Betting on Disaster
A Perfect Storm for the Catastrophe Bond Market, Michael Lewis' "In Nature's Casino", Florida's Quagmire
Wall Street is a machine for turning information nobody cares about into information people can get rich from.
During and after the Great Financial Crisis everyday Americans learned about the existence of exotic financial products like Collateralized Mortgage Obligations and Credit Default Swaps. These complex instruments seemed like financial chimeras, designed exclusively for speculation on the most intimate parts of financial life.
In reality, they were built for distributing and disambiguating risk across a sprawling market of participants who faced unique constraints in the value chain of home mortgages. Like commodity futures, foreign exchange or options markets, speculative trading provides much needed liquidity and price discovery for real economic users. A wheat farmer is not expressly a speculator but relies on a speculative market to help manage the risks inherent in agriculture.
This year, the Cat Bond (Catastrophe Bond) market has outperformed all other bond markets and like CMOs and CDS before it, the very existence of the market raises questions about the role of finance in society. In its simplest form, Cat Bonds help insurers spread excess risk to other investors. Per Bloomberg,
Investors in cat bonds pay the insured party when a contractually defined disaster strikes and specific parameters are met, such as a pre-determined pressure reading during a hurricane. When all the conditions are fulfilled, investors stand to lose some or all their money, which is then used to help cover the cost of the natural disaster in question.
The Cat Bond market emerged after Hurricane Andrew in 1992. Prior to Andrew, insurers had been using essentially subjective judgement about their risk exposure, when the $27 billion in damages from the storm were finally tallied, eight insurance companies failed. Michael Lewis wrote In Nature’s Casino for the New York Times, following Hurricane Katrina, another storm which caught insurance companies wrong-footed.
In nature’s casino, they had set themselves up as the house, and yet they didn’t know the odds.
Despite its actuarial rigor the business of most insurance is fairly basic diversification. The odds of any individual driver getting in an accident is difficult to predict but the number of accidents across a population of drivers can be forecast with near perfect accuracy. Natural disasters upset the basic arbitrage of insurance since, unlike a car accident, a large number of claimants are impacted at once.
But by their very nature, the big catastrophic risks of the early 21st century couldn’t be diversified away. Wealth had become far too concentrated in a handful of extraordinarily treacherous places. The only way to handle them was to spread them widely, and the only way to do that was to get them out of the insurance industry and onto Wall Street.
Like credit default swaps, options and futures, these instruments spread losses that would be calamitous when concentrated across the diaspora of global financial risk takers and make them more manageable.
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