Catastrophe bonds, known as cat bonds, transfer the insurance risk of catastrophic events from insurance and reinsurance companies to investors. Investors receive a higher yield relative to corporate bonds for taking on the risk of losses from specific catastrophic events, such as earthquakes or windstorms.
As long as the disaster covered does not occur during the term of the bond, which is normally three to five years, investors receive their interest. At maturity, they will also get the face value of the bond returned. However, if a disaster occurs, bondholders potentially lose most or all of their capital and their future interest payments because this money is used to help the insurer or reinsurer to pay out on claims.
Cat bonds are typically issued around events with high severity, but low probability of occurring, GAM says these remote risks impose the greatest stress on the balance sheets of insurers and reinsurers, which translates in to a good risk and return trade-off for investors.
GAM’s new fund will be managed by specialist US-based cat bond manager Fermat Capital Management. Fermat has run a cat bond fund for GAM since 2004 and its investment team has been involved in the asset class since the inception of the market in the 1990s.
Fermat will build a portfolio of 40 to 50 cat bonds, equating to around half the available issues in the cat bond universe. The fund aims to deliver attractive, consistent returns that are uncorrelated to other asset classes. Only well-understood and well-rewarded risks will be taken, with Fermat focusing mainly on natural catastrophe cat bonds.
Returns from cat bonds are linked to the occurance of catastrophes rather than what is happening in investment markets, so they can provide diversification with higher yields than corporate bonds with similar risks. However, they typically have lower liquidity than mainstream bonds and an expensive catastrophe could have a negative impact on returns.