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Welcome to the Alts Sunday Edition 👋

Last year, we explored the lucrative (and controversial) market for investing in ​life insurance contracts​.

Life settlement funds can generate strong returns — but as it turns out, they’re just a small part of the broader Insurance-Linked Securities market (ILS).

Currently, the ILS market is worth ​$100 billion​. And about half of that value is held in one specific type of instrument: Catastrophe Bonds.

If catastrophe does not occur, holders of these bonds can realize ample returns. (The cat bond market returned 17.3% last year.)

But when disaster strikes, investors could lose big — up to 100% of their principal.

And right now is the perfect time to explore this asset class. The world’s first ​Catastrophe Bond ETF​ is due to start trading this month.

Today, I’m going to dive into the cat bond market, trying to determine whether the yields on these bonds justify bearing the risk of catastrophe.

In this deeply researched issue, I'll show you:

Let’s go 👇

​​Brian Flaherty​ purchased his first mutual fund at 15. After graduating from UVA with a degree in Economics, he began advising institutions and high-net-worth investors as a strategist at a wealth management firm. Today, Brian helps investors uncover the best opportunities and make intelligent use of their capital. You can follow him on ​LinkedIn​.

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What are catastrophe bonds?

As the name suggests, catastrophe bonds are debt instruments whose returns are tied to a devastating real-world event.

Typically, ‘cat bonds’ pay investors a floating rate coupon, currently ​around 10% annually​.

If the covered catastrophe occurs, however, investors sacrifice the principal on their bond.

Instead of paying investors back, the bond issuer uses this money to cover their catastrophe-related losses.

What kind of catastrophes are we talking about here? Cat bonds almost universally cover natural disasters, which are ​split​ into two categories:

In the modern era, however, secondary perils may not be truly ‘secondary.’

Climate change is making secondary perils ​more frequent and more severe​. Just consider this year’s devastating California wildfires, which could be the costliest natural disaster in US history.

Moreover, because secondary perils are highly dependent on local conditions, they are ​much harder to model​. This makes proper risk pricing a challenge.

I spoke about this with ​Steve Evans​, who covers the ILS market at ​Artemis​. He noted that part of the challenge with covering secondary perils is that it opens investors up to too many small-scale risks – which isn’t the point of a ‘catastrophe’ market:

“There are fewer secondary perils in the cat bond market than there have been previously. For me, I’d like to see the market cover more of them in time, but the loss-sharing needs to be fair. Investors don’t want to face losses for every small event. If a catastrophe hits the front page of the newspaper, that’s the event investors should have to worry about.” – Steve Evans

For now, the market remains focused on natural disaster primary perils, although a few cat bonds also cover man-made disasters like ​cyber attacks​ and ​terrorism​.

The origins of the cat bond market, however, lie with one particular type of catastrophe – hurricanes.

The birth of catastrophe bonds

Although the idea of securitizing insurance risk had been around for ​decades​, the cat bond market was kickstarted by one specific storm: the infamous ​Hurricane Andrew​, which pummeled Florida in 1992.

Prior to the storm, insurers thought that a worst-case hurricane would cause about ​$7 billion​ in insured losses. (At the time, that was roughly equivalent to the total economic losses in the US from 1989's ​Hurricane Hugo​).

But Hurricane Andrew completely upended that assumption. The storm caused an unprecedented ​$15 billion​ in insured losses — twice what insurers anticipated.

Here’s an astonishing fact: In the few hours it took Hurricane Andrew to pass over Florida, the state’s property insurers lost ​every single dollar​ they had earned in premiums for the last 22 years. Plus a few billion dollars more.

In the wake of the storm, ​seven insurance companies collapsed​ and dozens more stopped doing business in Florida.

For insurers, this disaster was a wake-up call that they needed to hedge huge amounts of natural disaster risk.

Insurers have always hedged their books by taking out their own insurance policies, in what's known as ​reinsurance​. (Another fascinating topic we'll explore in the future)

The problem, however, was the ​reinsurance rates spiked​ in the wake of Hurricane Andrew. Traditional reinsurers simply did not have enough capital to bear all the risks that insurers demanded!

As a result, reinsurers started looking for ways to offer insurance hedging without carrying the risks on their own balance sheets.

Thus, catastrophe bonds were born,.

This allowed reinsurers to pass along the risks to investors (in exchange for yield, of course).

One of the first major catastrophe bonds was an ​$85 million issue​ sponsored by Hannover Re in 1994.

After that, the market grew rapidly. Today, there are about ​$50 billion​ worth of cat bonds outstanding, with ​$17.2 billion​ of new issuance in 2024.

Over the years, primary insurers have grown to be the ​majority issuers​ in the market, rather than reinsurers.

There have even been cat bonds issued directly by major corporations as an alternative to traditional insurance (including ​Google​ and ​Blackstone​).

But in terms of catastrophes covered, the market hasn’t strayed far from its roots — hurricanes still dominate.

In fact, in 2024, ​82% of new issuance​ was exposed to Atlantic hurricane risk, ​roughly in line​ with previous years.

That’s the state of the market – but how do these bonds work in practice?

As it turns out, the mechanics aren’t as straightforward as they might appear.

How do catastrophe bonds really work?

On the surface, the concept of a catastrophe bond is fairly intuitive.

If the covered catastrophe happens, investors lose a bunch of money. If it doesn’t happen, they don’t. Simple, right?

Not quite. And the reason it's more complex is because it's not always clear what it means for a catastrophe to actually occur…