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Welcome to Money. For the rest of us, this is a personal finance show on Money. How it works, how to invest it and how to live without worrying about it. I'm your host, David Stein. Today is episode 549. It's titled why Catastrophe. Bonds are yielding 12% and should you invest? Recently LeFreel and I were visiting family in Miami and Naples, Florida. We hadn't been there in eight years. We spent some time staying on Miami beach and and it rained the first four days we were there as a front stalled over the Atlantic coast and moisture just kept coming in. Now rain's not unusual in Miami. They get upwards of 60 inches per year. Now being in Florida, we know there's hurricanes and I was curious, well, how many serious hurricanes has Florida had that hit landfall over the past 25 years? And I found a database from NOAA and it was around. Now Florida is big and so there has not really been a direct hit to Miami over those 25 years. Miami gets lots of rain, but one thing that has changed is the intensity of the storms. And it's been that way in many places around the world. As the planet warms, clouds hold more water and that leads to what the insurance industry calls severe convective storms. The these are non peak perils in insurance nomenclature. A peak peril would be something really really big like an earthquake. Non peak peril would be something more localized like a severe convective storm. And Florida and Miami has been getting more of those. In 2024, a foot and a half of water fell across south Florida. And this wasn't associated with a hurricane or tropical storm, just a rainstorm. And meteorologists would classify something like that severe as once in a 200 year event. Yet that was the fourth year in a row there had been that level of massive storm in Florida. I pulled up an annual report that AON does. They're a company that helps businesses manage risk and they have an insurance arm, a reinsurance arm and their 2026 climate and catastrophe Insight report stated that extre extreme weather events are becoming more frequent and unpredictable. It's affecting new geographies and sectors. They, they point out that there's greater weather volatility and that businesses have to have to deal with that in order to be be resilient and to continue growing. Last year it was severe convective storms that had the highest economic and insured losses. Total losses last year due to natural disasters was $260 billion. That was down previous years. Now in that report and Financial Times referred to it they plotted out since 2000. So the past 25 years, the type of natural disasters that have been occurring and the biggest increase in terms of cumulative global economic losses has been tropical cyclones and flooding. But there's also been a big increase in severe convective storms to the extent that they're just about to overtake earthquakes. Munich Re, one of the world's largest reinsurers, stated recently, with respect to natural disasters in 2025, it's striking how many extreme events were likely influenced by climate change. This was true of the Los Angeles wildfires, multiple particularly strong hurricanes in the North Atlantic and many catastrophic floods. Numerous studies have indicated that climate change increases the frequency or severity of weather disasters, if not both. Munich Reef's chief climatologist Tobias Grimm said a warming world makes extreme weather disasters more likely. Given that 2025 was another very warm year, the past 12 years have been the warmest on record. The warning signs persist. Indeed, under prevailing circumstances, climate change can worsen further. And then Thomas Blunk, who's a member of the board of Management, said 2025 started off with very high losses caused by the wildfires in Los Angeles. But there, there weren't really any severe hurricanes that hit the United States in 2025. He says that was sheer luck. But the US is still number one in lost statistics, according to Blank, owing to the increased trend towards very considerable damage caused by non peak perils, again convective storms. Back in 2002, Warren Buffett, in the annual letter from Berkshire Hathaway and Berkshire Hathaway bought General Re in I believe the late 90s, there are reinsure. A reinsurance company sells insurance to property and casualty insurers. They're the insurance company's insurer. So an insurance company can buy additional coverage for these peak perils, earthquakes from a reinsurance company. And Buffett has always liked the insurance business. He liked the idea of float, which he Talked about in 2002, that you collect a premium, but you don't have to pay out losses until an event occurs. So you have all this money that can be invested. And he calls that money float. And then with a, an insurance company or reinsurer, the idea is that, all right, you collect this premium, you pay out losses, you're investing the money, you want the amount that you earned with the premiums and the investments to be greater than the losses paid, so then you can make a profit. And one of the things that he likes about this float, Buffett, is that the cost of it or the benefit of it to be able to use that float to buy businesses or to invest that cost of capital