How To Make Money Gambling On Mother Nature

Right now, as Hurricane Irene nears the end of its lumbering trip up the East Coast of the U.S., someone is making money. At the same time, other people are losing money — not in property damage or lost income from a closed business, but because they lost a bet against nature. They had bet that a major hurricane would not in fact occur (or would not occur and cause x amount of damage). The mechanism is what’s known as a “cat bond,” or catastrophe bond.

Here’s how it works. An insurance company sells a cat bond to an investor. The bond has a condition: if some predetermined natural disaster occurs — perhaps a hurricane hitting New York — the principle, what the investor/gambler paid for the bond, is lost. The insurance company keeps the money. If it doesn’t happen, the investor wins, and gets an extraordinarily high interest rate in return.

For the investor/gambler it’s simply a risky bet. For the insurance company, it’s a form of reinsurance. That is, if the disaster happens and the insurance company has to pay out a ton of money to its customers, winning its own bet on mother nature softens the blow of paying for a bunch of washed away, insured beachfront homes.

In 2007, The New York Times Magazine published a story on a hedge fund manager named John Seo, a leading light in the world of cat bonds. The piece explains the odd predicament or even contradiction that selling catastrophe insurance entails.

Right away, [Seo] could see the problem with natural catastrophe. An insurance company could function only if it was able to control its exposure to loss. Geico sells auto insurance to more than seven million Americans. No individual car accident can be foreseen, obviously, but the total number of accidents over a large population is amazingly predictable. The company knows from past experience what percentage of the drivers it insures will file claims and how much those claims will cost. The logic of catastrophe is very different: either no one is affected or vast numbers of people are. After an earthquake flattens Tokyo, a Japanese earthquake insurer is in deep trouble: millions of customers file claims. If there were a great number of rich cities scattered across the planet that might plausibly be destroyed by an earthquake, the insurer could spread its exposure to the losses by selling earthquake insurance to all of them. The losses it suffered in Tokyo would be offset by the gains it made from the cities not destroyed by an earthquake. But the financial risk from earthquakes — and hurricanes — is highly concentrated in a few places.

This is a recent problem. Insurance companies were able to sell hurricane insurance and other sorts of catastrophe insurance in the past because there was less risk out there. The trend of people building precariously on beachside dunes and over fault lines or whatever was materializing in the ’70s and ’80s, while those decades had a significant lull on catastrophe. “The insurance industry had been oblivious to the trends and continued to price catastrophic risk just as it always had, by the seat of its pants,” wrote the Times. “The big insurance companies ran up and down the Gulf Coast selling as many policies as they could.”

Then Hurricane Andrew happened in 1992, totally $15.5 billion in damages, more than the total amount of premiums ever collected in Miami-Dade County, the source of most of the payouts. That total proved an important point for insurers and investors about risk: that it could be accurately valued, by a new model developed by a researcher named Karen Clark. Post-Andrew, the insurance industry in south Florida was devastated. The piece continues, “That's where catastrophe bonds came in: they were the ideal mechanism for dissipating the potential losses to State Farm, Allstate and the other insurers by extending them to the broader markets.”

It’s an active and weird market of investors clinging to weather reports, jumpy investors selling off bonds at the last minute for pennies on the $100, and meteorologists suddenly being exalted gods—in certain corners of Wall Street anyway. It’s creepy, of course: people making money betting against events that kill and cause misery. But insurance is creepy in general, a vast and super-strategized table game of sorts. But cat bonds feel especially real. Look outside.

According to the Wall Street Journal the cat bond market was going bonkers yesterday in advance of Irene, while, "earlier in the week, we were seeing opportunistic trading–some investors liquidating positions to avoid any exposure to a potential landfall in North Carolina, and others taking a view that they can buy in at attractive levels," Paul Schultz, president of Aon Benfield Securities, told the Journal.

Hurricane season ends Nov. 30. Still plenty of time to talk to your broker.

Reach this writer at michaelb@motherboard.tv.