The attachment is to a paper Joe Calandro and I wrote for the November 2013 Gloom, Doom & Boom Report. "CatastropheInsured: Cat Bonds," discusses the money-making potential of a specific cat(astrophe) bond strategy. Such an investment appeals to a small audience but the characteristics apply broadly.
"What is the price?" should be fundamental to investment decisions. We know that is often not the case. A fund manager who invests in small-cap stocks must buy small-cap stocks. Managers are usually permitted the alternative of holding money in cash, but are wary of doing so. Relative performance is the manager's calling.
The qualification (above) of a "specific" cat bond strategy is in response to the question: "What is the price?" The answer, at times: "Not what it is should be." Catastrophe insurance is being mispriced, which is not a surprise in the current environment when anything goes. In "soft" markets, insurers cover catastrophe-exposed insurance polices at too low a price. In the cat bond area, there is too little on-the-ground understanding of the insurers' property and financial exposures when a catastrophe hits. Even more so, since catastrophes can come in pairs (e.g., hurricanes and financial panics).
After selling property insurance to businesses or homeowners (for instance), insurers (or, their investment bankers) bundle the policies into cat bonds as a form of reinsurance. This is meant to be similar to the process of securitizing mortgages or auto loans. Cat bonds have been sold for quite awhile, but it is only in the past couple of years that volume has skyrocketed. We know what happened when mortgage-backed securities boomed up until 2007. In general, investment mangers did not study the quality of the mortgages or the composition of the securities. Those who did crunch the numbers either stayed away or employed strategies to short the securities.
In defense of the investment managers who did not understand the mortgage securities, to do so required a tremendous amount of work and hiring specialists. For the most part, investors relied on the resourceful credit agencies that stamped sub-prime securities as AAA. So too, with cat bonds, where there is no substitute for exposure identification, cycle management, and contract documentation.
We are seeing a replay of 2007 across the investment spectrum. It is not a surprise that a burgeoning class of securitized liabilities has been bought by mutual funds and hedge funds. They zip cat bonds through their bond models and buy.
It will be interesting to see how this turns out.*
*In the spirit, if not the orbit, of Arthur Balfour, who, when signing the so-called Balfour Declaration of 1917, promising a homeland in Palestine for the Jews, commented: "I have no idea what the result will be, but I am certain that it will lead to a very interesting situation."