Catastrophe Bonds: Markets, Learning and Volatility

“Wall Street is a machine for turning information nobody cares about into information people can get rich from.” Michael Lewis, author of Liar’s Poker, Aug 26 NYTimes in his article about catatrophe bonds – which are used to share disaster lossses – Nature’s Casino:

From Miami to San Francisco, the nation’s priciest real estate now faced beaches and straddled fault lines; its most vibrant cities occupied its most hazardous land. If, after World War II, you had set out to redistribute wealth to maximize the sums that might be lost to nature, you couldn’t have done much better than Americans had done. And virtually no one — not even the weather bookies — fully understood the true odds.

But there was an exception: an American so improbably prepared for the havoc Tropical Depression 12 was about to wreak that he might as well have planned it. His name was John Seo, he was 39 years old and he ran a hedge fund in Westport, Conn., whose chief purpose was to persuade investors to think about catastrophe in the same peculiar way that he did. He had invested nearly a billion dollars of other people’s money in buying what are known as “cat bonds.” The buyer of a catastrophe bond is effectively selling catastrophe insurance. He puts down his money and will lose it all if some specified bad thing happens within a predetermined number of years: a big hurricane hitting Miami, say, or some insurance company losing more than $1 billion on any single natural disaster. In exchange, the cat-bond seller — an insurance company looking to insure itself against extreme losses — pays the buyer a high rate of interest.

everywhere he goes, he has been drawn to a similar thorny problem: the right price to charge to insure against potential losses from extremely unlikely financial events. “Tail risk,” as it is known to quantitative traders, for where it falls in a bell-shaped probability curve. Tail risk, broadly speaking, is whatever financial cataclysm is believed by markets to have a 1 percent chance or less of happening. In the foreign-exchange market, the tail event might be the dollar falling by one-third in a year; in the bond market, it might be interest rates moving 3 percent in six months; in the stock market, it might be a 30 percent crash. “If there’s been a theme to John’s life,” says his brother Nelson, “it’s pricing tail.”

The more John Seo looked into the insurance industry, the more it seemed to be teetering at the edge of ruin. This had happened once before, in 1842, when the city of Hamburg burned to the ground and bankrupted the entire German insurance industry many times over. Out of the ashes was born a new industry, called reinsurance. The point of reinsurance was to take on the risk that the insurance industry couldn’t dilute through diversification — say, the risk of an entire city burning to the ground or being wiped off the map by a storm. The old insurance companies would still sell policies to the individual residents of Hamburg. But they would turn around and hand some of the premiums they collected to Cologne Re (short for reinsurance) in exchange for taking on losses over a certain amount. Cologne Re would protect itself by diversifying at a higher level — by selling catastrophic fire insurance to lots of other towns.

But by their very nature, the big catastrophic risks of the early 21st century couldn’t be diversified away. Wealth had become far too concentrated in a handful of extraordinarily treacherous places. The only way to handle them was to spread them widely, and the only way to do that was to get them out of the insurance industry and onto Wall Street. Today, the global stock markets are estimated at $59 trillion. A 1 percent drop in the markets — not an unusual event — causes $590 billion in losses. The losses caused by even the biggest natural disaster would be a drop in the bucket to the broader capital markets. “If you could take a Magnitude 8 earthquake and distribute its shock across the planet, no one would feel it,” Seo says. “The same principle applies here.” That’s where catastrophe bonds came in: they were the ideal mechanism for dissipating the potential losses to State Farm, Allstate and the other insurers by extending them to the broader markets.

His bigger problem was that insurance companies still didn’t fully understand their predicament: they had $500 billion in exposure to catastrophe but had sold only about $5 billion of cat bonds — a fifth of them to him. Still, he could see their unease in their prices: hurricane- and earthquake-insurance premiums bounced around madly from year to year. Right after Andrew, the entire industry quintupled its prices; a few tranquil years later, prices were back down nearly to where they had been before the storm. Financial markets bounced around wildly too, of course, but in the financial markets, the underlying risks (corporate earnings, people’s moods) were volatile. The risk in natural-disaster insurance was real, physical and, in principle, quantifiable, and from year to year it did not change much, if at all. In effect, the insurers weren’t insuring against disaster; they were only pretending to take the risk, without actually doing so, and billing their customers retroactively for whatever losses they incurred. At the same time, they were quietly sneaking away from catastrophe. Before the 1994 Northridge earthquake, more than a third of California homeowners had quake insurance; right after, the insurers fled the market, so that fewer than 15 percent of California homeowners have earthquakes in their policies today.

