Betting on the Next Catastrophe

Brisk sales of a relatively new financial instrument called a catastrophe bond could help governments pay for disasters.

According to the National Oceanic and Atmospheric Administration, this hurricane season is on track to be above normal. Coming just one year after Sandy, the prediction raises questions about how society could better plan to pay for the damages incurred by these furious storms.

The catastrophe bond is gaining traction with some as a way to do that.  The bonds are also becoming popular with investors, who bet on the likelihood of a hurricane, earthquake or other natural disaster occurring.

“Catastrophe bonds are a way for a firm or insurer, who’s concerned with potentially large losses, to protect themselves, by paying a premium to get a large amount back if something happens,” said Howard Kunreuther, Professor of Decision Sciences & Public Policy at the Wharton School at the University of Pennsylvania.

The market for these bonds is soaring; it’s now worth about $18 billion.  One reason they’ve become popular is because the bonds are only loosely tied to the capital markets.

 “They are uncorrelated with traditional financial risks, because the likelihood of a hurricane or an earthquake has nothing to do with Federal Reserve policy or a recession,” said Economist Robert Hartwig with the Insurance Information Institute

Last month a subsidiary of New York’s Transit Agency, the MTA floated a catastrophe bond, tied to storm surge levels.

“The timing was right,” said Steve Evans, creator of Artemis, a website that analyzes catastrophe bonds and insurance-linked securities deals.

“They had a big hit from Sandy last year.”

The MTA lost about $5 billion dollars on Sandy related costs.

But the popularity of the catastrophe bond is drawing some comparisons to the other financial instruments that played a dubious role in the financial upheaval of 2008.

“There are a lot of similarities that can be drawn to the early stages of the mortgage market and the mortgage backed securities crisis we just came out of,” said Analyst Cian Desmond with Brighton House Associates.

But Desmond stopped short of calling the catastrophe bond market a bubble.

Analysts say catastrophe bonds are considered an essential strategy for insurance companies pay and other entities struggling to pay for catastrophic losses.

“We know that when the big one hits, and it has not yet hit, but we know it’s just a matter of time, that the flood damages are going to be tremendous, and really the insurance companies are at a crossroads now in deciding what they’re going to do about that,” said John Seo, co-founder and Managing Principal at Fermat Capital Management.

A catastrophe bond might also be a way for municipalities or even the federal government to manage flood risk.  It could even help the National Flood Insurance Program to climb out of debt. The Program had to borrow $9.5 billion just to pay for Sandy-related claims.

“We do think that government programs like NFIP should evaluate purchasing cat bonds from capital markets,” said Frank Nutter, President of the Reinsurance Association of America.

“The Biggert Waters Act of 2012 does require them to evaluate that,” he added.