is typically less than prevailing interest rates. And so it's a cheap source of capital to make investments. Recognizing though, that losses need to be covered, Buffett said that in order for their insurance operations to generate this low cost float over time, they have to one underwrite with unwavering discipline, price the insurance correctly, they have to reserve conservatively in terms of reserving for those losses, and then they have to avoid sort of the compounding of risk, what he refers to as an aggregation of exposures that would somehow lead to an impossible incident that could cause the insurance company to go and solve it. That does happen for insurance companies. There's typically around 20 insurance companies that go insolvent every year around the globe. Now, in that 2002 annual letter, Buffett said that most of their insurance businesses followed those three rules. They underwrote the insurance with unwavering discipline. They, they reserved conservatively and they avoided an aggregation of exposures. Their exception was General Reid, the reinsurer that they bought a few years earlier, and they had to take some charges to kind of get that to the level that they expected. His concern with General Reid and Buffett said cheap reinsurance is a fool's bargain. When an insurer lays out money today in exchange for a reinsurer's promise to pay a decade or two later, it's dangerous and possibly life threatening for the insurer to deal with any but the strongest reinsurer around. And that's why reinsurers tend to have very high credit ratings, because they're the insurer's insurer. Before we continue, let me pause and share some words. One of this week's sponsors, Gilt. For many business owners, tax time is a little scary. And we're sort of in that season now. You gather all the paperwork, you send it to your accountant, and you hope the numbers work out. I know in our business, taxes can be really frustrating, and that's where Gilt can help. 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That's J O I N g e l t.com joingelt.com about a year ago we looked at reinsurance and after some major disasters and exposures, losses that reinsurance companies had to absorb in 2017 and 2018, they started massively increasing their premiums. This is something I learned from a hedge fund manager many years ago. He said the best time to invest in a reinsurance company is after a disaster because then they have pricing power. And we've seen that as reinsurance companies increase premiums that flowed through to higher home insurance premiums for consumers over the past few years. The good news is reinsurance companies have had very strong returns over the past three years, double digit returns on capital. Their catastrophic losses in 2025 was $121 billion and that was 18% below the five year inflation adjusted average for reinsurers. And they that has allowed them to build up their capital base and then there's more competition. They're not having to raise reinsurance premiums as much and that will have a positive impact on home insurance premiums. Hopefully you and and me will see a lower increase in our home insurance premiums in 2026. Now a property and casualty insurer, one in Florida or anywhere else they can buy reinsurance. But more and more property and casualty insurers and reinsurance, they're laying off some of that risk through something called a catastrophe bond. Catastrophe bonds are a type of reinsurance but instead of going to an insurance company, they go to the capital markets, to investors and the investors take on that casualty risk of a severe natural disaster. These are also known as insurance linked securities. They're not public most of them, or historically they've been private. They've been Rule 144A securities. So they're for qualified institutional buyers. Richard Penny, who's the chief executive at Aon securities, says insurers have no choice but to identify ways to offload increasing risk. And they're doing it in the cat bond market. Cat bond is short for catastrophe bond. I've been aware of the cat bond market. Berkshire Hathaway participates, but it wasn't something that we as individual investors could participate in, except now we can. There is an ETF that came out last April that invest in cat bonds and that ETF is yielding just about 12%. That's attractive but we want to look at, well, what are the risk here? And this is really an opportunity. The number of cat bonds that have been issued last year in 2025 was a record annual issuance, exceeded $20 billion. And it's been increasing meaningfully the last three or four years. Right now there's about $50 billion outstanding. A typical cat bond, the maturity is three to five years. So it's a multi year bond and it's been a good performer. There's an index called the Swiss Re Global CAT Bond Performance Index. They have a number of them. But the global index, if we go back to 2002, so 20, 24 years of performance, cat bonds have returned 7.6% annualized, more than double the 3.6% annualized for the Bloomberg US Aggregate Bond Index. And it's done better than non investment grade bonds. U.S. high yield bonds returned 7.3% annualized. So this, this is sort of similar to high yield bonds in terms of overall performance. Volatility