Transferring natural disaster risk
According to a report by the Federal Reserve Bank of Chicago, insurers, reinsurers and certain state governments issue cat bonds as a means of transferring the risks associated with natural disasters to the capital markets. Under such an arrangement, a bondholder can reap a large return on the investment if a predefined series of catastrophes do not actually happen.
On the other hand, the investor may incur a huge loss if the natural disasters do occur.
Such a “predefined” catastrophe risk, might be, for example, a hurricane that causes at least $500 million in insured losses or an earthquake that a reaches a magnitude of 7 on the Richter scale.
According to the Brookmont ETF’s prospectus, such predefined risks may include the magnitude of losses arising from Florida hurricanes, California earthquakes, Japan typhoons, Europe windstorms and Europe earthquakes. In addition, the prospectus noted, “a weather catastrophe bond could provide coverage based on the average temperature in a region over a given period. Trigger events may also include earthquakes and tsunamis. In addition, catastrophe bonds may have trigger events that are non-natural catastrophes, such as plane crashes, or other events resulting in a specified level of physical or economic loss, such as mortality or longevity.”
Powell of Brookmont explained further: “If a large property casualty insurance company does a good job of insuring the property and casualty risk in a city located on the Gulf (of Mexico), they may be overexposed to city-specific hurricane damage,” he said. “This insurer may (then) issue an indemnity bond that helps to defray the cost of their insured damages over a certain amount caused by hurricanes in that specific city.”
Most cat bond investors are hedge funds, pension funds and endowments, and other larger sophisticated institutional investors, Powell noted.
“Our goal is to provide access to the asset class for a broader set of institutional investors and family offices,” he noted. “What actually makes the asset class so attractive is that there’s a disconnect between perceived risk and actual risk. Part of this perception is attributable to the historically private nature of the market, which we hope to change.”
The bonds have a floating-rate yield generally in the low teens, which is paid by the insurers’ premiums, said Powell.
“The bonds do not have counterparty risk as they are fully cash collateralized as a special purpose vehicle,” Powell added. “The proceeds from the bond sit in a collateral account and are returned to the investors unless the impairment events occur, which is typically a series of catastrophic events vs. simply one or two hurricanes hitting the city.”
Cat bonds transfer risk directly to capital markets, unlike traditional insurance, which relies on balance-sheet-driven capacity, Pagnani said.
“Cat bonds serve as a conduit to the capital markets and are an effective global risk-sharing tool. Insurance markets are increasingly stretched for capacity, particularly in high-risk states such as Florida and California,” he noted. “By leveraging actuarial science to price risk correctly, the capital markets can help close these gaps. The ETF will facilitate this process by attracting new investors to the insurance-linked securities market, thereby enhancing liquidity and broadening access to this unique asset class.”
The first cat bonds were issued in 1997, largely in response to Hurricane Andrew, which smashed into Florida and the Gulf Coast in 1992, causing $27 billion in damages, of which insurance covered $15.5 billion, resulting in the failure of eight insurance companies, said the Chicago Fed report.
In response, insurers reconsidered their risk exposure to vulnerable coastal areas, pushing up homeowners’ insurance prices in these communities, while some insurers and reinsurers cut their exposure to catastrophic events in coastal regions, said the Chicago Fed.
“We have seen robust growth and maturation in the cat bond market,” said Powell. “We believe the Brookmont Catastrophic Bond ETF could be a major factor in catalyzing that growth.”
Powell observed there is a “growing appetite” among investors for uncorrelated alternative income assets. According to Allied Market Research, a research and consulting firm, he noted, the alternative investment funds market was valued at $12.8 trillion in 2023, and is estimated to reach $25.8 trillion by 2032, growing at a compound annual growth rate of 7.9% from 2024 to 2032.
In addition to growing demand, said Pagnani, regulatory and market infrastructure developments have made launching a cat bond ETF more feasible.
Trigger types
The ETF’s portfolio will be structured as an approximation of the issued and outstanding cat bond universe based on key financial considerations including geography, peril and trigger type, Powell said.
“Trigger type” refers to the mechanism that would prompt payment to the bond issuer. For example, an “indemnity trigger” would lead to a payout based on the actual insurance losses experienced by the issuer, while an “industry loss triggers” bases payments on the estimated aggregate losses incurred by the insurance industry following a catastrophe, explained the Chicago Fed report.
“We expect a 10%-20% (compound annual growth rate) for the foreseeable future, and possibly more, based on necessary insurance innovations to price and manage the risk of owning a hard asset in geographies increasingly impacted by climate volatility,” he added.
The cat bond market may further expand due to increasing participation from non-traditional issuers, such as corporations, multilateral funding agencies like the World Bank, and municipalities, added Pagnani.
“If historical growth trends continue, we could see the market surpassing $100 billion within the decade,” he estimated.
Powell attributes the superior performance of the cat bond market to its private nature, as well as a misunderstanding of the return potential and the true risks being assumed.
“The asset class typically has an average (default) rate of between 1% and 2% with a low teens yield,” he explained. “Compare this to the high-yield bond asset class that has a long-term annual default rate of between 3% and 4% with a mid-to-high single digit yield.”
The biggest risk to a cat bond investor would be if a series of disasters do occur in the proscribed geography to the extent that it triggers the bond to start subsidizing the insurer's payout, which results in the impairment of their principal, Powell explained.
“However, with an average annual impairment rate between 1% and 2%, the occurrence of qualifying natural disasters is not as common as most people think,” he added.
Pagnani further emphasized that “a diversified portfolio approach, like the one we intend to implement with the ETF, mitigates concentration risk, ensuring that no single event disproportionately impacts returns. We aim to balance allocation across various geographies, peril types and issuers. By using sophisticated models to estimate the probability and potential impact of triggering events, we ensure that our portfolio is not overly exposed to any single event.”
Manghani himself is a weather expert, holding a Ph.D. in meteorology from North Carolina State University. He also formerly worked at WeatherPredict Consulting Inc., an affiliate of reinsurance giant Renaissance Reinsurance, which focuses on modeling atmospheric hazards and vulnerability.
Powell also believes that as natural disasters increase in magnitude and frequency, this marketplace will play an increasingly important and visible role in global capital markets.
One of the biggest recent natural disasters were the wildfires that hit southern California in January, killing 29 people and destroying 18,000 buildings.
Total property and capital losses arising from the fires could range between $76 billion and $131 billion, with insured losses estimated up to $45 billion, according to UCLA-Anderson School of Management.
Fitch Ratings reported that the California wildfires will likely cause certain catastrophe bonds to experience partial principal losses, but aggregate losses will not impede cat bond market issuance, which reached $17.5 billion in 2024. "Our preliminary principal loss estimate is less than 50 bps, or $250 million, for the cat bond market, absent any further catastrophes in 2025," Fitch said in its report.
“Our preliminary principal loss estimate is less than 50 bps, or $250 million, for the cat bond market, absent any further catastrophes in 2025,” Fitch said in a Jan. 25 report. Some 12% of the $50 billion cat-bond market is currently exposed to wildfire risk, but Fitch expects any realized cat bond losses to be “small in aggregate.”
