Katrina. Harvey. Irma. Each of these hurricanes was supposed to be a 1-in-200-years hurricane, and each did massive damage, capturing headlines around the world. But losses were not confined to those with homes or business in the areas affected, and investors were likely groaning at what seemed like good investments. Let’s take a quick view at investing in weather and catastrophes — or lack thereof.
Between 2000 and 2013, natural disasters cost the global economy about $2.5 trillion, affecting a third of small business owners. So how do insurance companies deal with the massive amount of payouts needed after a major weather event or extreme weather? By going into the reinsurance business.
This is where you come in. The short version is you take on a bond to reduce the liability of an insurance company; think buying someone’s debt, but only temporarily. Generally rated as BB or B, they are technically below the investment category.
Catastrophe bonds, or cat bonds, have only recently picked up steam in terms of popularity, they have been around for about 20 years. In that time, more than 300 transactions took place, only 10 of which resulted in losses by September 2017. Should they reach maturity, they pay out. If they are triggered, the insurer takes the principal, resulting in a loss for the investor.
While cat bonds can cover anything from wildfires to solar flares, half of the cat bonds currently issued, totaling about $26 billion according to the Wall Street Journal, have hurricane risk as part of the bond’s risk exposure, particularly in Florida. This makes sense, as one of the major pieces of advice to business owners is to insure against hurricanes.
“Aon Benfield’s U.S. hurricane bond index had an 8.7% average annual return over the past 10 years, compared with a 6.9% average over the decade for high-yield bonds,” the WSJ noted. “But cat bonds returned less over the 12 months through June 30: 6.4% compared with 7.9% for the high-yield index.” Maturities are typically between 3 and 5 years.
Unfortunately for cat bond holders, Hurricanes Harvey and Irma had other ideas. With an estimated $50 to 100 billion in damages for Irma and between $65 and 190 billion for Harvey, it’s a bad year to be in the reinsurance business.
There’s another weather-related investment, one not quite as devastating on a large scale. Weather derivatives — what the character Randall in the popular TV show “This Is Us” trades in — can boil down to trading in temperature patterns.
We’ll get to the specifics in a second, but the long and short of the bet is how temperatures will affect underlying assets. “These range from agricultural products (heat, wool, coffee, soy beans), energy (crude oil, natural gas), metals (eg gold, silver, copper) to financial assets (stock indices, interest rates),” according to The Conversation. “Such contracts allow both users and producers of agricultural goods, metals or energy, and investors in financial markets to manage their risk exposure to movements in the price of these underlying assets.”
It’s essentially insurance against weather, a potential threat to many small businesses in places where hurricanes don’t reach. Unlike weather insurance or cat bonds, weather derivatives bet on low-risk, high-probability events. If, for example, a company that produces a crop predicts hotter weather than the historical average by a few degrees, they can hedge their bets on the weather, rather than take the loss of crops due to the change in weather patterns. Those are between two separate parties, and are a discrete contract. If that wasn’t enough, in 1999, Chicago Mercantile Exchange offered weather futures to give even more options for betting on the weather.
While investing in or against the weather is the glamorous way of explaining catastrophe bonds and weather derivatives, they both boil down to investing in reinsurance. You take on the liability from an insurance agency or company producing goods. In the case of a cat bond, if nothing happens, you get your money back, plus interest. For weather derivatives, a company bets against itself that something bad will happen. If the temperature affects their product, such as a heat wave killing off their livestock, they will instead be able to collect money in lieu of products lost. And if all else fails, you can invest in a coat or swimsuit to combat the elements.