6 ms·

The Business of Betting on Catastrophe

92 points by anarbadalov 1y ago

MarkusQ 1y ago
This reminds me of the predator hierarchy (for example, see Colinvaux's "Why Big Fierce Animals are Rare"): the reinsurers spread the risk from various insurers and for various catastrophes around among a pool of meta-insurers. But this pool is necessarily smaller than that of primary insurers, and their risks more likely to be correlated (catastrophes can cause other catastrophes, and multiply primary insurers can be affected by the same catastrophe). For that matter, I'm also reminded of credit default swaps, and Lehrer's "We Will All Go Together When We Go."
- falseprofit 1y ago
  One aspect worth pointing out is that ILS are transferring insurance risk outside of the insurance industry. Appetite has gone up and down but e.g. hedge funds would normally not be available to assume insurance risk otherwise.
- kqr 1y ago
  Reinsurance does not only spread risk by pooling multiple insurers, but also smears out the impact of catastrophes geographically and temporally: big events in one year, in one part of the world result in more expensive reinsurance all over the globe for a few years forward, as reinsurers collectively stock up on capital again. So while locally catastrophes can cause other catastrophes, for the most part earthquakes in Thailand does not trigger wildfires in Texas. Nor does a hurricane in Florida one year cause more hurricanes in Florida the next year.
- simicd 1y ago
  It's correct that the number of reinsurers is smaller than that of primary insurers. But the risk born by reinsurers is less correlated, not more. Any given primary insurer has risk clusters (domestic market, line of business, etc.). If a large catastrophe happens in their domestic market they might go bust but what are the chances that it happens simultaneously to all markets globally? Say you're a primary home insurer in the US. If a hurricane hits you might not have enough capital to rebuild all the homes. A reinsurer which is also covering Europe, Asia, LatAm, etc. is less likely to go bankrupt. The reinsurer can cross-subsidize and use the insurance premiums from other regions to pay out the claims from the US market. All that matters is that on average the loss probabilities and severities are estimated correctly. And this is just using one line of business as example, reinsurers are covering property, casualty, life and health which add extra layers of diversification.
Onavo 1y ago
Not sure what the controversy here is. Catastrophe risk is the bread and butter of property insurance.
- falseprofit 1y ago
  Felt like the article ended before a thesis statement.
  - gwern 1y ago
    > She is the author of “Investable! When Pandemic Risk Meets Speculative Finance – A Cautionary Tale,” from which this article is adapted. So I think structurally, the conclusion here is that 'cat bonds are an example of how insurers can work with abstract risks, and so any risk (such as global pandemic) could be worked with this way', and the rest of the book then examines how people are trying to actually do so with pandemic risk.
  - panguma 1y ago
    Read the book, it’s in there.
- PaulHoule 1y ago
  But as traditional insurance, not cat bonds.
  - Onavo 1y ago
    I mean eventually once you proceed down the financial tree you get reinsurance linked securities. It's been this way for decades. It nothing new.
    - grvdrm 1y ago
      Indeed. Simplified: Insured->Broker->Insurer->ReinsuranceBroker->Reinsurer Here, where you see reinsurer, instead may be: ILS fund Cat Bond
munificent 1y ago
> New “efficiency features” regularly get introduced in ILS and written into contracts. One of the most transformative has been the use of parametrics. Unlike traditional insurance, which calculates payouts based on actual losses (what’s called indemnity), parametric insurance uses preset triggers to determine whether money gets released. During an interview, a London-based parametric expert gave me this example of a parametric scenario: If, during a hurricane, wind speeds off the Florida coast hit a predetermined trigger speed — say 175 mph — at a trigger distance of two miles offshore within a preset longitude and latitude grid, the payout is, in theory, immediate. No actual damage need occur; the trigger measures just need to be met. Wow, that is absolutely begging for exploitation. Whoever controls the authority reporting these figures now controls whether these bonds pay out. That in turn means that whoever holds those bonds has a huge financial incentive to manipulate what that authority says. Put another way, if you're holding a bond that will cost you $100 million if a hurricane windspeed hits 175 MPH, then you have $99 million bucks that are worth spending trying to get the NOAA to say anything but that.
- deleted 1y ago
  [deleted]
- gruez 1y ago
