The Business of Betting on Catastrophe

> New “efficiency features” regularly get introduced in ILS and written into contracts. One of the most transformative has been the use of parametrics. Unlike traditional insurance, which calculates payouts based on actual losses (what’s called indemnity), parametric insurance uses preset triggers to determine whether money gets released. During an interview, a London-based parametric expert gave me this example of a parametric scenario: If, during a hurricane, wind speeds off the Florida coast hit a predetermined trigger speed — say 175 mph — at a trigger distance of two miles offshore within a preset longitude and latitude grid, the payout is, in theory, immediate. No actual damage need occur; the trigger measures just need to be met.

Wow, that is absolutely begging for exploitation.

Whoever controls the authority reporting these figures now controls whether these bonds pay out. That in turn means that whoever holds those bonds has a huge financial incentive to manipulate what that authority says.

Put another way, if you're holding a bond that will cost you $100 million if a hurricane windspeed hits 175 MPH, then you have $99 million bucks that are worth spending trying to get the NOAA to say anything but that.

CTO at an ILS fund. Cat bonds are essentially securitised versions of fully collateralised reinsurance contracts where the premium is the coupon plus the return on collateral. A benefit being that you can trade them. They're not usually used for speculation as stated in the article - investors are typically pension funds looking for investments that are uncorrelated to traditional financial market risk. e.g. on a US hurricane exposed cat bond you may only lose money if a huge hurricane blows through Florida, no matter what credit and equities are doing. It's true that a lot of the deal sourcing is relationship-driven, but there is a good amount of data-driven tech involved in overlaying the insured's past claims and underwriting data on top of simulated catastrophe model output, applying your own view of climate, vendor model adjustments, hurricane activity etc.

This reminds me of the predator hierarchy (for example, see Colinvaux's "Why Big Fierce Animals are Rare"): the reinsurers spread the risk from various insurers and for various catastrophes around among a pool of meta-insurers. But this pool is necessarily smaller than that of primary insurers, and their risks more likely to be correlated (catastrophes can cause other catastrophes, and multiply primary insurers can be affected by the same catastrophe).

For that matter, I'm also reminded of credit default swaps, and Lehrer's "We Will All Go Together When We Go."

I like to think I’m somewhat intelligent, but there’s something I don’t understand here. The article cites an example of pandemic bond holders receiving a return of 40% over 3 years and these bonds being a useful way for the issuer to secure needed funds in the event of a pandemic. Unless a pandemic happens every ~8 years, isn’t this a ridiculous and unsustainable risk premium to pay?

So, it's betting not on the outcome, but specifics of the event. The analogy could be sports betting where you bet on a player making a particular individual score, not just the win/loss.

At the end of the day, if it prevents bankrupting companies, countries and the insurers when an event occurs then it is a good thing.

I know of a Australian-based insurer that only operates in the far North primarily for residents who can't get reasonable premiums to cover for floods and cyclones from the major insurers. They reinsure with a global company so paying out an event in Australia is offset with no events elsewhere.

Interestingly the frequency of cyclones is decreasing, but the strength is projected to increase with "global warming": Higher water temperature = more energy. So betting on the strength makes sense.

Not sure what the controversy here is. Catastrophe risk is the bread and butter of property insurance.

As if pandemics weren't already political enough. Let's get large corporations, investment funds and billionaires involved and give them direct stake in declaring what is or isn't a pandemic, how many deaths have happened in a certain area, what was the cause of death etc. That should end well.

This is the dumbest idea I've read about in a long time.