A flood of recent reports suggest the $20 billion catastrophe bond market is bulging with growth as desperate investors seek out yield. Could the market already be overbought?
So-called catastrophe bond see investors receive interest payments in exchange for buying bonds linked to specific disaster events (say, an earthquake in California). The bonds have been around for years. If a disaster does occur and the insurer's losses exceed a certain amount the face value of the bond can be wiped out. But investors have been attracted to high yields (up to 15%) and the non-market correlated nature of the bonds.
In the first quarter of this year, according to Verisk's Property Claim Services, investors poured $1.2 billion into catastrophe bonds. This is up 37 percent over the same period last year. BNY Mellon has issued a report suggest it expects to see the number of cat bonds outstanding to grow to $50 billion by the end of 2018. Data from Swiss Re shows pension funds accounted for 14 percent of direct investment in new cat bonds issued, up from 0 percent in 2007. A market that was once the preserve opt of hedge funds, insurers and reinsurers and those with an expert knowledge of disaster risk bought them.
This is good in one sense. There is a more diversified pool of capital for insurance markets to draw on—this could make the market more resilient. The falling yields created by the new money has helped cut the cost of buying insurance for consumers. According to a recent Financial Times article the cost of insurance fell about 15 per cent last year as a result of the new flood of money.
But as more investors rush in to the market yields are already plunging. The average yield in the market in recent months has dropped to just over 5 per cent, half the level of a year ago. Some are now thinking the inexperienced insurance market investors are in over their heads. The market has not seen a large catastrophe in some time (Sandy was bad, but it wasn’t a California earthquake) and the yield offered on the risk on offer is too low. Be warned.