Changes in Florence’s Path, Strength Muddy Cat Bond Traders Understanding of Risk

Catastrophe-bond investors are trying to assess the potential fallout from Hurricane Florence and whether they’re in store for painful losses.

If the storm’s path of destruction – which is aimed at North and South Carolina – causes enough damage in certain areas, some portfolio managers holding catastrophe bonds could be on the hook. The securities are used by insurance companies to transfer the risk of disasters. Issuers make coupon payments to investors, but if certain trigger events occur – like hurricanes – bond holders can lose all their principal.

As the storm approaches, disaster modelers like Risk Management Solutions will provide industry loss estimates to portfolio managers, who will use the information to work out what the storm means for their bonds, said Ed Hochberg, chief executive officer of global reinsurance brokerage JLT Re Inc.’s North-America division.

“The portfolio managers are scrambling right now to take in some of the input,” said Hochberg. They will “be cranking through those numbers trying to figure out how this will affect their positions.”

An index used to gauge the disaster bond market’s performance lost more than 15 percent in a week during hurricane season last year. But the benchmark, which is only updated at the end of each week, hasn’t yet reacted to the storm and is at a record high.

Hochberg, whose firm originates catastrophe bonds, said the secondary market for the securities is typically quite slow. But last year during Hurricane Irma, activity picked up. He’s expecting the same from Florence.

“We’ll start to see some trading activity,” said Hochberg. “There will be all sorts of different hedging positions going on, and looking to potentially reduce positions – even if they’re going to have to trade at a loss, but it’s better than the loss if they got completely wiped out.”

Hurricane Florence, which has weakened to a Category 2 storm, is lumbering toward the U.S. Southeast and could hit land on Friday. It could cause $10 billion to $20 billion in damage over the long run, according to Chuck Watson, a disaster modeler with Enki Research. Some $2.1 billion, or nearly 6 percent, of the $37 billion catastrophe bond and insurance-linked securities market specifically protects against U.S. named storms and hurricanes, according to data provider Artemis.

Investors appear undeterred by last year’s Atlantic hurricane season: $11.6 billion of catastrophe bonds and related securities have been issued so far in 2018, closing in on last year’s record of $12.6 billion. Among this year’s issuers is the Federal Emergency Management Agency, which for the first time turned to capital markets in July via a special-purpose vehicle with $500 million of bonds.

“It does look like another test,” Hochberg said of the storm, “but the market performed well last time.”