Though it’s still more than 500 mile out from the US coastline, Hurricane Florence is already pummeling the financial models that insurance companies – not to mention the investors who help capitalize insurers – use to price risk. Because of this, institutional and retail holders of so-called “catastrophe bonds” could brook huge losses that could deter them from buying these types of bonds in the future – which could deprive insurers of a crucial source of funding.
The bonds, which gained popularity in the aftermath of Hurricane Andrew, allow insurers and reinsurers to transfer risk to a pool of investors. Basically, investors receive a premium if insurers go a set amount of time without paying out a major claim. But if a natural disaster strikes, bondholders will lose some or all of their principle.
But unfortunately for these investors, the risk models that banks and buyers use to price this risk are moot in the face of extremely rare storms like Florence, which appears to be much more devastating than these models would have reflected. The problem with this, according to WSJ, is that, in situations like this one, investors must struggle with true uncertainty, rather than risk (which can be priced). Plus, storm surges and torrential rains are expected to lead to catastrophic flooding in coastal areas – something that is difficult for financial models to measure.
Investors don’t like unexpected losses: They represent uncertainty, which can’t be calculated, rather than risk, which can be priced. A major unexpected loss is likely to make investors think twice before rushing back into alternative capital, so the industry could take longer to recover and prices could rise more sharply. That is good for the insurers left behind—so long as their losses haven’t been too great—but makes insurance more costly for everyone else.
Florence is unusual not only because of where it is heading, but also because it is expected to slow down dramatically when it nears the coast, according to AIR Worldwide, a risk modeling firm. This slow speed and the peculiar shallow coastal shelf off the Carolinas are likely to help the storm suck up more water and gather power, producing a bigger storm surge, pushing more seawater inland and bringing much more rain over several days. That means higher winds for longer and more flooding.
Flood risk is much harder to model than other perils because the high resolution that models need, which requires detailed land survey data and extra computing power. Flooding was a big problem after Hurricane Harvey in Texas last year, but there was limited flood insurance cover in the state. Analysts at Jefferies think there is much more private flood insurance in North Carolina for homes and businesses. Also, since last year, the National Flood Insurance Program has bought more private reinsurance including the sale of its first catastrophe bonds, increasing the amount of money at risk from flood losses in general.
With at least three other powerful storms forming in the Atlantic, this year’s hurricane season could match, or even exceed, the colossal toll suffered during last year’s hurricane season. However, cat bond trading on the secondary market experienced a notable bump ahead of the hurricane season.
Only two hurricanes as strong as Florence have hit the Carolinas in modern history: Hazel (1954), which caused $15 billion worth of losses when adjusted for inflation, and Hugo (1989), which cost $20 billion, according to modeling firm RMS.
The industry has seen a big increase of new capital since the financial crisis, mainly through flows of fast-moving, alternative capital into catastrophe bonds and similar products. In 2008, alternative capital represented $19 billion, or 6%, of total reinsurance capital; at the end of the first quarter this year that had grown to $95 billion, or 16%, of industry capital, according to Moody’s Investors Service.
To be sure, losses incurred by policy holders last year far exceeded the $100 billion forecast, which is giving insurers some hope. Even after photos of Hurricane Maria flooded cable news, pricing on cat bonds barely budged. Some companies now believe that losses would need to not just exceed, but more than double, expectations to impact pricing in the cat bond market. But others are less confident.
Last year, people in the industry spoke of a $100 billion loss as the kind of event that would finally push up pricing after years of declines or low growth. But the three Atlantic storms that hit the U.S. and Caribbean in 2017 caused losses greater than that and pricing still barely moved. Now industry participants think it would take $250 billion in losses, according to a survey this week from specialist research firm, Artemis. However, if the losses were more surprising, because they were beyond what models typically predicted, then a smaller loss of $150 billion could cause a contraction in the supply of capital to insurance markets and a rise in prices.
Still, given the storm’s unusual path, which could hammer areas not accustomed to hurricanes, there’s a chance that some bond buyers might balk. What’s worse, one meteorologist highlighted a disturbing sign that the storm could be even more damaging than analysts presently expect.
Big news: #HurricaneFlorence is going through another eyewall replacement cycle. The storm just finished one cycle yesterday, where the size of the eye doubled. We could be seeing another expansion of the eye with this next cycle and look at that monstrous eye at the end of loop. pic.twitter.com/rBdrfjFFcH
— Michael Ventrice (@MJVentrice) September 12, 2018
But insurance companies aren’t the only financial services companies that could suffer as a result of the storm. Over a longer time horizon, regional banks that sport a large depositor base in the affected areas could face difficulties as demand for residential mortgages and other consumer financial products slackens. Raymond James’s David Long highlighted a few of these banks in a note published this morning, adding that since most homes in coastal areas of North Carolina, South Carolina and Virginia don’t have flood insurance, meaning that default rates on residential mortgages could spike. Fortunately for these lenders, the losses will be borne by the firms that bought up and bundled the mortgages, rather than the originating bank.
Separately, Fig Partners analyst Kevin Fitzsimmons said there are 14 publicly-traded banks headquartered in Florence’s projected landfall zone, a swath of coastline that includes Charleston, S.C., Myrtle Beach, S.C., Wilmington, N.C. and Norfolk, VA.
Here’s a summary of their points, courtesy of BBG:
19 of Raymond James’s covered banks have exposure to 10 coastal areas likely to be in the storm’s path; as a percentage of deposits, Towne Bank has the most exposure (~73% of total deposits in impacted regions), followed by Carolina Financial (~47%); Union Bankshares has 14.5%, United Community ~8%, First Bancorp 7.5%, Synovus 5.4%, BB&T 5.3%; remaining 12 banks have 5% of their deposit base in impacted regions
Banks with commercial real estate (CRE) exposure may see some material impacts, with construction/land development loans, farming/agriculture loans likely most impacted
C&I loans may suffer if businesses can’t operate/suffer damages, though some businesses may benefit (hardware stores, contractors), and insurance will be big factor
Banks may see more deposits from insurance claims, government assistance, grants/other fundraising efforts; banks providing low-rate loans to those affected may stimulate local economy
While the future is, of course, uncertain, the anxieties engulfing the cat bond market are just one more healthy reminder that financial models have their shortcomings. And when investors become too reliant on their outputs, they’re vulnerable to a potentially devastating surprise.