Shelter from the Storm

Your retirement savings may soon rest on a bet against Mother Nature. The reason? The rise of cat bonds. Short for "catastrophe bonds," cat bonds transfer the financial risks that come with disasters such as hurricanes and earthquakes from insurance companies to the broader capital markets. Bruised by the stormy global economy, investment managers are ...

By Katherine Yester

October 6, 2009, 3:14 PM

Your retirement savings may soon rest on a bet against Mother Nature. The reason? The rise of cat bonds. Short for "catastrophe bonds," cat bonds transfer the financial risks that come with disasters such as hurricanes and earthquakes from insurance companies to the broader capital markets. Bruised by the stormy global economy, investment managers are flocking to these bonds in a bid to diversify away from assets linked too closely with suffering market trends, such as mortgage-backed securities. Even with climate scientists predicting more severe storms on the way, cat bonds are proving to be a gamble with plenty of willing takers.

How does a basic cat bond work? An insurance company sells a bond to investors who bet that, say, a hurricane won’t hit Miami and cause $1 billion in damages in the next year. If there is no hurricane, the investors get impressive payouts. But if the hurricane hits and the losses exceed $1 billion, the insurance company is off the hook and the investors are wiped out.

Growth in the cat-bond market has been swift. In the two years after Hurricane Katrina devastated New Orleans, the market for cat bonds roughly tripled to more than $13 billion. Goldman Sachs estimates the market will exceed $23 billion by the end of the year, and John Seo, a hedge fund manager at Fermat Capital Management, expects it to grow to at least $150 billion in the next 10 to 15 years.

So far, insurance companies and investors consider cat bonds win-win. After Katrina, insurance companies realized their pockets weren’t deep enough to cover another major catastrophe. With cat bonds, they are increasingly able to offload some of their risk, especially along vulnerable coastlines. "We have twice as much property value placed in every square mile along [U.S.] coastlines every 10 years," Seo explains. "Our catastrophe losses are going to double every 10 years." And the bonds have been a sound deal for investors, returning an average of 11 percent per year since 2005. But given that investors are now betting billions against the weather, their returns can only be as good as Mother Nature allows.