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The most profitable hedge fund strategy of last year was buying something a lot of people don't like thinking about cat bonds. They have, unfortunately nothing to do with cats. In this case, cat is short for catastrophe, and cat bonds are for extreme weather events.
Cat bonds are only four very rare, very catastrophic events, whether it's California quakes or even a Japanese tsunami.
We talked about them with Gautam Nike, a Bloomberg reporter and editor based in London.
The way it works is that if a defined event doesn't occur, then the investor they get to keep their money and they get paid a very handsome risk premium. If that catastrophe as defined does occur, they can lose some of their money or all of the money. So it's a big risk and it's a gamble against mother Nature.
Gautum told us that while these bonds have been around since the nineteen nineties, they've been growing in popularity recently. A record sixteen billion dollars in cat bonds were issued in twenty twenty three, bringing the total market value to forty five billion today. On the show how cat bonds went from a niche corner of the financial world to becoming one of the market's hottest items, and how the increasing risks from climate change might complicate that. This is
the big take from Bloomberg News. I'm Sarah Holder, So Gadam, how do catastrophe bonds work?
So what catastrophe bond is a specialized form of insurance. So typically an insurance company would issue a cat bond if it didn't want to take on the risk of a Katrina like event occurring and destroying tens of thousands of homes and leaving the insurer on the hook for a huge amount of money. So cat bond is a way to pass on this risk to Wall Street, which is not traditionally part of the insurance industry.
Catastrophe bonds are usually held for three to five years, and Gatham says the length is set that way for a reason.
So it's not for ten, fifteen, twenty years that would be a huge risk. It's for a very narrow specific timeframe.
But even in that specific timeframe, weather is notoriously hard to predict. Have you ever used a weather app So Gautam wanted to understand how the people buying these bonds were deciding which disasters to bet against. And when it comes to cat bonds, there's no firm that's bought more of them than for Matt's Capital Management. So Gadam went to Connecticut to visit them.
So, you know, a typical hedge fund might have I don't know, marble floors and expensive art hanging in the on the walls, and you know, might be located in central Manhattan. But Fermat is quite different. You know, it's based in a pretty affluent town of Westport and Connecticut, but it's on a fairly modest street and opposite a car repair shop. If you enter the offices of Fermat, you know, you basically find meteorology and weather journals, a
lot of wonky literature. In the reception area, you have a lot of white boards where equations and physics details are scrawled.
At the center of all these whiteboards is John so For, Matt's co founder and managing director.
He has a background in biophysics, and I think he's really used that scientific and mathematical acumen to good stead and sort of created his own models and his own mathematical techniques.
One of Soo's earliest finance jobs involved creating unique derivatives to cover seemingly random events.
So, for example, you know a charity that was organizing a golf tournament and would give somebody a car. If someone hit a hole in one, what is the likelihood of that hole in one occurring? And if it does occur, the charity might be wiped out. They'd be on the hook for you know, losing the car or prize money. So you would want to buy insurance against that happening.
So he would calculate that kind of risk and create a derivative product that would you know, protect the charity and get someone did hit that hole in one.
So told Gautam that when he started from matt with his brother in two thousand and one, he set out to build a science based model that would weigh the probability of a natural disaster against the returns on a cat bond. And his method starts with gathering a a bunch of meteorological data.
There are specialized companies that take a lot of the meteorological data and crunch it and they come up with sort of a magic number what is the estimated loss of a particular event. So let's say a California earthquake. What is the likelihood that a particular earthquake could occur in a particular year in a particular area of California where there are a lot of expensive homes. Well, you'd have to know your plate tectonics, you have to understand
the history of earthquakes. You'll have to look at the data that shows who has built homes in which area. And there are specialized companies that provide this kind of information. So what John so does is he buys these models from these companies, but then he does his own calculation. On top of that, he adds his own magic source to refine it so that he can sort of beat the capond market and perhaps beat other investors.
And this magic sauce includes more unconventional methods like watching hours of film of California wildfires to understand where they're happening and how they're spreading, anything that might help refine the data coming in. And that also includes a model that has made for Matt's betting approach unique, one that borrows from out of all things airplane physics.
