Eye of the Storm

A Wall Street Convergence

The cost of disasters is growing every day. Without speculating about the causes or the extent of global climate change, Hayes says it is a plain fact that hurricanes have been in “a more active phase” for the past decade. And the population in catastrophe-prone places like Florida and California continues to swell, bringing with it all of the residential and commercial building that population growth entails.

What’s more, she says, when homes and buildings are destroyed by wind, flood, fire, or earthquake, they tend to be replaced by larger, more expensive structures. If your house burns down, Hayes says, “you probably won’t just rebuild the same house, you’ll build a bigger one.”

In other words, our national response to catastrophes is not just to further develop cat-prone areas, but to fill them with more expensive buildings.

Reinsurers like Lloyd’s of London and Swiss Re have always placed big bets on the chance that a Category 5 hurricane, for example, will not hit Florida in a given season. And they have always been able to buy reinsurance for themselves—what amounts to “re-reinsurance”—as protection in case those bets go badly. But as the price tag for calamities has risen, the reinsurance market has needed new sources of capital to cover the increased risk. Beginning after Hurricane Andrew in 1992, and especially since the busy hurricane seasons of 2004 and 2005, Wall Street has joined them in buying the risk laid off by insurers.

The 1990s saw the emergence of new funding instruments for reinsurance. For instance, seasonal catastrophe bonds, or “cat bonds,” are issued by primary or reinsurers working through investment banks and sold to investors like any other bonds. “Sidecars” are limited-purpose companies through which investors share the risk of certain policies with an insurer or reinsurer in exchange for a portion of the premiums. They’re evidence of what Karon says is a much greater interest from capital markets in “the securitization of risk.”

(Another sign of this: The London Daily Telegraph reported in late September that investment bank Goldman Sachs had proposed to acquire the Benfield Group for about $700 million British pounds. The deal fell through in October, reportedly because Goldman was unable to secure debt financing. Benfield executives, including Karon, declined to comment.)

Hedge funds have been particularly active in assuming catastrophe risk, Karon says. Since Katrina, “we have gone to the hedge funds [on behalf of clients] just as we would to a reinsurance company. We say, “Here are the risks,’ and ask if they want to do a deal.”

Why are they saying yes? For one thing, hedge fund managers like catastrophe risk because it is not correlated with their other investments, and therefore represents a way to diversify, Karon says: “If the wind blows, that has nothing to do with whether the stock market goes down, or oil prices go up, or currency moves in a particular direction, or any of the other things a hedge fund could be betting on. They can make a big weather bet, and the risk is not correlated.”