When I first started writing for rollingalpha.com (back when it still had a blogspot domain), one of the first topics that I wrote about was the Subprime Mortgage Crisis. And in that post, I began by explaining how financial crises usually start with a really good (and clever) idea.

Examples:

1. The Subprime Mortgage was a solution for the traditional mortgage market, which dictated that those without payslips were not worthy of receiving credit, in spite of the fact that most commission-based jobs (estate agents, salesmen, waiters and strippers) have higher incomes than traditional salaried positions. Greed resulted in that whole policy turning into “No Credit Check Required At All”.
2. The Collateralised Debt Obligation was the solution to unsellable risky securities – which could be combined so that the risks would offset, thereby creating less risky securities. Much like taking flour and egg yolks and sugar, which might be unappetising when served individually, and turning them into cake (much more appetising). Greed resulted in the whole policy turning into “It doesn’t matter if the eggs are rotten – combine anything with anything, and once you ice it (with a credit rating), you get cake”.
3. Loans to South East Asia allowed investors to profit off newly-liberalised and fast-growing economies. But then Greed resulted in everyone forgetting that fast-growing economies are small economies – if you pump in too much, they explode in a bad way. Which they did. Causing the South-East Asia Currency Crisis.

The point is: I’m now alert to things that I find:

1. Clever; and
2. Profitable.

Because those things seem clever and profitable to everyone. When that happens, everyone gets stupid.

On that happy note, let me tell you about this clever and (seemingly) profitable solution to a problem faced by the Insurance industry.

They’re called Catastrophe Bonds.

What Is A Catastrophe Bond?

So do you remember how Hurricane Sandy (although she was only a tropical storm by the time she landed in New Jersey) swept through the North East of America, causing power-cuts and generally mangling Coney Island with a tidal surge?

Well the insurers had a bad time of it.

It’s the problem with catastrophe insurance. You can say:

“Well, massive hurricane catastrophes only really happen in New York once every 90 years, and serious storms every 30 or so, and those are the only times we’d pay out. So we can offer insurance at quite low premiums with quite infrequent payouts – so let’s do it!”

Which makes sense. Unfortunately, the insurer doesn’t know when they’ll be on the line for the insurance (that 90th year when the serious hurricane strikes could arrive next February). So any good insurance house would reinsure itself with other insurance houses, which may make sense for the insurance house on its own – but for the insurance industry collectively, it means that the whole thing could implode just as the storm wreckage clears.

Solution: offer the general investing public the opportunity to be the insurer.

Here’s how it works:

1. Each insurance policy represents a collection of cash inflows (premiums), with an expected cash payout at an actuarially-calculated probability-weighted future date (when the insurance houses estimate that the next major catastrophe will take place).
2. Obviously, the premiums collected are expected to be worth more than the potential payout, along with a whack of “interest income” as compensation for the risk management undertaken by the insurer. Otherwise, no insurance house would offer the insurance.
3. But insurers are limited in the number and variety of policies that they can offer, because all that risk has to sit on their books. Of course, that problem can be partially solved by reinsurance (insurers insuring themselves against their own payouts by paying premiums to other insurers) – but this option is limited by the risk appetite of the insurance industry as a whole.
4. But imagine if Insurance Houses could “re-insure” themselves by offering bonds to the public?
5. That would remove risk from the books of Insurers, and allow them to underwrite more policies.
6. And investors would have access to a form of risk that is unrelated to the economy (after all, the compensation for major catastrophe insurance is ultimately determined by the frequency and magnitude of natural disasters). Because of that, there has been a grand disparity between the yields on cat bonds and those of treasuries (even last year, that difference was as high as 11%. 11%!!).
7. That is an ENORMOUSLY ATTRACTIVE PROPOSITION.
8. Access to returns that have almost nothing to do (at this point) with the vagaries of government policies and the fickle sentiment of foreign capital?
9. Delightful.

Cat Bonds In Practice

According to the article I read in last week’s Economist, cat bonds first arrived in the aftermath of Hurricane Andrew in the mid-1990s. A decade ago, the market of cat bonds outstanding was only $4 billion (tiny). Currently, it’s up to $19 billion (still tiny – but less so).

But that’s still some pretty hectic growth (about 17% per year). And about 80% of that market is being absorbed by large institutional investors (like pension funds).

Like I said: it’s very attractive. High returns that seem unrelated to stock market risk. Yum.

A Roadmap To Pitfalls

In case it’s not obvious, I think that this is brilliant. There’s a clear need for, um, “insurance-linked securities” (ILS for short). But let’s talk through some of the implications for too much money being thrown into them (after all, Credit-Default Swaps were also meant to be insurance policies…):

1. Large Pension Funds start making more enquiries with Investment Banks for Cat Bonds and other ILS instruments.
2. The Investment Banks approach the Insurance Houses, and point out that there is an opportunity here for the executives to transform their industry. After all, everyone needs insurance. And it would be good if more people could be offered it. Also, the larger the customer pool, the more spread out the risk.
3. And, you know, if the customers decide that they want to drop their insurance – that’s alright as well. Because they’d forfeit their premiums and you’d get away without having to pay for anything! And unlike mortgages, you wouldn’t have to sell a house to recover capital!
4. But they’d also point out that there is a window here, which needs to be taken advantage of.
5. So the Insurance executives think it over for a second, can’t see any immediate downside, and try out a small cat bond issuance deal.
6. It’s wildly successful. Demand is high. The cash is flush. E’r’body gets a bonus.
7. Boom.
8. So the insurers sell more insurance. And they lower the premiums slightly, and offer the policies slightly more freely, and then promptly package them off and sell them to pension funds.
9. More cash. More bonus. And now the speculators start to get excited about these awesome instruments whose risk is uncorrelated with market risk.
10. So the Investment Bankers come back to the Insurers, and ask if there is any way that more insurance policies could be written. What about insurance for natural disasters in lesser known locations? And maybe some developing countries?
11. A wave of international insurance mergers and acquisitions ensues.
12. The world heralds the revival of the financial industry.
13. Insurance policy premiums get cheaper as the Insurance actuaries are encouraged to mince and shave their numbers to get probabilities less likely (“I mean, this is all just guesswork after all”) and to make riskier insurance policies more feasible.
14. The market then expands to include health insurance, auto insurance, life insurance, and so on.
15. The world is suddenly awash with cheap high-risk insurance policies.
16. Welcome: Global Warming.

In the aftermath, when both finance and weather have wreaked havoc, the actuaries will protest that the freak rise of natural disasters was not something that their models could have predicted, as their models were based on historical weather patterns. Regulators will be called in to reform the Insurance Risk Management process. Someone will suggest that certain types of key insurance policies be ring-fenced. A number of CEOs will be fired. Others will appear in Congress to testify that the crisis had nothing to do with them, and it was a system failure that they couldn’t possibly have foreseen, and that new procedures have been implemented to prevent a repeat occurrence.

And then, the craze for insurance-linked securities will be over. We’ll know their risks, we’ll recover, and they’ll go back to being an interesting side-line in the array of alternative investments that get discussed in CFA textbooks.

Of course, it may never happen. But, naturally, because I like I-told-you-so dances, I had to write this just in case. So that if it does, I’ll suddenly be a guru with an interactive ebook contract and multiple invitations to guest feature on popular podcasts.

Oh – and if you are going to be part of the ILS wave, get in there soon. While they’re still a good idea!

PS: and don’t buy shares in any reinsurers. Their days are numbered.