He plotted one curve, which was the probability of a catastrophe against the potential losses. And then he plotted another line which showed how much profit he could make at different levels of risk. And when he put those two together on a piece of paper, they looked like the cross section of a wing. Once he realized, WHOA, this
is just like a wing of an airplane. I can look at the physics of lift to compute the risk and reward at every point on those curves, and once you calculate that, you have a slightly better idea, quite a better idea of whether to invest in a particular set of bonds or not.
But like other cat bond investors, a key part of Sow's strategy is to diversify. For Matt's bonds cover properties from Florida to New Zealand.
So typical hedge fund would buy one hundred or two hundred different cat bonds. One would be save for a typhoon in the Philippines. What would be against a tsunami occurring in Japan. One would be against a wildfire in California. Now, the likelihood statistical likelihood of several of those natural disasters which are down to Mother Nature, really they're pure luck, right, The chances of those occurring in the same year are
very very low. So even if one or two or three get triggered, these investors have positions in a whole bunch of other cat owns that don't get treated, so they don't lose money on those.
For Matt So has taken catbond trading to the next level. The company accounts for a quarter of the entire cat bond market and had returns around twenty percent in twenty twenty three. That's way higher than the average eight percent returns brought in by the rest of the hedge fund market, and So is really confident in his calculations here he is on Bloomberg TV.
Is the market or cat bron prices a better predictor of where hurricanes might make landfall or perhaps the kind of damage they may cause? Then an outfit like the NAA, Right, I think that there as good a predictor as you're going to get.
After the break. What happens when the disasters cat bond traders are betting against get more unpredictable. Hey, we're back. Before the break. We were talking with Gautum Nike about catastrophe bonds and the man at the center of the firm that owns the most of them, John So. With the weather getting more unpredictable and extreme, I wanted to know what does that mean for So's models. Gadam says, So's calculations are some of the best in the industry, but they aren't bulletproof.
You know, when Hurricane Katrina hit, his portfolio lost three percent, So he has his down years. You know, if there's a big catastrophe and he's holding cap bonds linked to that, he will suffer a hit just like any other investor.
And Gautam says the way some cat bonds are structured also means that investors can be on the hook for less rare weather events what are called secondary perils.
You have a lot more mid size natural disasters, so flooding, wildfires, tornadoes, and thunderstorms. Very often an insurance company will take a hurricane and package it with secondary I'll say, here's a cat bond. It covers a hurricane, but also covers floods, and it also covers wildfires. So as an investor, if you buy this cat bond, you know about the earthquake stuff, you're quite confident you have got to handle on the risk there. But the stuff on floods, the stuff on
wildfire you have much less certainty about. So when you take on that cat bond, when you buy it, you're taking on risk you don't fully understand.
So instead of predicting Hurricane Katrina, so it could be predicting a thunderstorm in New York City.
That's right exactly.
So my last question, katim if so has a better model to predict these natural disasters or the risk levels of these natural disasters using a lot of data and a lot of know how and technical expertise. This seems like information that governments and cities might want and that residents might want. It could save lives, help people anticipate devastating losses. Is buying and selling cat bonds really the the best are the only use case for his risk model?
I think that I would say that cat bonds provide a very important service in that they help ensure people against catastrophic risk when traditional methods of protecting you, such as insurance, aren't available. Last year, less than one third of the three hundred and eighty billion dollars in global climate losses was covered by insurance. So the developing world, per countries we know, really at high risk from catastrophic events driven by climate change. They have very little insurance,
but a CAT bond could provide that. So the World Bank right now has about a billion dollars an issued outstanding cat bonds for poorer countries, and it expects to increase that to about five billion. So I think CAT bonds will increasingly play a role in helping to sort of bridge that gap a little bit.
This is the Big Take from Bloomberg News. I'm Sarah Holder. This episode was produced by Adriana Tapia. It was edited by Caitlin Kenny and Sharon Chen. It was mixed by Ben O'Brien. It was fact checked by Naomi. Our senior producers are Naomi Shavin and Elizabeth Ponso. Nicole Beemsterbor is our executive producer. Sage Bauman is our head of podcasts. Thanks for listening. Please follow and review The Big Take wherever you listen to podcasts. It helps new listeners find
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