With Hurricane Irma hitting the Gulf Coast of the United States following Hurricane Harvey a little over a fortnight ago, investors holding catastrophe bonds for storms over these regions are likely to lose their money.
Financial losses of investors pale into insignificance against the death and destruction of the hurricanes, but insurance is big business and insurers have been offloading some of the risks to investors through the investment banks that create the bonds.
There appears to be more investor demand by American investors for the bonds than supply. They’re generally not held by small investors, but by the “family offices” of wealthy families, by wealthy individuals and by pension funds.
The first catastrophe bonds were created following Hurricane Andrew, which struck Florida in 1992.
Catastrophe bonds, or “cat” bonds, are part of a larger category of investments called “insurance-linked securities”.
If there is a trigger event for the bond, which is tightly defined by geography and by peril type, investors loose all or part of their money.
Catastrophe bond investors earn up to 10 per cent a year on their money. If the bond is not triggered over the typical three-year life of the bond, investors receive their capital back. Cat bonds also appeal to investors because of their low correlation with investment markets.
Early estimates of the insured losses from Hurricane Harvey across Texas and Louisiana are up to $US20 billion; and added to that will be the insurance bill for Hurricane Irma.
Those investors in the cat bonds that cover storms in any of the affected states will have have lost at least a portion of their money.
Wealthy investors would likely be investing in a managed fund that holds several cat bonds to provide diversification by regions and by type of peril.
Minimum investment amounts for these funds are of the order of $100,000. If they are well advised, only a small portion of the portfolio would be invested in them, which implies an investment portfolio worth millions of dollars.
While that keeps catastrophe bonds out of reach of small investors, the Australian financial services industry has been known to roll-out higher-risk investments to mum and dad investors.
Starting in the early 2000s, hedge funds, which have high investment minimums and often include risky investment strategies, were made accessible to small investors.
Their promoters promised out-sized returns and low risk. They also promised returns that were not correlated to the performance of investment markets.
Australian fund managers bundled several overseas-based hedged funds into single managed funds with very low investment minimums.
Returns were ho-hum, not least because of hefty fees. And then, with the financial crises of 2008 and plummeting sharemarkets, it turned out that their returns were highly correlated with sharemarkets after all.
Like hedge funds, insurance-linked investments have their own quirks and risks that small investors are unlikely to be in a position to fully understand.