If you buy a beach house in Florida, you need insurance. But the insurance company itself does not want to take the risk of having to pay out in the event of a hurricane. Therefore, the insurance company insures itself with a reinsurer. However, they may not want to take the risk. At the end of this chain are investors like John Seo.

Seo manages the world's largest hedge fund, which invests exclusively in so-called cat bonds. Insurers and reinsurers issue these documents to be able to pay in the event of an accident. However, if the house on the Florida coast is not destroyed, investors like John Seo will benefit.

Catastrophe bonds basically function like other debt instruments. A company issues the securities and receives money from investors. Depending on the solvency of the company, it pays its debtor an annual interest, also known as a “coupon.” At the end of the term, investors usually get their money back.

What distinguishes “cat bonds” is their risk profile. Depending on the structure, investors completely lose their capital if certain thresholds are exceeded, for example, if a storm causes insurance losses of more than $500 million or an earthquake exceeds a certain level on the Richter scale.

Numerous bankruptcies gave insight to the industry

However, this market has been thriving since its inception in 1997. In 1992, five years earlier, Hurricane Andrew caused the largest storm damage to date in the United States: $27 billion. Of them, 15.5 billion dollars were insured. Ultimately, eight US insurers went bankrupt, according to an analysis by the US Federal Reserve in Chicago.

After Hurricane Andrew, the need for insurance and reinsurance increased dramatically. To have the liquidity needed to meet demand, the insurance industry created catastrophe bonds.

Initially, “cat bonds” remained a niche market. Hurricane Katrina in 2005 drained insurers' coffers, giving the market a boost to growth. In the zero interest rate phase after the great financial crisis, investors were hungry for any debt security that even gave a yield, such as catastrophe bonds.

Here also lies the great attraction for investors. Compared to US or German government bonds, the risk of “cat bonds” is significantly higher. But also the coupon and, therefore, the profitability potential.

Furthermore, the securities barely correlate with other areas of the capital market. The occurrence of earthquakes, storms or forest fires hardly correlates with economic activity. Catastrophe bonds offer investors the opportunity to diversify beyond the usual instruments, or even the chance to establish themselves in a niche. Like John Seo.

A biophysicist conquers the market with catastrophe bonds

The Fermat de Seo hedge fund, named after the French mathematician who for centuries exasperated number theorists with his “last theorem,” has little to do with the glamor of Wall Street. Fermat resides in Connecticut, in a former post office, according to a Bloomberg portrait of Seo. There is an auto repair shop across the street.

SEO itself is also not a product of the financial industry. In 1998, this PhD biophysicist made his way into trading ILS (insurance-linked securities), which also includes catastrophe bonds. Seo founded the hedge fund in 2001, initially with $30 million in capital. Today, after countless natural disasters of increasing proportions, the manager manages a good ten billion dollars.

Your skill with numbers and statistical models is valuable to clients. Last year, Fermat generated a 20 percent gain, more than double that of hedge funds overall with an eight percent return.

Profit opportunities for hedge funds like Fermat are likely to continue to grow. Not only is the number of events worth insuring increasing (large and small natural disasters, droughts, forest fires, etc.). But also because it is necessary to secure completely different areas, the value of which is constantly increasing.

“There was a hurricane that devastated a potato field in the Hamptons. Today the storms are destroying tens of millions of dollars worth of homes,” Richard Sandor told Bloomberg. Sandor, chief economist at the Chicago Futures Exchange in the 1970s, was one of the first to suggest creating tradable products to address rising insurance costs.

Catastrophe bonds are not for all investors

“Cat bonds” are now a niche market in which billions are still traded. And private investors can participate too. Although not through the popular ETFs, but through actively managed funds. Examples here are this background Credit Suisse (WKN: A2QJJA) or the Twelve Cat Bond fund (WKN:A2JEYC).

But should small investors do the same? The opinions of professionals differ. Asset manager Alexander Beffert from Ditzingen, for example, uses the papers for his clients “as a 'gift' to classic bonds in the form of broadly diversified and actively managed investment funds.”

Portfolio manager Maksym Dundar of RP Rheinische Portfolio Management also sees arguments in favor of “cat bonds.” “Bond price risks are not at all correlated with other market risks. This means that an expansion can be very useful, especially when it comes to diversification.”

Jörg Franzen, CEO of Franzen Gerber & Westphalen Asset Management, criticizes these documents. “Catastrophe bonds are only interesting for investors as a fund solution with a good manager, since many of the risks of natural catastrophes are summarized there and the default of a bond is mitigated by diversification.” securities – due to their complexity and risks of loss.

“The bottom line is that investors are adequately compensated.”

Stock market expert Dundar also reminds us of the risks of these investments: “However, potential investors should be aware of the manageable size of the catastrophe bond market, which is only around $40 billion.” Furthermore, papers are subject to certain cycles and marked seasonality. “Much of the performance and risk typically materialize during the Atlantic hurricane season, which runs from June to November.”

Investors should therefore think twice before investing in this market segment, especially since, as asset professional David Bienbeck of Albrech & Cie Vermögensverwaltung points out, “the segment as a combination is not necessarily ideal given the alternatives in the current interest rate environment”.

However, it is also clear that the brief phase of higher interest rates will soon come to an end. In this sense, “cat bonds” could soon become interesting again. Because the returns are appropriate to the risks, says Dundar: “The bottom line is that investors are currently being adequately compensated for the risks with current returns in almost double digits, in euros.”