Catastrophe Bonds Offer an Exciting Alternative

Catastrophe Bonds Offer an Exciting Alternative 

Lucrative investment opportunities with fixed interest rates are currently few and far between. One alternative is catastrophe bonds, which offer attractive interest at relatively low risk. In this interview, Joachim Klement, Head of Thematic Research at Credit Suisse, answers the key questions about this relatively new asset class. 

The opportunity to invest in catastrophe bonds is still quite new for private clients. They came about after Hurricane Andrew hit the coast of Florida and the Bahamas in 1992, leaving behind a trail of destruction. Total losses amounted to 26 billion US dollars. Due to this catastrophe, insurers started looking for new ways to reinsure losses – and struck it rich on the financial markets.

With catastrophe bonds, or CAT bonds for short, certain risks are hedged – for example, earthquakes in Japan or hurricanes in a specific region of the US. This is accompanied by attractive interest and a risk premium. If the insured event does not occur, the invested capital is returned to the investor at the end of the term, plus interest. Otherwise, losses are paid for using the bond. In this case, the investor loses a proportion of their money or can even lose it all.

CAT bonds are no longer the exclusive domain of institutional investors. For a number of years now, private individuals have also been able to invest in this type of product. According to Joachim Klement, Head of Thematic Research at Credit Suisse, CAT bonds are an interesting alternative to fixed-interest bonds.

How can I invest in catastrophe bonds as a private investor?

Joachim Klement*: For private investors, it is very difficult to invest directly in CAT bonds. It is also not recommended, as they are very complex. Personally, I would never purchase just a single catastrophe bond, as specialist knowledge is required to understand them. However, private investors can invest in certain funds which, on average, comprise 50 to 60 catastrophe bonds.

How many of these funds are currently available?

There are currently five such funds listed in the Fund Lab, one of which is offered by Credit Suisse. Investments can be in Swiss francs, dollars, euros, or pounds, whereby foreign currencies are generally hedged.

CAT bonds insure against natural catastrophes. Can I invest in products that hedge against human error, such as a shipwreck or a plane crash?

These types of products are available within insurance-linked strategies. Private investors can invest in corresponding funds. These funds typically invest in several CAT bonds as well as additional reinsurance. However, at less than three percent, the proportion of shipping and aviation risks is generally very low.

In the past there were only individual CAT bonds, which did not repay the entire amount of capital.

Joachim Klement

CAT bonds are praised for their low risk and high interest. However, in the event of the catastrophe, a total loss is possible. How high is the risk in reality?

In the past, there were only individual CAT bonds, which did not repay the entire amount of capital. Hurricane Katrina in 2005, Hurricane Ike in 2008, and Fukushima in 2011 led to a virtually 100 percent loss in those bonds used to insure these events. This shows that major catastrophes are extremely rare but, nevertheless, lead to a loss of over half the capital. With the funds, the situation is different, as diversification helps to absorb the risk. Even after these three major catastrophes, losses only ranged between three and four percent.

The risks of natural catastrophes are increasing due to global warming. Does this mean that the risks are also increasing for investors? Could the calculation models of insurance companies be incorrect, for example?

The insurance industry can model events extremely well. For example, they know exactly how strong the wind must be during a hurricane to lift the roof off a building or to pull a house from its foundation. Climate change is taken into consideration for these models. It is also in the interest of the insurance companies for these calculations to be accurate.

Why is that?

The insurance company itself is liable for a certain amount of losses. This is similar to the deductible of the health insurance model, which all patients pay themselves. Reinsurance companies are responsible for the losses in the second instance. Third-party investors are liable only in the third instance and only if the amount lost is very high. So, even if the model were incorrect, the buffer before CAT bonds have to be paid is huge. They have to be used only in the event of a devastating natural catastrophe with extremely high total losses. For example, in the case of Hurricane Matthew last year, the insurance companies were fully liable.

Due to high investor demand and the generally high liquidity caused by zero-interest bonds, interest rates for CAT bonds have decreased. Are CAT bonds still really an attractive option?

Yes. The risks are still adequately compensated for compared with high-yield bonds, or "junk bonds," and corporate securities, for which the interest level has also decreased. CAT bonds are particularly attractive because they are much less volatile.

CAT bonds are attractive as a portfolio diversifier and their revenues are relatively stable. Other price drivers play a role than, for example, with equities.

Joachim Klement

And compared with other products?

The diversification of the product portfolio makes them attractive and revenues are relatively stable. Other stock price drivers also play a role as, for example, with shares. Earthquakes strike regardless of the events on the financial market, making them a good small addition to a portfolio.

You emphasize "small addition." Why is that?

In reality, CAT bonds should have a maximum share of five percent because they also involve risks. The liquidity of the funds in particular is not the best, for example, when it comes to withdrawing money. Often, this is only possible every two weeks, or even every month.

What kind of return is still realistic with CAT bonds?

CAT bonds have generated a return of up to five percent per year over the last five years.

With CAT bonds, I earn money in the event of a natural disaster. Do you not have any moral objections about offering these types of products?

It is not true that investors earn money in the event of catastrophes. In fact, it is quite the opposite, as the money goes to the insurance companies. CAT bonds generate a return only if the event does not occur. Furthermore, thanks to catastrophe bonds, there is more capital available to insurance companies, meaning that people can insure their homes and not end up bankrupt in the event of a natural catastrophe.

Nevertheless, it is questionable that CAT bonds invest only in developed countries and not third-world countries, where there are statistically more natural catastrophes.

Poor countries simply do not have enough money to pay the insurance premiums. Even though Hurricane Matthew caused huge losses in Haiti, there were no bonds to meet the costs. It is a dilemma. Thanks to CAT bonds, insurance premiums have decreased because they increase the pool of funds for insurance policies. This, however, benefits only rich countries such as the US, Japan, and countries in Europe. Developing countries come away empty-handed. An area with future potential is microinsurance, which gives poor people access to financial services – similar to microcredit.

Credit Suisse has a large share in the catastrophe hedging business. Why is that?

Credit Suisse was one of the first banks to invest in this asset class—or rather, the former bank Clariden Leu was, which was later integrated into Credit Suisse. As a result, together with the Liechtenstein-based bank, LGT, Credit Suisse was among the first in the industry to offer this type of investment.