produce attractive returns over time, if managed well.
Second, cat bonds also offer access to a market that would otherwise be closed to capital market investors as the conventional natural peril risk transfer markets of insurance and reinsurance are heavily regulated under regimes that require participants to be licensed by national or regional insurance regulators.
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With a few exceptions, most insurance and capital markets regimes are mutually exclusive, precluding investment managers being dual licensed both to invest in bonds and equities and also to write insurance cover.
Both the niche investment and the diversification approaches require analysts specialised in understanding the risks embedded in cat bonds and, as importantly, the modelling used to structure them.
Recent developments in the modelling techniques used in the catastrophe markets have allowed the bonds to cover catastrophic risks in new geographic regions with greater certainty and precision.
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This is good, not only for those using cat bonds to lay off risk, but also for investors as these enhanced models allow better analysis of the risk/reward profile of the bonds.
Of course, this is not necessarily a win-win situation.
While better modelling leads to better comprehension of the risk profile of a bond, it also leads to a better understanding of the correct pricing of that risk.
The consequence of this is an increased granularity in the perils covered by a given bond issuance and more sophistication in the return demanded by investors for assuming catastrophic risk.
While coupon is a good indicator of investor expectations, few, if any investors in the cat bond market model on the assumption that their principal will remain completely intact.
In general, retail investors have a different expectation profile.
Indeed, for all the talk of the growth in cat bond issuance, and the healthy returns offered, a flourishing retail market seems unlikely.
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For one, retail investors are naturally loss adverse, with capital preservation featuring high on their priority list.
The specialised nature of the analytics required to evaluate cat bonds, not to mention the complex sophistication of the models used in the market, cause consumer regulators to be wary of the development of a retail cat bond market for fear that the high coupons and the challenge of understanding the embedded risk make retail investors vulnerable to losses of principal and potential prey for the unscrupulous.
However, the absence of a deep retail market is unlikely to hinder the growth of the market, given the other factors underpinning its development.
To put it another way, as long as the spectre of extreme weather stalks the in.
Claude Brown is a partner at Reed Smith