The market was broken: people on fault lines and beachfronts were stuck either paying far too much for their insurance or with no real coverage except the vague and corrupting hope that, in a crisis, the government would bail them out. A potentially huge, socially beneficial market was moments from birth. All it needed was a push from nature. And so on Aug. 24, 2005, John Seo was waiting, waiting for a storm. And here it came.

Catastrophe bonds do something even odder: they financialize storms. Once there’s a market for cat bonds, there’s money to be made, even as a storm strikes, in marginally better weathermen. For instance, before the 2005 hurricane season, a Bermuda cat-bond hedge fund called Nephila found a team of oceanographers in Rhode Island called Accurate Environmental Forecasting, whose forecasts of hurricane seasons had been surprisingly good. Nephila rented the company’s services and traded bonds on the back of its reports. “They kind of chuckle at what we do,” says a Nephila founder, Frank Majors. “The fact that we’re making $10 million bets on whether Charley is going to hit Tampa or not. It made them a little nervous at first. We told them not to worry about what we’re going to do with the information. Just give it to us.”

Catastrophe risk is fundamentally different from normal risk. It deals with events so rare that experience doesn’t help you much to predict them. How do you use history to judge the likelihood of a pandemic killing off 1 in every 200 Americans? You can’t. It has happened only once. (The Spanish flu epidemic of 1918.) You lack information. You don’t know what you don’t know. The further out into the tail you go — the less probable the event — the greater the uncertainty. The greater the uncertainty, the more an investor should be paid to live with it.

The financial markets, or, at any rate, the arcane corner of Wall Street that dealt exclusively with highly unlikely financial events, had figured this out. The traders who sold insurance against extreme market collapses — the tail risks — all tended to charge exactly the same price, between four and five times their expected losses. Expected loss could be defined like this: Say an investor wanted to buy $1 billion of insurance for a year against a once-in-100-years stock-market crash. The expected loss would be 1 in 100, 1 percent of $1 billion: $10 million. The insurance would thus cost $40 million to $50 million. The pattern held across Wall Street. The trader at Lehman Brothers who priced stock-market-crash insurance didn’t know the trader at Harvard Management who priced the insurance against drastic interest-rate changes, and he didn’t know the trader at O’Connor and Associates who priced the insurance against the dollar’s losing a third of its value. But their idea of a fair premium for insurance against financial disaster suggested they were reading the same books on the subject — only there were no books. “The reigning theory is that the taste for risk is as arbitrary as the value of a painting,” Seo says. “But if this is so, why are these preferences so consistent across markets?” … Thus the hunches of Wall Street professionals found vindication in Seo’s arithmetic. The expected loss of the more ordinary risk of a single earthquake was $1 million (a 10 percent chance of a $10 million loss). The insurance cost $2 million, or twice the expected loss. The expected loss of the remote combined risk was $100,000 (a 1 percent chance of a $10 million loss). But the insurance cost $400,000: four times the expected loss. All those practical traders who were pricing tail risk at roughly four times the expected losses had been on to something. “Here I saw the beginnings of a market mechanism that directly links 1-in-10-year risk pricing to 1-in-100-year risk pricing,” Seo says. The intuitive reason that extreme, remote risk should be more highly priced than normal everyday risk was “a happy agreement between human psychological perception and hard mathematical logic.”

Seo’s math — which soon left middle school for graduate school — served two purposes: to describe this universal rule about the pricing of risk and to persuade investors that there was a deeper, hidden logic to investing in catastrophe. They could have some sense of what the price of the risk should be. It was an extraordinary idea: that catastrophe might be fair.

While markets can bring many benefits, they can also generate new forms of risk. A week later, also in the New York Times, financial journalist Richard Lowenstein quotes Keynes on liquidity vs. volatility in an article in the Sept 1 NYTimes about the Mortage Crash in USA:

John Maynard Keynes who observed the paradox of securities markets: their very liquidity, which investors perceive as a safeguard, creates the conditions for disaster. “Each individual investor flatters himself that his commitment is ‘liquid,’ ” Keynes wrote, and the belief that he can exit the market at will “calms his nerves and makes him much more willing to run a risk.” The catch is that investors, collectively, can never exit in unison. Whenever they try, panic and losses are the sure result.

There is also a discussion of the article on O’Reilly Radar, where John Seo responds to some questions.

One thought on “Catastrophe Bonds: Markets, Learning and Volatility”

  1. Interesting read. Given the current market volatility and instability of the some of the countries largest finanical firms (AIG ect) does it make Catastrophe Bonds more or less risky. If the risk stays the same for a Catastrophe doesn’t it make traditional investments more risky relative to Catastrophe risk.

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