  The same incentive exists for economic figures (inflation linked bonds) and market prices (cash settled derivatives), and it's seemingly not an issue, and those are far easier to game than physical measurements like wind speed or whatever.
  - jallmann 1y ago
    Manipulation of reported economic numbers has been an issue in the past, see LIBOR.
  - krisoft 1y ago
    > and those are far easier to game than physical measurements like wind speed or whatever. I’m not so sure about that. I bet that we could tamper with an anemometer somewhere out in a field. Easiest is to put brushless motor with a propeller next to it and blow propwash on it. More technically difficult is to tamper with the signal between the sensor and the station, or MitM the station. If you are careful and only modifying the measurments when the weather is already crummy they might not even suspect.
paxys 1y ago
As if pandemics weren't already political enough. Let's get large corporations, investment funds and billionaires involved and give them direct stake in declaring what is or isn't a pandemic, how many deaths have happened in a certain area, what was the cause of death etc. That should end well.
leemelone 1y ago
This is the dumbest idea I've read about in a long time.
- motoxpro 1y ago
  Why is it dumb?
danielfoster 1y ago
I like to think I’m somewhat intelligent, but there’s something I don’t understand here. The article cites an example of pandemic bond holders receiving a return of 40% over 3 years and these bonds being a useful way for the issuer to secure needed funds in the event of a pandemic. Unless a pandemic happens every ~8 years, isn’t this a ridiculous and unsustainable risk premium to pay?
- HillRat 1y ago
  The class B bonds paid roughly 11% over LIBOR, so about 40% over three years, against the risk of a viral outbreak for five different families, defined as At least two countries experiencing at least 250 fatal cases increasing over twelve weeks, so the trigger did not have to be as globally-significant as COVID-19 turned out to be. That’s a pretty aggressive coupon, but the chance of a regional outbreak was also pretty high.
  - danielfoster 1y ago
    Makes sense now, thank you! I feel like the author should have mentioned this.
    - panguma 1y ago
      Well, she did, in the book.
  - dmurray 1y ago
    Based on that description it would have been triggered by COVID-19, swine flu in 2009, and I think just missed out (depending on the fine print) on SARS in 2002. That's two or three in 18 years, so losing your money once every eight years is not far off the recent performance of this kind of bond.
21secondstogo 1y ago
CTO at an ILS fund. Cat bonds are essentially securitised versions of fully collateralised reinsurance contracts where the premium is the coupon plus the return on collateral. A benefit being that you can trade them. They're not usually used for speculation as stated in the article - investors are typically pension funds looking for investments that are uncorrelated to traditional financial market risk. e.g. on a US hurricane exposed cat bond you may only lose money if a huge hurricane blows through Florida, no matter what credit and equities are doing. It's true that a lot of the deal sourcing is relationship-driven, but there is a good amount of data-driven tech involved in overlaying the insured's past claims and underwriting data on top of simulated catastrophe model output, applying your own view of climate, vendor model adjustments, hurricane activity etc.
- bvan 1y ago
  And I thought I was the only ILS guy reading HackerNews..
  - 21secondstogo 1y ago
    TwelveSecuris, London!
  - grvdrm 1y ago
    Me too. Wouldn’t say my comments make that obvious. But in/around the space too - portfolio manager.
  - genedan 1y ago
    Actuary here. I don't work in ILS but I'm familiar with what you're talking about.
throwaway422432 1y ago
So, it's betting not on the outcome, but specifics of the event. The analogy could be sports betting where you bet on a player making a particular individual score, not just the win/loss. At the end of the day, if it prevents bankrupting companies, countries and the insurers when an event occurs then it is a good thing. I know of a Australian-based insurer that only operates in the far North primarily for residents who can't get reasonable premiums to cover for floods and cyclones from the major insurers. They reinsure with a global company so paying out an event in Australia is offset with no events elsewhere. Interestingly the frequency of cyclones is decreasing, but the strength is projected to increase with "global warming": Higher water temperature = more energy. So betting on the strength makes sense.
- PaulRobinson 1y ago
  Reading this as somebody who tries to solve betting markets with data and python, yeah, you’re right, this is just prop bets but with less data due to lower frequency events. I honestly think there’s EV in this - you can expect some sports guys to be booking tickets to Baden-Baden next year if they find this article.

