Soldiers in the Missouri National Guard, 117th Engineer Team clean up after the catastrophic tornado in Joplin, Mo. (credit: Ann Keyes/Missouri National Guard)
Corrected on August 3, 2011. The original version misidentified the company Mariah Re as O’Ryan Re.
The Central U.S. is a tornado sweet spot. During spring and early summer, the west-to-east flow of cooler air in the upper atmosphere can slap tropical air masses traveling north from the Gulf of Mexico so violently it creates a swirling vortex that concentrates the warm air’s considerable energy, a tornado.
They are inevitable. They are destructive. And they are unpredictable. Yet they are insurable. The hows and whys of insuring property against a natural disaster such as a large tornado bear explaining. The short answer is “cat bonds,” but first some background.
“The cat bond business isn’t really taken into account by (government) emergency managers,” according to Matthew Hochstein, a FEMA consultant based in Evanston, IL. “Cat bonds are mitigation of financial risk” and do not address “the ability to respond to, or immediately recover from an event,” like a tornado.
It would be wrong to say that government doesn’t care about cat bonds however. State governments in California, Oklahoma, Alabama and Florida either regulate or provide catastrophe insurance products for citizens because of the potential for disasters within their borders.
Florida uses its financial clout to offer residents reduced-cost insurance against hurricanes. For the most part however, families and business owners are on their own to safeguard their financial security.
Cat bonds speak directly to the economic losses incurred because of a natural disaster, much of it property-related, not the loss of life. “Ultimately we’re providing capital to help rebuild” after a catastrophe, says John DeCaro, a principal at Chicago alternative investment manager, Elementum Advisors, which trades catastrophe bonds.
American Family Insurance, based in Madison, WI., protects property-owners throughout the Midwest, many of them in the tornado sweet spot.
When there’s a disaster, American Family has to make sure it can meet obligations to its policy-holders. To accomplish this, the company turns to “a marketplace where insurance companies buy insurance to cover these things,” according to Greg Gisi, director of risk management there.
That marketplace, called reinsurance, is where one insurance company (the reinsurer) provides insurance to another insurance company (the insured). The reinsurer helps the insured deal with expensive risks where the value of property at risk is greater than its resources on hand.
Reinsurance was originally conceived after fire devastated Hamburg, Germany, in 1842. Insurance reserves were inadequate, and four years later Cologne Re, the first reinsurer, gave property insurers a second party to transfer risks to. The destruction in pre-reinsurance Hamburg ultimately required 40 years to rebuild from.
More recently, Hurricane Andrew wrecked Florida coast during August 1992, causing damage then estimated at over $26 billion. According to The New York Times, eleven insurance companies went bankrupt.
Soon after Andrew new financial instruments called catastrophe bonds were invented to transfer large, rare, catastrophic risks to publicly traded markets, instead of just reinsurance companies. “They’re a way to expand the number of reinsurers that provide protection to American Family,” explains Gisi.
Last year American Family sponsored a company that issued two cat bond series linked to tornadoes and hail in the Midwest. Standard practice is to have an offshore shell company created for the sole purpose of creating the bond and providing reinsurance. “Those cat bonds were actually issued by a company in the Cayman Islands named Mariah Re,” says Gisi.
“The reinsurance premiums that we pay to Mariah Re are used to provide the investors their investment income,” says Gisi.
Recent severe tornadoes have made those bonds particularly volatile investments. “There’s been an increase in trading activity on those notes because of real concerns arising from Alabama-Mississippi tornadoes that happened on April 27,” says John DeCaro, the Chicago investor.
The price fluctuations have no bearing on American Family. Once bonds are issued, the initial bond holders put up cash that goes in to an account that collateralizes the reinsurance obligation to American Family, says Gisi, and from that point forward, regardless of investor volatility, “our cost of financing that risk doesn’t matter.”
It does matter to DeCaro, whose firm has invested in the bonds. He’s monitoring NOAA’s weather reports out of Norman, OK., to determine where tornadoes are going to occur, and how intense they are.
“We find a way to track and determine what the potential impact will be on our bond positions when a tornado happens,” says DeCaro, whose firm’s positions are based on an interpretation of facts as it sees them.
Compared with another trader’s perspective “that leads to a difference of opinion in terms of the valuation of an investment that we can take advantage of”, says DeCaro.
The differences of opinion trace back to the catastrophic risk models, and to real-time specialty data services that the firms use.
Mariah Re priced the bonds using a severe thunderstorm risk model from AIR, the Boston-based firm formerly know Applied Insurance Research that pioneered catastrophic risk management beginning in 1987.
The other major provider of catastrophic risk management models is RMS, based in Newark, CA. RMS recently changed its risk model for Atlantic Ocean hurricanes, something that prompted the downgrading of a number of already-issued catastrophe bonds.
Elementum relies on those risk management models, plus data provided by weather information boutiques like Planalytics, based outside Philadelphia, and ImpactWeather, located in Houston.
The Mariah Re bonds “have dropped probably 3 points on average in the past month,” says DeCaro. “Fortunately, for us as an investor, they were not materially exposed to any of the events that have occurred in the Southern states.”
That price change doesn’t affect the security of American Family policy holders, though it could make Gisi’s job harder, “Adding volatility means that if I want to put one out this year, it might change the price that I may issue a new one at,” something that could increase the cost of disaster insurance to property owners.