has been less. So the Swiss RE Global CAT bond index since 2002 has only had one neg negative 2% and that was in 2022, the same year the Bloomberg US aggregate had a negative 13% return. There have been periods where the index hasn't done as well. And we'll look at the structure of these cat bonds here in a minute and we'll see there's a variable rate component to it. But for the 10 years ending December 31, 2022, the Swiss Re Global Cat Bond Index returned 4.3% annualized versus 1.1% for the US aggregate and 4% for the US High Yield Index. What's intriguing about cat bond investing is you're not exposed to default risk of corporations, so it's this is not credit risk. And you're not really, really exposed to interest rate risk because these cat bonds are variable rate. You're exposed to natural disaster risk. And so this is a different return driver. And if there is a severe natural disaster, then the insurance company can collect from the cat bond issuer. Before we continue, let me pause and share some words from this week's sponsors. Delete me makes it easy, quick and safe to remove your personal data online. At a time when surveillance and data breaches are common enough to make everyone.
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That's JoinDeleteMe.com David20 code David20 now, these cat bonds, the type of risk that they're protecting against, there's two dimensions. There's a specific peril. Is it a windstorm or an earthquake? Earthquake. And that's generally been the majority of the CAT bond exposures, earthquake and wind, and including the ETF that we'll take a closer look at. So there's the actual peril, and sometimes it's one peril, sometimes it could be multiple perils. Then there's the territory. What is the geographic region that is being insured? And catastrophe bonds typically are insuring the highest loss layers, so they're the most extreme losses. So there might be a hurricane, but it could be a minor hurricane. And so the property and casualty insurer ensures the losses they don't get severe enough to trigger payouts for the cat bonds and the CAT bonds. Now, these are complicated bonds. That's why they're private bonds, because there's the peril, there's the territory. But then what is the trigger for paying out the losses? Sometimes it could be an indemnity trigger. So if the specific event occurs in a specific region, do the losses exceed some threshold losses to that specific insurance company? Or it could be an industry loss trigger. So the insurance industry as a whole suffered these losses and then it'll pay out. Now, the structure itself for these CAT bonds is complicated. It starts with the sponsor establishing a special purpose vehicle, an spv. And that SPV sits in the middle. You have the investors on one side and you have the insurance company on the other side. And that insurance company has a reinsurance contract with the spv, that legal entity. So if there's a specific loss event, the SPV pays the insurance company. The same time you have the investors that are investing their principal in the spv. And the SPV takes that principle and puts it in a trust and then invests that principle, that collateral pretty conservatively in like treasury bills or other very high quality variable rate securities. And so the investors are getting variable rate interest on their principal investment, but they're also getting premiums from the insurance company that are passed through the SPV to the investors because they're insuring against that risk. If you look at some of these catastrophe bonds, these cat bonds, the yields are 8 to 16% depending on the level of risk. And the reason why the yields are that high is because of the collaterals being invested, but mostly because of the premium that the insurance company is paying to the SPV to insure against losses. So when we think about it, if a particular portfolio of CAT bonds is yielding 12% on average, historically. And if we go back over 25 years and look at the return for the CAT bond index, it's returned around 7.3%, which suggests that over time the losses have been about 5% per year for a cat bond portfolio. There has been one fund that I've been aware of, but the minimums were so high it just wasn't practical for me or many most people to invest. It's the Stoneridge High Yield Reinsurance Risk Premium Fund. The institutional version, Tickerus S H R I X the call it retail but high net worth versions, SHRMX that has a $250,000 minimum. The institutional version, it's 25 million. The expense ratio are very high, 1.8% for the institutional version and 1.9% for that high net worth share class. How has it done? Well, over the past 10 years it's returned 6.4% annualized. If we compare that to the Swiss Re Global Cat Bond Performance Index, that's returned 6.9% annualized. So gross of fees, this fund would have outperformed the index net of fees. It lagged by about 50 basis points. But that kind of again gives you an idea. Historically, over the past 10 years, cat bonds, or even longer because we went back to 25 years for the actual index kind of 7% return over long holding periods. Except we have the issue that the severity of storms is increasing. Natural disasters, not earthquakes, but wind events are and, and flood