Dr. P.V. Viswanath

pviswanath@pace.edu

Investors, still reeling from one disaster, are betting on the likelihood of another.

Amid the volatility in the markets, wealthy individuals and big institutions are flocking to hedge funds that buy so-called catastrophe bonds and other investments tied to the probability of Gulf Coast hurricanes, Japanese earthquakes, large snowfalls in Canada and other natural disasters.

It is a diversification play, as investors continue to look for assets that do not move in tandem with equities and traditional fixed-income products.

A Credit Suisse hedge fund that specializes in insurance-linked securities has doubled, to more than $3 billion, since the middle of 2009. Early last year, the New Zealand Superannuation Fund, which manages and invests money for the country’s retirees, pledged $250 million to a hedge fund focused on catastrophe bonds and the like. And a new $80 million fund, started by an alumnus of the hedge fund Citadel, just listed on the London Stock Exchange.

“Any other hedge fund might have had problems raising money after the Lehman collapse, but these guys have been going gangbusters,” said Judy Klugman, managing director at Swiss Re Capital Markets, the world’s largest underwriter of catastrophe bonds.

The market for catastrophe bonds, or cat bonds, first emerged in the 1990s, in the aftermath of Hurricane Andrew. Insurers, hurting from $17 billion in losses, began tapping into the capital markets as an alternative to traditional reinsurance.

Here is how the typical deal works: An insurer will issue a bond whose returns are tied to the likelihood of one or more natural disasters over a certain period of time, say a major hurricane’s hitting Florida in the next three years. If the event does not happen, investors earn a yield on the bond, from 2 to 14 percent. But the principal can be wiped out if a devastating storm does strike.

Last year, companies issued more than $5 billion in catastrophe bonds, bringing the total amount outstanding to nearly $14 billion, according to data from Credit Suisse and Swiss Re.

Hedge funds even step directly into the role of insurer, writing their own contracts instead of buying the securitized bonds. The volume of such deals now amounts to roughly $300 billion, including coverage for things as varied as crop damage and terrorist attacks.

“We’ve graduated from the science project mode of the early 2000s to being an actual market,” said Frank Majors, a founder of Nephila Capital, a hedge fund that manages about $3 billion of insurance-related investments. “It’s still not a huge market, but it’s a market where people are there because there is a meaningful value proposition.”

The securities suffered a serious blow during the financial crisis. After the collapse of Lehman Brothers, which served as a trading partner on four major deals, buyers started taking a closer look at the underlying collateral on the catastrophe bonds. Many found it lacking.

The dearth of leverage to amplify gains further spooked big players, including large, diversified hedge funds. In 2010, so-called multistrategy funds made up just 2 percent of catastrophe bond buyers, down from 14 percent in 2007, according to data from Swiss Re.

“The big securities dealers are providing a lot more leverage in other areas than they are in catastrophe bonds,” said Brett Houghton, managing partner at Fermat Capital, a roughly $2 billion hedge fund that focuses on insurance-related investments. “I don’t think it’s as easy for those guys to make the 15 to 20 percent return targets they’re trying to promise their investors without leverage.”

What is left now is mainly a small group of funds like Fermat that specialize in insurance-linked investments. It is a boom time for the group, which is benefiting from investors’ push to find new ways to diversify their portfolios. The New Zealand fund cited such reasons for making its first foray into the catastrophe bond market, with a $250 million commitment to a hedge fund run by Elementum Advisors.

Catastrophe bonds and other insurance-related securities have no correlation to the broader markets. In 2008, the Swiss Re catastrophe bond index rose 2.3 percent, compared with a loss of 38 percent in the Standard & Poor’s 500-stock index. The catastrophe bond index returned 10.5 percent from 2007 through 2010, compared with an 11 percent fall in the S.&P.

“The fact that we demonstrated positive returns has been very helpful in getting new funds into the space,” said Paul Schultz, president of Aon Benfield’s investment banking division, which packages and sells catastrophe bonds. “We have more investors participating in this asset class than ever before. There’s a growing following and growing level of interest.”

Issues:

1. Why would catastrophe bonds not move in tandem with bonds and equities?
2. A friend of mine says: "With global warming, the global economy is being driven by one natural catastrophe after another -- if there are unexpected rains in a wheat producing area and the harvest suffers, don't you think the national economy would be affected?." What do you think of this? If this is so, would the diversification ploy work?
3. "..the principal can be wiped out if a devastating storm does strike." Doesn't sound like a very safe bet to me!
4. And these catastrophe funds magnify their exposure through leverage! Isn't that adding risk to risk?
5. Why can't these fund managers get 15% to 20% returns without leverage? What's a reasonable expectation of return on these funds? Can we think logically about it?