Yahoo Finance Swedroe: Revised Catastrophe Bonds Worth A Look
Insurance-linked securities (ILS) are a relatively recent financial innovation designed to allow risk to transfer from the insurance industry to the financial markets. Pension funds, banks and sovereign wealth funds are the largest holders of ILS, and hedge funds recently have started to specialize in managing ILS portfolios. Catastrophe (cat) bonds make up the largest segment of the ILS market. The cat bond market has grown to about $25 billion since the first issuance in 1994.
Catastrophe Bonds
Cat bonds are sponsored by insurance companies and other entities to protect against catastrophe losses, including natural disasters and other extreme risks such as adverse mortality arising from pandemics. Cat bonds are sponsored by the entity desiring to reduce its exposure to risks, and/or to raise more capital so that it can offer more insurance to customers.
The capital raised from investors is used to fund a special purpose vehicle (SPV) that holds high-quality, low-risk securities. The sponsoring entity makes coupon payments and, if the bond matures without a triggering event, the principal amount is returned to investors. However, if a triggering event occurs, the sponsoring entity can access capital in the SPV to pay claims, after which the remaining coupon and principal payments of the bond are curtailed.
The natural attraction of cat bonds is that there is no reason to believe events such as natural disasters are correlated with the risks of other financial assets. Thus, cat bonds offer diversification benefits.
Steven Clark, Mike Dickson Jr. and Faith Roberts Neale contribute to the literature on cat bonds with their July 2016 study “Portfolio Diversification Effects of Catastrophe Bonds,” which covers the 14-year period from 2002 through 2015.
The authors observe that from January 2006 to December 2014, the Eurekahedge ILS index showed negative returns in only seven out of 108 months. The largest negative monthly return, -3.94%, was in March 2011, the month of the Tohoku earthquake. The second-largest monthly loss was just -0.74%, in September 2008, followed by the third-largest loss, -0.57%, in October 2008.
To test their diversification benefit hypothesis, Clark, Dickson and Neale analyzed the diversification benefits of cat bonds in several different ways. Following is a summary of their findings:
Because their correlations with other financial assets are low, there is strong support for the notion that cat bonds provide substantial diversification benefits when they are added to an investment opportunity set already consisting of traditional asset classes (U.S. equities, international equities, bonds, commodities and real estate).
Cat bonds demonstrate significant portfolio diversification benefits in various out-of-sample analyses, including naive 1/N strategies (essentially equal-weighting asset classes) and when using a mean-variance model, a minimum-variance model and a volatility-timing model.
The payoffs from cat bonds cannot be replicated in the mean-variance space by portfolios holding only other asset classes.
The standard deviation of cat bonds is much smaller than the standard deviations shown by the other indexes, contributing to a significantly greater Sharpe ratio (which assumes normal distributions). However, the cat bond index does display extreme kurtosis and has the longest left tail (as you would expect large losses when low-probability, but high-risk, events occur).
Cat bonds added substantial diversification benefits during the 2008 financial crisis and reduced drawdown measures and conditional value at risk in times of market distress.
More Supporting Research
Cat bonds’ diversification benefits were confirmed by Peter Carayannopoulos and M. Fabricio Perez, authors of the 2015 study “Diversification through Catastrophe Bonds: Lessons from the Subprime Financial Crisis.”
However, they also found that cat bonds were not zero-beta assets during the 2008 financial crisis. In fact, the dynamic correlation coefficients of cat bonds with the market and the corresponding hedge ratios were statistically significant during the crisis. They believe the rising correlation of cat bonds was caused by the “structure of CAT bond trust accounts and the composition of the assets used as collateral in the trust account.”
The authors go on to add: “Assets used as collateral in these trust accounts proved to be of lesser than expected quality and, furthermore, counterparties in swap agreements, put in place in an effort to immunise collateral asset returns from market fluctuations, were exposed to considerable credit risk or even defaulted during the crisis.”
The good news is that Carayannopoulos and Perez found that the effects of the financial crisis on cat bonds had disappeared by 2011, as the correlations with the market returned to their statistically insignificant precrisis levels.
They noted: “These results may imply that the new and improved collateral structures created for CAT bonds issued after 2009 have been perceived as effective by market participants. These new structures attempt to enhance the credit quality of the collateral asset and include limits to the type of assets permitted in the collateral account, and constant monitoring and reporting of the collateral account balance.”
Summary
The evidence supports the theoretical benefits regarding the diversification that cat bonds provide. However, it’s important to note that in this era of historically low interest rates, and with investors seeking alternatives to equities given the size of the losses they experienced both in the 2000-2002 bear market and the 2008 financial crisis, increased interest in cat bonds has led to the inevitable lowering of the risk premium they command as the trade has become more crowded.
Thus, investors should not assume that historical returns will be repeated. In addition, in recent years, insurance losses have been relatively low, and investors may have become complacent, relying on that trend to continue. Investors should tread carefully.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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