Could tornado BONDS boostyour NEST EGG?
EVERY year about one million earthquakes and 90 hurricanes are recorded worldwide.
For families affected, these can be devastating. And for insurers, financially crippling.
When Hurricane Katrina hit the U.S. more than a decade ago, it was estimated to have cost insurance companies £62 billion.
Hurricane Sandy, which followed seven years later, cost them £15.5 billion when it hit several states, including New York.
So it is no wonder that, just as an individual takes out home, car or health insurance to protect against the unexpected, insurers also take out cover. These policies, known as catastrophe bonds, are a multibillion-pound business.
The insurer pays investors in the bond a premium — just as you would for car or home cover. Then cash in the bond is used to foot the bill should the worst happen.
As with any insurance, the higher the risk, the more expensive the premium for the insurer. Typically, these policies pay an income of between 2 pc and 8 pc a year.
When you think the average savings account pays less than 1 pc, this is an attractive return.
Catastrophe bonds have only been around since the mid-Nineties, but are today issued by many of the world’s biggest insurers including Lloyds, Swiss Re and AIG.
They are most common in the U.S., where there is a strong insurance market and natural disasters are more frequent.
They are even issued by government catastrophe schemes such as the California Earthquake Authority and big organisations, such as U. S. rail operator Amtrak.
Simon Vuille, co-manager of the Lombard Odier CAT Bond fund, says the bonds are unique as their price and payouts are linked to the weather — and unaffected by stock market crashes or political crises.
They are also popular as the interest they pay usually climbs if the base rate rises, he says.
Each catastrophe bond issued is very specific. For example, in Mr Vuille’s fund, there is a holding for insurance against an event such as the 1926 Great Miami Hurricane, which devastated Florida and much of the Caribbean.
In today’s money, the damage caused would cost insurers more than £115 billion.
Because such an event happens only about every 200 years, the bond pays just 3 pc.
Another example is insurance against earthquakes in California. The payout, at 2 pc, is even lower as a large earthquake only occurs in the Golden State approximately once a century.
An earthquake is also likely to cost insurers less than a flood or storm, meaning the risk is lower, as it is not standard on home insurance policies.
A more unusual holding in Mr Vuille’s fund is protection against mortality. ‘This would be triggered if there were an extreme number of deaths in a specific country in one year, in the hundreds of thousands, and a life insurer would have to pay out on those deaths,’ he says.
‘Typically, what would cause this is a catastrophe such as a tsunami or, more likely, a pandemic.’
Each of the 94 bonds Mr Vuille invests in has specific criteria that must be met before it will pay out to the insurer.
The risk is that if the worst case scenario does happen, the money in the bond will be used to cover the insurer’s costs.
This means the fund manager could lose all of the money he holds in that bond, which could hit the fund’s return and value of your savings.
Dr John Seo, co-founder of Fermat Capital Management, which manages the GAM Star Cat Bond fund, says: ‘ The biggest risk in any typical year is that there is another Great Miami Hurricane.
‘ Such an event could see catastrophe bond funds lose around 25 pc of their value.’
Mr Vuille says, however, that the default rate on the bonds he’s held in the past has been very low — the last default followed the 2011 Fukushima nuclear disaster in Japan. The average payout of the bonds in his fund is 4.5 pc.
His Lombard Odier CAT Bond fund is down 0.2 pc over the past year, while the GAM Star Cat Bond fund is up 2.8 pc in the same period, turning £10,000 into £12,800 and yields in the region of 4.1 pc.
Nathan Sweeney, manager of the Architas Diversified Real Assets fund, has been investing more cash in catastrophe bonds ahead of the General Election.
He has 3 pc of his £183 million fund in the CATCo Reinsurance Opportunities fund, which has returned 26.5 pc in a year, turning £10,000 into £12,650.
Mr Sweeney says: ‘If there are no major disasters then the returns on offer from catastrophe bonds are very attractive.’
However, Juliet Schooling Latter, from Chelsea Financial Services, warns: ‘These funds often pay a very high income. But with that high yield comes high risk, so catastrophe bonds are not for everyone.’
And James de Bunsen, manager of the Henderson Alternative Strategies Trust fund, says: ‘ I don’t think catastrophe bonds pay enough for the risk you take.’