A Value Investing-Based Approach to Catastrophe Bonds and Tail Risk Hedging

Frederick J. Sheehan

Independent

Joseph Calandro Jr.

Fordham University – Gabelli Center for Global Security Analysis

Abstract:

This paper is a compilation of two articles that were written on the subject of catastrophe bond valuation (Part 1 of the paper) and tail risk hedging (Part 2 of the paper) from a value investing perspective. The paper presents a practical introduction to these topics that was written to the value-oriented readership of Marc Faber’s popular investment periodical, “The Gloom, Boom & Doom Report” in 2013 and 2014.

A Value Investing-Based Approach To Catastrophe Bonds And Tail Risk Hedging – Introduction

The Insurance-Linked Securities (ILS) market is two decades old,1 and is used by insurers to transfer certain risks to the capital markets. The most popular component of this market is catastrophe bonds (cat bonds), of which there was $15 billion in outstanding principal at the end of 2012.2 Institutions and pension funds are attracted to these bonds due, predominantly, to their yield and diversification benefits.

We approach cat bond valuation differently than many other investors. As followers of the late Benjamin Graham, we apply a value investing-based approach to cat bond valuation.

While the fundamentals of cat bonds are different than the fundamentals of a traditional bond, the theory that Mr. Graham founded applies just as much to cat bonds as it does to other bonds (or any other kind of investment for that matter).

In the case of cat bonds, margins of safety exist when the price of catastrophic risk provides a meaningful cushion to the investor on a “stressed” basis. There are quantitative, qualitative and behavioral factors to catastrophic stresses, and therefore a proper (or put another way, fundamental) analysis must examine all three. In addition, cat bonds are subject to the serendipity of insurance and interest rate cycles, which must also factor into the analysis. Needless to say, many of these factors are currently “off model”; meaning, not addressed in a material way in many quantitative catastrophe models.

A lesson of Financial History is that during financial panics all types of assets are hurriedly sold, sometimes on a distressed basis. A current attraction of cat bonds is that natural catastrophes are not correlated to financial panics. However, cat bonds may not be as uncorrelated as many people currently think they are. When correlations converge during a panic the phenomenon frequently involves assets that did not move together in the past, which “all of sudden” move together; the proverbial “1-in-100 year flood” that seems to occur every decade or so. We posit that in a future crisis cat bonds will join in some unexpected convergence to one.

Cat bond managers tend to concentrate their portfolios in certain perils such as hurricanes in Florida, earthquakes in California and pandemics. At times, there are ways to economically hedge such concentrations in much the same way that certain successful value investors have economically hedged other risks. By doing so, one can protect a portfolio when the broader market is systematically underpricing risk and therefore capitalize on volatility expansion when a catastrophe does strike–and catastrophes are always at-risk of striking–and the resulting “harder pricing.” In short, the portfolio management objective of the cat bond value investor should be to move with cyclical volatility instead of against it.

History

The consequences of quantitatively constructed portfolios predicated on wishful thinking (e.g., “housing prices never go down”) is so recent that we will simply note that the manager who looks at the present deeply in the eye already enjoys a certain comparative advantage. This is not to say that we ignore history: We intensely study the history of asymmetries inherent in insurance finance. Take, for instance, the San Francisco Earthquake of 1906, which was a well-known catalyst of the Panic of 1907.3 Under-capitalized (and/or overexposed) banks, trust companies and insurance companies suffered the financial consequences of this catastrophe, which in some cases was fatal. In total, approximately one hundred insurance companies incurred losses due to this earthquake.

Berkshire Hathaway catastrophe bonds

Berkshire Hathaway catastrophe bonds

See full research here via SSRN.