A Cat Bond Premium Puzzle?

Abstract

Catastrophe Bonds whose payoffs are tied to the occurrence of natural disasters offer insurers the ability to hedge event risk through the capital markets that could otherwise leave them insolvent if concentrated solely on their own balance sheets. At the same time, they offer investors a unique opportunity to enhance their portfolios with an asset that provides an attractive return that is uncorrelated with typical financial securities Despite its attractiveness, spreads in this market remain considerably higher than the spreads for comparable speculative grade debt. This paper uses results from behavior economics to suggest why cat bonds have not been more attractive to the investment community at current prices. In particular, the authors suggest that "ambiguity aversion", "loss aversion", and "uncertainty avoidance" may account for the reluctance of investment managers to invest in these products. In addition, since Catastrophe Bonds are a new type of investment, investors must invest time and money up front in order to educate themselves about the legal and technical complexities of the Cat Bond market before that investor can make a "to-buy or not-to-buy" decision. Such a transaction cost may reduce the attractiveness of the new bonds to the point where the investor would prefer to stay out of the market. The bulk of the paper consists of quantitative assessments of each of these hypotheses, along with a demonstration that Cat Bonds are indeed much more attractive than high yield bonds in terms of their Sharpe ratios (the ratio of the "excess return" over the risk free rate to the standard deviation of returns on the bonds). This is accomplished by simulating potential losses for hypothetical Cat Bonds under a wide variety of hurricane scenarios for the Miami/Dade county are. These findings lead the authors to suggest that issuers of Cat Bonds could themselves take steps to lower the cost of placing risk in this manner. Specifically, issuers might standardize a simple structure of terms to decrease the investor's cost of education. In addition issuers could better quantify and reduce pricing uncertainty. These steps will should increase demand for these instruments and produce a concomitant reduction in price.