Dear Mr. Berko: Could you please tell me what cat bonds are and how they’re different from other bonds? And could you tell me the name of the college that offers annuities yielding 10 percent? I’d like an answer without your usual abrasive sense of humor.
— S.D., Fort Walton Beach, Fla.
Dear S.D.: Catastrophe bonds, or cat bonds, are inherently risky investments. They’re primarily issued by insurance companies through investment banks, which retail them to hedge funds, pension funds, asset managers, mutual funds and individual investors. Today’s cat bonds are issued with three-to eight-year maturities and carry coupon rates between 5 and 8 percent. Cat bonds are issued to raise money in case of a catastrophe, such as a hurricane or earthquake. There’s a special condition in the indenture of a cat bond, stating that if the issuer of the bond suffers a loss from a particular predefined catastrophe, the principal and interest of the cat bond will be forgiven.
Suppose that Dr. Smith, a large-animal dentist from Tuscaloosa, bought a 7 percent $10,000 cat bond maturing in three years and covering the Mulberry Bush Bridge in her city. And suppose that six months later, on a misty Tuesday morning, a herd of elephants, frightened by two mice, escaped from the Tuscaloosa zoo and rampaged across the Mulberry Bush Bridge, causing it to collapse. Because a catastrophe occurred, the indenture of Dr. Smith’s bond would provide for a payout to the insurance company, and she would give up all or part of the $10,000 she invested. But if three years passed without there being catastrophic injuries to the bridge, Dr. Smith would walk away with her $10,000 plus three years’ interest at 7 percent. Cat bonds keep insurance rates low and reduce risk to insurers by sharing some of the catastrophe risks with investors.
Now the Federal Emergency Management Agency wants to divest itself of more flood insurance risk and pass it on to investors by issuing cat bonds before the next hurricane season begins in June. The size of the cat bond market is a little over $33 billion. And the decision to issue cat bonds is an alternative to the traditional reinsurance market. So FEMA expects to issue its first cat bond around the first week of July, transferring some of the National Flood Insurance Program’s risk exposure to Dr. Smith and others in the risky bond markets. The NFIP’s losses from last year’s three major hurricanes could exceed $10 billion. Certainly, the NFIP definitely needs a stronger financial framework to continue protecting its policyholders. After a record drought of 10 years that featured no major hurricane landfalls in the U.S., Harvey, Irma and Maria reminded Americans last year about how powerful and destructive these monsters can be. Hurricane season runs through November. And Colorado State University’s forecast calls for seven hurricanes, three at Category 3 strength or worse. So there’s a lot of potential damage, and there’s a lot of money at risk. I think that interest rates on cat bonds will set record highs this year.
