Raging Milton to mean substantial losses for cat bond investors

Investors in catastrophe bonds are girding themselves for substantial losses as the combined destructive force of Hurricanes Helene and Milton looks set to trigger payment clauses on a scale not seen in years.

Two weeks after Helene unleashed severe floods in more than a dozen states, Florida is bracing itself for the impact of Milton, which regained Category 5 strength on the five-step Saffir-Simpson scale. It’s expected to make landfall early on Thursday morning, pushing a wall of water onshore. Millions of people have already fled the coastline, including residents in the densely populated city of Tampa.

Even if Milton hits the Tampa metropolitan area as a weaker Category 4 hurricane, it “could lead to one of the biggest reinsurance loss events in history,” Florian Steiger, founder and chief executive of Icosa Investments AG, said in an interview.

Such a scenario would have the potential to exceed the fallout of Hurricane Ian in 2022, according to Steiger. Ian’s impact led to a 10% slump in the Swiss Re Catastrophe Bond Index back in September 2022, sending shockwaves through catastrophe-bond portfolios and feeding an issuance boom as insurers shifted more of the risk on their books over to the capital markets.

Tanja Wrosch, head of cat-bond portfolio management at Twelve Capital AG, says if Milton hits Tampa head-on as a major hurricane, catastrophe-bond losses “will be more significant than from Ian.” The Swiss asset manager has a $5 billion portfolio, including $3.8 billion of catastrophe bonds. 

“A big component from Milton will be storm surge — flooding from the ocean,” she said.

Catastrophe bonds, or cat bonds as they’re known in the industry, are issued by insurers and reinsurers to provide financial protection against the most severe natural disasters. Investors who buy the bonds stand to make large gains if a predefined event doesn’t occur, but can lose a big chunk of their capital if it does. Those losses are used to cover insurance claims.

Potential cat-bond losses from Milton and Helene would mark a stark turnaround for a debt market that last year underpinned the most profitable hedge fund strategy, according to an analysis provided by Preqin. The Swiss Re Global Cat Bond Index soared 20% in 2023, trouncing returns across other key debt markets.

In 2022, Ian caused about $60 billion of insured losses. Milton may result in $60 billion to $75 billion of damages and losses, with some models showing the total reach as much as $150 billion, Chuck Watson, a disaster modeler at Enki Research, said in an X post.

How much cat-bond investors will be called on to pay to cover Milton’s impact depends on the scale of the damage. Florida Citizens, the state’s insurer of last resort, stands to collect about $500 million from one of its cat bonds, according to a person familiar with the issuance.

Cat-bond investors may also take a hit from the inland flooding caused by Hurricane Helene. Moody’s RMS estimates that US private-market insured losses from Helene will be $8 billion to $14 billion.

“Helene was a one-in-a-thousand year rainfall event,” said Jonathan Schneyer, director of catastrophe response at CoreLogic Inc., a catastrophe-modeling firm in Irvine, California. “It shows the power of a hurricane further inland.”

Talk of a trigger event in the aftermath of Helene and Milton comes after cat-bond investors managed to dodge losses tied to Hurricane Beryl. Even though Jamaica was declared a disaster area after Beryl ripped through the Caribbean island three months ago, the catastrophe bond issued to protect the government didn’t trigger. That led to demands for a review of Jamaica’s catastrophe insurance framework, amid a wider discussion among a group of Caribbean nations calling for “an examination” of cat bonds and other insurance-linked securities. 

The securities are intended “for tail events,” Michael Bennett, head of derivatives and structured finance at the World Bank treasury, which helped arrange Jamaica’s bond, said in August. 

In the case of Jamaica, Beryl very narrowly missed hitting the parameter that would have caused the bond to pay out, Robert Muir-Wood, chief research officer in insurance solutions at Moody’s, said at the time. “It was a very close call.”

This time, though, holders of cat bonds look to be facing a whole array of trigger events. Investors are exposed to losses tied to flooding from Helene through their holdings of cat bonds issued by the Federal Emergency Management Agency. In an emailed response to questions, FEMA said it had transferred $1.9 billion of flood risk to the private sector ahead of the 2024 hurricane season, with most of that landing in the cat-bond market.

FEMA said it’s “too early to make any projections” about the extent to which those bonds will trigger. As with other indemnity-style hurricane bonds, the calculation depends on actual losses suffered on the ground, which can take a long time to calculate.

“Usually, you have an initial estimate in a couple of weeks, but the speed of the payout is usually months to years,” depending on the complexity of the loss, said Rhodri Morris, head of insurance-linked securities analytics at Twelve Capital.

Investors in the $60 billion private market for insurance-linked securities may be facing an even greater risk of losses than cat-bond holders because ILS products have lower trigger thresholds.

Meanwhile, there are signs that some cat-bond traders are starting to lose their nerve. On Monday, someone dumped a Florida cat bond for just 67 cents on the dollar, according to Twelve Capital.

There’s currently a lot of “noise” in the cat-bond market, Wrosch said. “There have been some distressed trades.”

Though investors are in for a turbulent patch, the cat-bond market has a history of bouncing back. After Hurricane Ian triggered losses, investors started demanding meaningfully higher premiums to take on such risks. That development helped lead to record returns a year later, according to the Swiss Re index.