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Catastrophe (CAT) Bonds: Diversification when you need it

"With returns driven by hurricanes and earthquakes, cat bonds offer true diversification from other asset classes"

The catastrophe (cat) bond space is seeing unprecedented demand for capital. The abundance of quality issuance since Hurricane Ian in what can often be a restricted asset class is opening up an unexpected opportunity and therefore portfolio diversification potential.

In an environment of high inflation and volatile financial markets, investors are increasingly turning to innovative investment options to safeguard their returns and enhance portfolio diversification. One such solution is Catastrophe Bonds, commonly referred to as (cat) bonds or insurance-linked securities (ILS).

What are Cat Bonds?

Crucially for portfolio diversification, cat bonds have typically low correlation to more traditional investments, even during periods of heightened volatility."

Catastrophe bonds, also known as cat bonds, a type of insurance-linked security (ILS) are fixed income instruments issued by insurers and reinsurers to transfer to investors exposures from potentially large insured losses associated with natural catastrophes, as well as other ‘perils’ such as terrorism and cyber risk. These bonds provide a form of reinsurance so that the insurer’s liabilities are covered, and they can afford to settle in full and aid recovery. In return - investors in cat bonds get paid a fixed rate of interest – just like a regular bond.  The skill is to calculate each cat bond’s true risk and identify the opportunities with the most attractive yields. 

 

 

Why invest in cat bonds now?

  • Diverse return drivers
  • Uncorrelated with broader financial markets
  • Enhanced liquidity
  • Strong ESG credentials
  • Attractive entry levels relative to history
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Key Characteristics

Adaptive to rising rates and inflation.

Cat bonds by their very nature and construct are adjustable-rate instruments that are indexed to inflation. The coupons on cat bonds are all floating rate; every basis point rise in interest rates on the short end of the curve flows directly into the coupon.

With regard to inflation, insurance companies themselves meticulously reset their premiums on an annual basis with every policyholder according to prior and expected inflation. This means that the very nature of the business itself is indexed to inflation.

Fear, uncertainty and doubt drives insurance and reinsurance buying.

Fear, uncertainty and doubt tends to affect the psychology of insurance buyers, compelling them to buy more insurance at a premium.

But crucially, investors in the cat bond market do not necessarily pay for the benefit with a higher risk because a market crash, or even an event like the war in Ukraine, cannot cause a hurricane or earthquake to occur.

Alignment with ESG principles.

Cat bonds are well aligned with environmental, social and governance principles.

E: They are at the forefront of monitoring changes in weather extremes and their impact on economies.  

S: Insurance in general is a social form of finance, applied to neutralise risk across a broader pool to reduce its impact and severity on society.  

G: The cat bond market brings an unprecedented level of market transparency around pay outs for catastrophes. This allows governments to plan and budget for their response to such catastrophes. 

The current market conditions have created a significant imbalance between supply of cat bonds and capital able to absorb it. So effectively coming into the second half of 2024, there is the potential for much-increased issuance volume of cat bonds, as demand for risk capital is so high.”

Cat Bonds during crisis years

In a world of specialist asset classes whose alternative status has been undermined by correlations with other risk assets, cat bonds offer diversification on a fundamental level. Because their pricing is not driven by economic or corporate events, returns from cat bonds are largely independent of mainstream markets and fundamentally non-correlated with traditional asset classes.

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Disclaimer: Past performance is not an indicator of future performance and current or future trends. The indications could be based on figures denominated in a currency that may be different from the currency of your residence country and therefore the return may increase or decrease as a result of currency fluctuations. Capital at risk: all financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Any reference to a security is not a recommendation to buy or sell that security.
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