Avoid crashes with crash bonds?


The global epidemic continues as a catastrophe for our civilization. Increasing its impact: Very few people would insure against it. Of course, Hollywood has made a lot of films about infectious disease outbreaks over the years, but that seems to be the case from there – not around us, but in terms of entertainment.

One such organization that defended itself against such disasters was the tennis tournament Wimbledon. It paid about 2 2 million annually for epidemic insurance 17 years before the Covid-1 hit. The company’s policy will cover about ২ 122 million to cover the cost of canceling the tennis tournament in 2020. For Wimbledon, the policy was financially valuable. Of course, the epidemic means the price of such protection has risen so Wimbledon will not renew it in 2021.

Buying protection against disasters Disaster bonds, or cat bonds, is a relatively new development. 1 The Cat Bond was first issued after Hurricane Andrew and the Northbridge Earthquake in the Catac decade, which mainly affected the states of Florida and California in the United States. Prior to these two disasters, in order to issue property insurance, insurers were required by law to cover the losses of such incidents. But the losses of these two were so severe that many insurance companies went bankrupt covering them. So cat cats were improved in response.

From an investment standpoint, since such catastrophes do not occur due to the economy and capital markets, creating a diversified portfolio of insurance policies can be an attractive investment opportunity.

So how have cat ties been performed year after year?

Insurance-linked securities industry

The market for insurance-linked securities (ILS) is small. At the end of 2020, compared to more than 3 3 trillion invested in hedge funds and 4 4 trillion in private equity funds, it measured 118 billion in outstanding bonds. Although the ILS market includes insurance policies for life and epidemics, disaster risk is more than 90%.

The mechanics of a disaster bond are straightforward: the issuer builds a special purpose vehicle (SPV) for a specific disaster, called a flash flood in South Texas. Investors make the original contribution, which is transferred to a collateral account in the SPV and receive coupon payments from the issuer until maturity, which is usually about three years. If the prescribed risk does not occur, the principal is repaid. If a disaster occurs, the full or partial principal will be used to compensate the issuer for compensation. Therefore, insurance and reinsurance companies issue cat bonds to transfer risk to other investors.

Insurance-linked securities market: ব 118 billion (2020) outstanding bond

PI chart of the insurance-linked securities market: অস 118 billion (2020) outstanding bond
Source: Lane Financial LLC, Factor Research

Composition of Crisis Bonds

With its fault lines, hurricanes, and flood-prone rivers, the United States is at greater risk of natural disasters than Europe. This is reflected in the formation of the cat bond. About 60% of it focuses on wind and earthquakes. The term wind is used by the insurance industry and it may seem rather benign, but it includes hurricanes and tornadoes that can destroy an entire region.

Located between the Pacific and Asian tectonic plates, Japan is at risk of severe earthquakes, yet surprisingly some cat ties have been issued there. As capital markets mature and countries prosper throughout Asia, more cat bonds may be issued because such developments bring higher rates of insurance for companies and citizens.

While disaster insurance may undoubtedly benefit many cities and regions, some risks are very likely to occur, which makes the policies very expensive. For example, many houses on Mount Vesuvius near Naples, Italy, will be damaged or destroyed by the aftermath of a major volcanic eruption, which could happen in our lifetime.

Composition of Disaster Bonds

The chart shows the composition of the crash bond
Source: Lane Financial LLC, Factor Research

Growing losses from disaster insurance

An interesting fact point: the number of man-made disasters reached 250 in 2005 and only 855 in 2020. The two biggest ones in 2020 were civil unrest and riots in the United States, which affected 224 states, and an explosion in the Lebanese port of Beirut, which destroyed a significant portion of the city, causing more than 4 billion in damage.

In contrast, the number of natural disasters increased from 50 in 1970 to 2020. It can be cited as information on global disasters, but also for increased urbanization, which results in population density and higher property values. Climate change is another factor that may contribute to this trend.