92 points by anarbadalov 1y ago

This reminds me of the predator hierarchy (for example, see Colinvaux's "Why Big Fierce Animals are Rare"): the reinsurers spread the risk from various insurers and for various catastrophes around among a pool of meta-insurers. But this pool is necessarily smaller than that of primary insurers, and their risks more likely to be correlated (catastrophes can cause other catastrophes, and multiply primary insurers can be affected by the same catastrophe). For that matter, I'm also reminded of credit default swaps, and Lehrer's "We Will All Go Together When We Go."

falseprofit 1y ago
One aspect worth pointing out is that ILS are transferring insurance risk outside of the insurance industry. Appetite has gone up and down but e.g. hedge funds would normally not be available to assume insurance risk otherwise.
kqr 1y ago
Reinsurance does not only spread risk by pooling multiple insurers, but also smears out the impact of catastrophes geographically and temporally: big events in one year, in one part of the world result in more expensive reinsurance all over the globe for a few years forward, as reinsurers collectively stock up on capital again. So while locally catastrophes can cause other catastrophes, for the most part earthquakes in Thailand does not trigger wildfires in Texas. Nor does a hurricane in Florida one year cause more hurricanes in Florida the next year.
simicd 1y ago
It's correct that the number of reinsurers is smaller than that of primary insurers. But the risk born by reinsurers is less correlated, not more. Any given primary insurer has risk clusters (domestic market, line of business, etc.). If a large catastrophe happens in their domestic market they might go bust but what are the chances that it happens simultaneously to all markets globally? Say you're a primary home insurer in the US. If a hurricane hits you might not have enough capital to rebuild all the homes. A reinsurer which is also covering Europe, Asia, LatAm, etc. is less likely to go bankrupt. The reinsurer can cross-subsidize and use the insurance premiums from other regions to pay out the claims from the US market. All that matters is that on average the loss probabilities and severities are estimated correctly. And this is just using one line of business as example, reinsurers are covering property, casualty, life and health which add extra layers of diversification.

Onavo 1y ago

Not sure what the controversy here is. Catastrophe risk is the bread and butter of property insurance.

falseprofit 1y ago
Felt like the article ended before a thesis statement.
- gwern 1y ago
  > She is the author of “Investable! When Pandemic Risk Meets Speculative Finance – A Cautionary Tale,” from which this article is adapted. So I think structurally, the conclusion here is that 'cat bonds are an example of how insurers can work with abstract risks, and so any risk (such as global pandemic) could be worked with this way', and the rest of the book then examines how people are trying to actually do so with pandemic risk.
- panguma 1y ago
  Read the book, it’s in there.
PaulHoule 1y ago
But as traditional insurance, not cat bonds.
- Onavo 1y ago
  I mean eventually once you proceed down the financial tree you get reinsurance linked securities. It's been this way for decades. It nothing new.
  - grvdrm 1y ago
    Indeed. Simplified: Insured->Broker->Insurer->ReinsuranceBroker->Reinsurer Here, where you see reinsurer, instead may be: ILS fund Cat Bond

munificent 1y ago

> New “efficiency features” regularly get introduced in ILS and written into contracts. One of the most transformative has been the use of parametrics. Unlike traditional insurance, which calculates payouts based on actual losses (what’s called indemnity), parametric insurance uses preset triggers to determine whether money gets released. During an interview, a London-based parametric expert gave me this example of a parametric scenario: If, during a hurricane, wind speeds off the Florida coast hit a predetermined trigger speed — say 175 mph — at a trigger distance of two miles offshore within a preset longitude and latitude grid, the payout is, in theory, immediate. No actual damage need occur; the trigger measures just need to be met. Wow, that is absolutely begging for exploitation. Whoever controls the authority reporting these figures now controls whether these bonds pay out. That in turn means that whoever holds those bonds has a huge financial incentive to manipulate what that authority says. Put another way, if you're holding a bond that will cost you $100 million if a hurricane windspeed hits 175 MPH, then you have $99 million bucks that are worth spending trying to get the NOAA to say anything but that.

