(Bloomberg) — For hedge funds, the science of disaster last year helped them generate some of the best returns among alternative investment strategies.
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Calculations around natural disasters such as hurricanes and cyclones have led to record profits for funds managed by firms such as Tenax Capital, Tangency Capital and Fermat Capital Management. All three companies outperformed industry benchmarks by more than double, according to public filings, outside estimates and people familiar with the funds' numbers.
Behind these record returns were bold bets on catastrophe bonds and other insurance-related securities. So-called cat bonds are used to protect against losses that are too large for the insurance industry to cover. That risk is instead transferred to investors who are willing to accept the possibility of losing some or all of their capital in the event of a disaster. In return, they can earn huge profits unless a contractually predetermined catastrophe occurs.
Last year, everything came together to create a uniquely profitable cocktail for these investors.
“I don't think we've seen a market like this since cat bonds were created in the 1990s,” Tenax analyst Toby Pugh said. The London-based hedge fund's portfolio of about 120 stocks returned 18% last year.
According to Preqin, a consultancy that provides data on the alternative asset management industry, the best hedge fund strategies in 2023 are bets on insurance-related securities (of which catastrophe bonds are a major subcategory), yielding more than 14%. Ta. Preqin's industry-wide benchmark return was 8% across strategies. This was matched by a 19.7% increase in total return for the Swiss Re Global Cat Bond Performance Index.
Concerns about extreme weather events caused by climate change and decades of high inflation that add to the cost of rebuilding after natural disasters are further fueling cat bond issuance.
But the seeds for Catbond's record performance in 2023 were planted years ago.
While several major hurricanes hit the U.S. in 2017, prompting investors to scrounge up the cash needed to cover property losses, the securities were generally a bad bet. The returns in 2019 and 2020 were also overwhelming.
Then, in September 2022, Hurricane Ian hit Florida.
Munich Re said Ian was the most destructive storm in the state's history, causing $100 billion in losses, only 60% of which were insured. This event prompted insurance companies to shift more of their book risk to capital markets. And with restructuring costs rising significantly amid rampant inflation, the cat bond market is poised to rise again.
“Insurance price growth in the housing sector has gone from 8% to 20%,” said Jean-Louis Monnier, global head of insurance securities at Swiss Re. “Insurance companies had to buy more insurance.”
Cat bond issuance in 2023 reached a record $16.4 billion, including non-real estate and private transactions, according to Artemis, which tracks the market for insurance-related securities. With these transactions, the company estimates that outstanding market balance has reached an all-time high of $45 billion.
To limit the influx of newly issued risk, cat bond investors demanded – and received – even greater returns. Spreads – the premium over the risk-free rate that investors are rewarded for taking “catastrophe” risks – reached their highest level in early 2023. Returns have since been amplified by a relatively mild U.S. hurricane season, meaning fewer triggering events and more money for investors. .
Greg Hagood, co-founder of Nephila Capital, a $7 billion hedge fund specializing in reinsurance risk, said last year's spreads were “probably the best in my career compared to the risks we're taking on.” It was great,” he said.
Dominic Hagedorn, co-founder of Bermuda-based Tangency Capital, said hedge fund interest in insurance-related securities had increased “significantly” over the past 12 to 18 months. “Given the current state of spreads, I wouldn't be surprised if they stayed like this for another year or so,” he said.
The impact of global warming on weather patterns is a key feature of cat bond modeling, and recent changes have set the stage for new loss patterns.
Karen Clark, a pioneer in catastrophe risk modeling, says there is a growing market focus on so-called secondary disasters, such as severe convective storms, winter storms and wildfires, and that there is demand and opportunity there. He says it's because there is.
“Climate change is having the biggest impact on wildfires,” said Clark, co-founder of Boston-based Karen Clark & Company, adding that individual events can cost between $10 billion and $30 billion. He said it could lead to losses. growing up. “
Brett Horton, a managing director at Fermat, which invested about 20% of its $10.8 billion in assets last year, said such secondary risks are a good way to “help diversify your portfolio.” He also said they remain difficult to model, which means they involve “some degree of uncertainty.”
According to the Swiss Re Institute, global cat bond capacity has grown at an inflation-adjusted rate of about 4% annually over the past six years, roughly in line with the increase in exposure to natural catastrophes. . According to estimates by insurance broker Aon, global ILS capital reached approximately $100 billion at the end of the third quarter of 2023.
Tangency's Hagedorn said cat bond investors hoping for another record year should keep in mind that spreads are tightening due to inflows. And Tenax expects cat bond returns this year could be around 10% to 12%, compared with 18% last year. This is assuming 2024 is once again a “no-loss year,” meaning no natural disaster occurs large enough to trigger the bond's carefully worded payment clause.
“Of course we don't know if there will be hurricanes or earthquakes this year,” said Nephila Capital's Hagood. “But what I can say is that spreads are near historic highs for the sector. Broadly speaking, we think the market is paying well for the risk.”
–With assistance from Nishant Kumar and Janet Paskin.
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