The damage from the disaster has increased over the last 50 years and has stopped significantly since 2005. The combined damage of the 2005 catastrophe (Hurricanes Katrina, Wilma and Rita); 2011 (Japan and New Zealand earthquakes and Thailand tsunami); And 2017 (Hurricanes Harvey, Irma and Maria) accounted for nearly half of all losses from secondary hazards since 1970. This pattern clearly raises significant concerns for the insurance industry.

Disaster insurance loss (US billion)

Disaster Insurance Loss Bar Chart (US Billion)
Source: Swissari, Factor Research

Crisis bond performance

There are two cat bond indicators in the public domain that allow us to analyze the income of this unique asset class. The Eurekahej ILS Advisory Index consists of more than 30 equity-weighted fund managers that focus primarily on catastrophic bonds. The SwissRe CatBond Index is a diversified portfolio of cat bonds weighed by market capitalization.

The two indicators had identical performance trends. The Swiss Catbond Index achieved significantly higher returns between 2005 and 2021, but this was partly explained by fees and transaction costs. Cat bond returns were exceptionally consistent and resulted in approximately 2. Its sharp ratio. The biggest draw occurred in 2017, but the SwissR index recovered its losses relatively quickly, although its Eurekahej rivals did not gain much.

To be sure, these indicators need to be considered carefully: both increase their income. The SwissR index eliminates costs and allows Eurekahej index fund managers to import their track record. This encourages survival bias: fund managers only continue to import their track records if they reflect well on them.

Performance of Crisis Bond Index

Crisis Bond Index Performance Line Chart
Sources: EurekaHaze, Swiss Ray, Factor Research

Relation to the Tragic Resource Class

In our view, the EurekaHage ILS Advisors Index provides a good representation of the actual returns of this asset class because they are fake fees and transaction costs. As such, we will confine the rest of our analysis to that index.

Incomplete returns compared to the traditional asset class: This is the main marketing pitch of investing in cat bonds. According to our calculations, the correlation between the S&P 500 and US bonds from 2005 to 2021 was 0.2 and 0.1, respectively.

Many hedge fund strategies claim to offer incomplete returns. But it rarely lasts when the stock market crashes. Cat bonds, however, offered attractive diversification during the global financial crisis of 2008 and the Cowid-1 crisis of 2020: the relationship between the S&P 500 was relatively low.

Correlation of Catastrophe Bond Index with S&P 500 and Bonds

The line chart shows the correlation between the S&P 500 and the bond breakdown bond index
Source: Eurekahez, Switzerland, Factor Research

Disaster Bonds: Diversity Advantages

With high risk-adjusted returns and low correlation with stocks and bonds, cat bonds have been an excellent diversified strategy for traditional therapeutic portfolios. Although adding 20% ​​allocation to an equity and bond portfolio would reduce the annual return slightly by 0.3% from 2005 to 2021, the sharp ratio would increase from 0.90 to 0.95 and the maximum draw would fall from 29% to 26%.

Diversification Benefits from Crisis Bonds, 2005 to 2021

Bar Chart of Variation Benefits from Crisis Bonds, 2005 to 2021
Sources: EurekaHaze, Swiss Ray, Factor Research

More thoughts

There has been very little allocation of capital as there is today. Fixed income, one of the main asset classes, has become structurally attractive due to low to negative yields. But investors who want to redistribute capital in alternatives from fixed income can be delighted by the unique features of cat bonds. Consistent returns, less volatility, some downturns and less correlation with equities – what’s not to like?

Okay, maybe cat bond histor has been historically misjudged. Before 2005, there were less major disasters. The Eurekahez ILS Advisory Index has generated zero returns since 2017.

Moreover, future disasters could further affect the global economy, making cat bond returns less unrelated. A hurricane in Florida could severely damage the local economy, but a major earthquake in the San Francisco Bay Area could really have a global impact.

Investing in cat bonds probably won’t lead to disaster, but it may not be as attractive as insurance policy for portfolios like in the past.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Monticello

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Nicholas Robben

Nicholas Ravener is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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