deleted 1y ago
[deleted]
gruez 1y ago
The same incentive exists for economic figures (inflation linked bonds) and market prices (cash settled derivatives), and it's seemingly not an issue, and those are far easier to game than physical measurements like wind speed or whatever.
- jallmann 1y ago
  Manipulation of reported economic numbers has been an issue in the past, see LIBOR.
- krisoft 1y ago
  > and those are far easier to game than physical measurements like wind speed or whatever. I’m not so sure about that. I bet that we could tamper with an anemometer somewhere out in a field. Easiest is to put brushless motor with a propeller next to it and blow propwash on it. More technically difficult is to tamper with the signal between the sensor and the station, or MitM the station. If you are careful and only modifying the measurments when the weather is already crummy they might not even suspect.

paxys 1y ago

As if pandemics weren't already political enough. Let's get large corporations, investment funds and billionaires involved and give them direct stake in declaring what is or isn't a pandemic, how many deaths have happened in a certain area, what was the cause of death etc. That should end well.

leemelone 1y ago

This is the dumbest idea I've read about in a long time.

motoxpro 1y ago
Why is it dumb?

danielfoster 1y ago

I like to think I’m somewhat intelligent, but there’s something I don’t understand here. The article cites an example of pandemic bond holders receiving a return of 40% over 3 years and these bonds being a useful way for the issuer to secure needed funds in the event of a pandemic. Unless a pandemic happens every ~8 years, isn’t this a ridiculous and unsustainable risk premium to pay?

HillRat 1y ago
The class B bonds paid roughly 11% over LIBOR, so about 40% over three years, against the risk of a viral outbreak for five different families, defined as At least two countries experiencing at least 250 fatal cases increasing over twelve weeks, so the trigger did not have to be as globally-significant as COVID-19 turned out to be. That’s a pretty aggressive coupon, but the chance of a regional outbreak was also pretty high.
- danielfoster 1y ago
  Makes sense now, thank you! I feel like the author should have mentioned this.
  - panguma 1y ago
    Well, she did, in the book.
- dmurray 1y ago
  Based on that description it would have been triggered by COVID-19, swine flu in 2009, and I think just missed out (depending on the fine print) on SARS in 2002. That's two or three in 18 years, so losing your money once every eight years is not far off the recent performance of this kind of bond.

21secondstogo 1y ago

CTO at an ILS fund. Cat bonds are essentially securitised versions of fully collateralised reinsurance contracts where the premium is the coupon plus the return on collateral. A benefit being that you can trade them. They're not usually used for speculation as stated in the article - investors are typically pension funds looking for investments that are uncorrelated to traditional financial market risk. e.g. on a US hurricane exposed cat bond you may only lose money if a huge hurricane blows through Florida, no matter what credit and equities are doing. It's true that a lot of the deal sourcing is relationship-driven, but there is a good amount of data-driven tech involved in overlaying the insured's past claims and underwriting data on top of simulated catastrophe model output, applying your own view of climate, vendor model adjustments, hurricane activity etc.

bvan 1y ago
And I thought I was the only ILS guy reading HackerNews..
- 21secondstogo 1y ago
  TwelveSecuris, London!
- grvdrm 1y ago
  Me too. Wouldn’t say my comments make that obvious. But in/around the space too - portfolio manager.
- genedan 1y ago
  Actuary here. I don't work in ILS but I'm familiar with what you're talking about.

throwaway422432 1y ago

So, it's betting not on the outcome, but specifics of the event. The analogy could be sports betting where you bet on a player making a particular individual score, not just the win/loss. At the end of the day, if it prevents bankrupting companies, countries and the insurers when an event occurs then it is a good thing. I know of a Australian-based insurer that only operates in the far North primarily for residents who can't get reasonable premiums to cover for floods and cyclones from the major insurers. They reinsure with a global company so paying out an event in Australia is offset with no events elsewhere. Interestingly the frequency of cyclones is decreasing, but the strength is projected to increase with "global warming": Higher water temperature = more energy. So betting on the strength makes sense.

PaulRobinson 1y ago
Reading this as somebody who tries to solve betting markets with data and python, yeah, you’re right, this is just prop bets but with less data due to lower frequency events. I honestly think there’s EV in this - you can expect some sports guys to be booking tickets to Baden-Baden next year if they find this article.