For hedge funds, the science of catastrophes helped generate the most effective returns of any different funding technique final yr.
The calculus round pure disasters comparable to hurricanes and cyclones fed document beneficial properties at funds managed by companies together with Tenax Capital, Tangency Capital and Fermat Capital Administration. All three delivered outcomes that had been greater than double an industry benchmark, in accordance with public filings, exterior estimates and other people conversant in the funds’ numbers.
Behind these document returns had been daring bets on disaster bonds and different insurance-linked securities. So-called cat bonds are utilized by the insurance coverage business to protect itself from losses too huge to cowl. That threat is as a substitute transferred to traders prepared to simply accept the possibility that they could lose part of — or all — their capital if catastrophe hits. In change, they get rewarded with outsize earnings if a contractually pre-defined disaster doesn’t happen.
Final yr, every thing got here collectively for these traders in a uniquely worthwhile cocktail.
“I don’t think we’ve seen a market like this since cat bonds were born in the 1990s,” mentioned Toby Pughe, an analyst at Tenax. The London-based hedge fund’s portfolio of about 120 of the securities delivered an 18% return final yr.
The perfect hedge fund technique of 2023 was a guess on insurance-linked securities (of which disaster bonds are the dominant sub-category), which generated over 14%, in accordance with Preqin, a consultancy that gives knowledge on the choice asset administration business. Preqin’s benchmark return for the business — throughout methods — was 8%. That compares with a 19.7% acquire within the Swiss Re International Cat Bond Efficiency Index Complete Return.
Cat bond issuance has been turbo-charged by concern about excessive climate occasions fueled by local weather change, and by decades-high inflation that’s added to the price of rebuilding after pure disasters.
However the seeds of 2023’s document cat-bond efficiency had been planted a number of years in the past.
The securities had been typically a dud guess as not too long ago as 2017, when a number of massive hurricanes slammed into the US and traders had been referred to as on to cough up the money wanted to cowl property losses. Returns had been additionally underwhelming in 2019 and 2020.
Then, hurricane Ian hit Florida in September 2022.
Ian was essentially the most harmful storm within the state’s historical past, inflicting $100 billion in losses of which solely 60% was insured, in accordance with Munich Re. The occasion led insurers to shift extra of the chance on their books to the capital markets. And with a lot increased reconstruction prices amid rampant inflation, the stage was set for the marketplace for cat bonds to return roaring again.
“The increase in insured values on the residential side went from 8% to 20%,” mentioned Jean-Louis Monnier, international head of insurance-linked securities at Swiss Re. “Insurance companies needed to buy more cover.”
In 2023, cat bond issuance reached an all-time excessive of $16.4 billion, together with non-property and personal transactions, in accordance with Artemis, which tracks the marketplace for insurance-linked securities. These offers introduced the full excellent market to a document $45 billion, it estimates.
To mop up the inflow of newly-issued threat, cat bond traders demanded — and obtained — a lot greater returns. Spreads — the premium over the risk-free charge that traders receives a commission to tackle “catastrophe” threat — reached a excessive in early 2023. Returns had been then amplified by a comparatively benign US hurricane season, that means fewer set off occasions and extra money for traders.
Greg Hagood, co-founder of Nephila Capital, a $7 billion hedge fund specializing in reinsurance threat, mentioned that final yr’s spreads “were probably the highest they’ve been in my career, relative to the risk we’re taking.”
Dominik Hagedorn, co-founder at Bermuda-based Tangency Capital, mentioned hedge fund curiosity in insurance-linked securities has picked up “quite significantly” over the previous 12 to 18 months. “Given where the spreads are at the moment, I wouldn’t be surprised if that stayed like that for another year or so,” he mentioned.
The influence of worldwide warming on climate patterns is a key function of cat bond modeling, with latest adjustments setting the stage for brand spanking new patterns of loss.
Karen Clark, a pioneer in modeling disaster threat, says there may be rising market curiosity in so-called secondary perils, comparable to extreme convective storms, winter storms and wildfires, as a result of that’s the place the demand and alternatives are.
“Climate change is having the biggest impact on wildfires,” the place particular person occasions will result in losses starting from $10 billion to $30 billion, mentioned Clark, co-founder of Boston-based Karen Clark & Co. “That’s where the cat bond market can grow.”
Brett Houghton, a managing director at Fermat, which delivered about 20% last year on its roughly $10.8 billion of belongings, mentioned that such secondary perils are a great way to “help diversify your portfolio.” He additionally mentioned they continue to be onerous to mannequin, which suggests they arrive with “some uncertainty.”
Cat bonds are additionally increasing to incorporate new sorts of threat. Final yr marked the primary time traders in public markets had been in a position to purchase publicity to cyber-catastrophe bonds, which company executives now charge as considered one of their most feared exterior threats.
Cyber cat bonds “were a big success in 2023,” mentioned Monnier of Swiss Re. “There’s still a limited subset of investors that can invest in cyber, but I think the next step will be a broadening of acceptance” from Wall Avenue.
International cat bond capability has grown at about 4% yearly for the previous six years — adjusted for inflation — which is roughly in keeping with the expansion of pure disaster exposures, in accordance with Swiss Re Institute. Globally, ILS capital reached about $100 billion on the finish of the third quarter of 2023, insurance coverage dealer Aon Plc estimates.
Cat bond traders hoping for one more document yr ought to word that inflows have tightened spreads, in accordance with Hagedorn at Tangency. And Tenax reckons its return on cat bonds this yr could also be round 10% to 12%, in contrast with final yr’s 18%. That’s assuming 2024 is one other “no loss year,” that means there’s no pure catastrophe sufficiently big to set off the bonds’ fastidiously worded cost clauses.
“I can’t tell you if there’s going to be a hurricane or earthquake this year, obviously,” mentioned Hagood of Nephila Capital. “But what I can tell you is spreads are near historical highs in the sector. So broadly speaking, we believe the market is being well paid for the risk.”
