Why People Take A Gamble On Mother Nature With Catastrophe Bonds

Oct 10, 2018
Originally published on October 10, 2018 8:03 pm
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AILSA CHANG, HOST:

All right. Among the people keeping a close eye on damage from Hurricane Michael are investors, specifically investors who have bought what's known as catastrophe bonds. To help explain what those are and why they matter, we're joined by NPR's Jim Zarroli. Hey, Jim.

JIM ZARROLI, BYLINE: Hi, Ailsa.

CHANG: OK. So first things first - what in the world is a catastrophe bond?

ZARROLI: Well, let me take you back to Hurricane Andrew, which swept through south Florida in 1992. The damage was a lot greater than anybody expected. Some insurance companies went bankrupt, and the reinsurance market, which is the way insurance companies usually protect themselves from big losses, actually dried up for a while. So this new way of controlling for risk was developed, and it was called the catastrophe bond. Essentially, an insurance company sells a bond and the investor gets paid interest for it.

CHANG: OK. So tell me how that works. Like, what would happen if there is a catastrophe like a hurricane or some out-of-control wildfire or an earthquake?

ZARROLI: Well, if there is a serious natural disaster, then the buyer of the bond has to foot the bill for some part of the damage. So if you buy one of these bonds, you're sort of gambling that there won't be a bad hurricane season this year because, you know, if there is, you could take a loss. For example, right now, about $15 billion worth of catastrophe bonds have some exposure in Florida where Hurricane Michael has hit.

CHANG: What kinds of investors are buying cat bonds?

ZARROLI: Well, mostly big institutional investors, hedge funds, mutual funds, maybe your own pension fund. They like to include them because they're a good way to diversify risk. And what I mean is if the economy slows, you typically see a lot of different assets, like stocks and real estate and so on, lose value at the same time. But the value of catastrophe bonds isn't tied to the economy. It's tied to, you know, Mother Nature.

CHANG: Right.

ZARROLI: So when everything else is losing ground, you can still make money on them.

CHANG: OK, I see.

ZARROLI: So they're a way of hedging risk, which investors like.

CHANG: Are these really popular, these catastrophe bonds or cat bonds?

ZARROLI: Pretty popular. There's about $30 billion invested in them right now overall. And the reason has to do with their yield. They typically earn an investor at least 5 percent and sometimes a lot more than that. And that's because they're potentially so much riskier than other kinds of bonds, so anyone investing in them is going to want to be paid more.

CHANG: There have been some pretty major storms just in recent memory. Last summer, there were three in a row. We had Harvey, which flooded Houston for days. Then we had Irma, then Maria; then just last month, Hurricane Florence slammed into the Carolinas - I mean, one after another. Have investors lost a ton of money on their cat bonds because of these storms?

ZARROLI: Yeah. Last year was particularly challenging for the bonds, and there was a lot of speculation that would kill off the market. There was this fear, you know, investors would see these big losses and nobody would ever want to buy a catastrophe bond again. But the market has come back pretty well.

CHANG: So as we're seeing more catastrophic storms, are cat bonds just going to become a riskier investment?

ZARROLI: Yeah, and that's always going to be a potential problem. The more big storms you have, sort of the less attractive these bonds are going to seem.

CHANG: Yeah.

ZARROLI: But there is another issue, I think, that is even more of an immediate problem. Over the past decade, interest rates on things like treasury bonds have been very low, so investors have turned to these catastrophe bonds because, you know, they could earn much higher interest rates on them. Well, now interest rates in general are rising, so, relatively speaking, catastrophe bonds aren't as attractive as an investment as they were. And that's bound to weaken demand for them.

CHANG: So interesting - a lesser known consequence of all these storms. That's NPR's Jim Zarroli in New York. Thank you, Jim.

ZARROLI: You're welcome. Transcript provided by NPR, Copyright NPR.