Pensioners and others near retirement living on the shoreline may be surprised to find that they’re insuring their own houses this hurricane season. That’s because many of pension funds they have their money with are beginning to invest heavily in catastrophe bonds in pursuit of higher returns. These kinds of bonds allow investors to collect money from disaster insurance companies in return for assuming some of the risk if a disaster strikes. As Bloomberg notes, this is relatively unprecedented:
“This is the biggest change to the reinsurance sector’s capital structure in the last 20 years,” said David Flandro, global head of business intelligence at Guy Carpenter in New York. “Catastrophe reinsurance is relatively high-risk, high-return. Pension funds are looking for direct access. Most of the capital is here to stay.”
We’ve seen this before, as pensions have taken to investing with hedge funds and various high-risk, high-return “alternative investments” in order to plug gaping holes in their balance sheets. This is essentially an extreme version of that same trend.The entry of pension funds into the catastrophe insurance market could be causing a number of distortions within the insurance market, however. As Matthew C. Kline writes:
Buying a catastrophe bond exposes you to the same kinds of risks that insurers and reinsurers face whenever they provide coverage against floods, earthquakes, and other causes of widespread property damage. This can be attractive because these instruments pay very high yields and are basically uncorrelated with other assets. […]While we shouldn’t cry for the reinsurers just yet, some pension funds may end up buying these high-yielding assets before they fully understand how to model their risks, just as some loaded up on subprime mortgage securities during the mid-2000s. (On the bright side, investors won’t have to worry about fraud when calculating the probability of another Hurricane Sandy.)Initially, this would depress the cost of disaster insurance, which might lead to overbuilding in risky areas and laxer enforcement of building safety codes. It could also push the insurers and reinsurers to underwrite new risks they are less familiar with in an effort to prop up margins, a danger that was highlighted by the UK’s Prudential Regulation Authority last month.
Ideally, pensions should be invested in the most conservative options possible, with minor adjustments to contributions if a fund endures years of bad investments. Instead, consistently underfunded pensions relied on rosy estimates of future returns and even paid out “bonus” checks to public employees during good years rather than stashing the money away to offset bad years. Now many of these funds are desperately searching for the highest returns they can get: even if it means gambling on the weather.[Damaged houses photo courtesy of Shutterstock]