events are. And so the type of exposure, and that's what these managers do of these cat bond funds and ETFs, they're trying to figure out, okay, what is the best pricing, what exposure do we want to have? How can we make sure it's diversified so that we can generate what effectively has been around a 7 annualized return. Now there's actually an ETF that came out last April. It's the Brookmont Catastrophe Bond ETF Ticker is ILS obviously chose that because it's short for Insurance linked securities and it's a partnership between two firms, Brookmont Capital Management, which is an expert in ETFs and King Ridge Capital Advisors. They are insurance linked security specialists. Their book of business is investing in catastrophe bonds. Their principals have decades of experience in reinsurance and capital markets and they do catastrophe risk modeling and valuation. So they're figuring out they're coming up with odds of a catastrophe risk and then they're seeing well what how is the deal structured? What are the mechanisms for the various triggers, what is the exposure? They do climate risk assessment and they come up with a portfolio and in this case it's an ETF that we can invest in. Ticker's ILS brand new, not very big, only about $39 million invested in this ETF. The expense ratio is 1.58%. That's net. It's cheaper than the Stoneridge offerings. But these are not cheap. But it's very, very specialized knowledge, complicated portfolios. They have 71 bonds in the portfolio, so 71 separate cat bonds. The coupon payments around 11 and a half percent. And they say the credit rating equivalent, it's like high yield B plus. But the spread over the comparable high yield bonds is almost 4%. But I like to think of it it's yielding 11 to 12%. But that's before any payouts as it relates to natural disasters. And historically CAT bonds have offered higher incremental yield or spread compared to non investment grade bonds. So I took a look at their portfolio again, 71 bonds, but we care about what their exposure is. 22% is in windstorms in Florida, the state that over the past 25 years has had 15 to 18 major hurricanes. But there's also exposure to windstorms in Louisiana, earthquakes in California and US has about 10% exposure. There's also some multi peril buckets where it could be a multiple of things. There's some Japan earthquake exposure, Texas windstorm, North Carolina windstorm. And as I look through the portfolio, they didn't break it out but I it, it appears to be mostly windstorm exposure because my sense is that they those generate higher yields. And as you look through the portfolio though, but insurance linked securities, they're all listed 144 as some yield 8.3%. There's some that have a coupon over 15% and the average is just about 12%. Since it was launched last April, the Fund has returned 5.9%. So it doesn't even have a one year return. But if there isn't any disasters, it would return around 11 to 12%. But the reality is if you hold this ETF, there will be natural disasters because they are increasing, particularly wind events and the, the cost of them. But again, it comes back to what Buffett said. We know there's going to be exposure, but how is the insurance priced? How are these cap bonds priced? And that's as an investor, we have no idea. We're relying on the manager to determine that and to build out the portfolio. But we know that there will be disasters and that can bring the return from 12%, the total return down to 7% and potentially it could be as low as 4% annualized and there could even be losses. But that's investing that. That's the risk. But what's cool about it is this is natural disaster risk, it's not credit risk because of the structure. One of my thoughts was, well, traditionally these cat bonds, they're private and pension funds have been investing in them more. You're building out a portfolio, but an ETF's liquid. Do you sell the ETF before hurricane season starts in the US So you earn this coupon and I don't know if these cap bonds are how they're struct if the premium kicks up during hurricane season. And that's why, you know, this is kind of one of those, those ETFs that you invest in it and you kind of just observe how it works, how the returns have been. But here is a public daily traded wrapper around an illiquid investment. And it has, and it has about 13% in treasury bills right now. So there is some room for liquidity. The premium, the net asset value has stayed pretty steady. I find it really intriguing because it's a different return driver. But I also recognize that due to climate change, natural disaster risk is increasing, especially flood risk, wind risk and storm risk, as hurricanes are getting more severe. But they don't happen every year. And now we have insurance companies, we have the capital markets trying to price those risk and we can invest in them and hopefully earn a 7% annualized return that this type of investment has achieved historically. What do you think? Is this something you're going to invest in? We'll see. That's episode 549. Thanks for listening. You may be missing some of The.
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Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money investing in the economy. Have a great week. Sam.