Drooling Cat-Bond Investors Overlook Risk, Montross Says

Berkshire Hathaway Inc. (BRK/A)’s Franklin “Tad” Montross said pension funds that increased bets on catastrophe bonds to improve investment returns may flee the market after a major natural disaster.

Issuance of the securities has been increasing as investors seek assets that are uncorrelated with most capital markets and offer higher returns than corporate debt. Cat bonds pay hundreds of basis points more than benchmark yields, such as the London interbank offered rate, to investors who risk losing all their principal to an insurance company if a costly enough natural disaster strikes.

“With interest rates being where they are, I don’t think it’s a surprise that a cat bond with a yield of 350 or 500 basis points over Libor looks attractive,” Montross, chief executive officer of Berkshire’s General Re unit, said today at a conference in New York. “People are drooling for those.”

Berkshire, led by billionaire Chairman and CEO Warren Buffett, sells contracts to insurers to help shoulder costs from the largest natural disasters and competes against cat bond issuers. Montross has criticized Wall Street for pumping capital into his industry that may be more fickle than the balance sheets that reinsurance companies have built. Investors who lose their principal in a catastrophe may have an “emotional reaction” and head for the exits, he said today.

“What happens after the $150 billion earthquake, when Nevada is basically coastline to the Pacific?” Montross asked the audience at the conference, hosted by Standard & Poor’s. “This whole issue that it’s a non-correlated asset class, which makes it so attractive as people look at their risk-return profiles, is one that really needs to be thought through very, very carefully.”

Sales Accelerating

About $44 billion of dollar-denominated cat bonds have been issued since 1996, according to data compiled by Bloomberg. Sales of the securities have been accelerating, with $4.17 billion so far this year, exceeding the $3.87 billion the same period in 2012.

Cat bonds issued this year with an average maturity of 3.3 years pay about 5.56 percentage points more than short-term lending rates, data compiled by Bloomberg show. That compares with an average yield of about 5 percent for similar-maturity corporate bonds ranked either B or BB, according to Bank of America Merrill Lynch index data.

Cat bonds have climbed about 4.1 percent in the last year, according to the Swiss Re Cat Bond Price Return Index. The measure tracks dollar debt sold by insurers and reinsurers.

Aura of Credibility

The influx of capital to the industry pressured reinsurance rates ahead of June 1 renewals, as the industry priced risk before the Atlantic hurricane season, Guy Carpenter & Co., the reinsurance brokerage of Marsh & McLennan Cos. (MMC) said this week. About $10 billion of new capital has entered the market through cat bonds and other investment structures in the last 18 months, according to the broker’s report.

The new sources of funds are relying too heavily on catastrophe models in making their decisions about prices, Montross said. Reinsurers and insurers use data and simulations from third-party companies to help asses risk.

The models have “lent an aura of credibility” to pricing, Montross said. “Anyone who’s in the industry knows that the models are always wrong. Directionally, they’re helpful, but we are trying to price a risk today that we do not know the cost of.”

Buffett has praised his company’s insurance operations which span Gen Re to auto policies underwritten by Geico. Collectively, the businesses “shot the lights out last year” and have made an underwriting profit for 10 straight years through 2012, he said in a March letter to shareholders of his Omaha, Nebraska-based company.

To contact the reporters on this story: Noah Buhayar in New York at nbuhayar@bloomberg.net; Charles Mead in New York at cmead11@bloomberg.net

To contact the editor responsible for this story: Dan Kraut at dkraut2@bloomberg.net; Alan Goldstein at agoldstein5@bloomberg.net

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