How to squeeze big dividends from catastrophe insurance

When you look at the destruction wreaked by natural disasters, it’s hard to imagine how the communities affected will ever manage to piece the mess back together again. Just look at the harrowing images coming out of the Philippines since Typhoon Haiyan struck.

When disaster strikes in developed countries of course, insurance companies pick up the lion’s share of the tab. But still, you often wonder how the insurers can pay up without going bust.

And as for making money out of the sector, your first thought may be to run a mile. Well, today I want to explain a little bit about how catastrophe insurance works. More than that, I want to show you what I reckon is the best way to make a decent income out of this sector.

Bear in mind that these earnings are completely uncorrelated to stock market earnings, and you may agree that a little bit of exposure to the industry could be a very good thing for your portfolio…

Some people might have reservations about profiting from the threat of disaster. But I don’t see any reason to feel uncomfortable about it. After all, the insurance companies are providing a vital lifeline, many would be much worse off without them!

The guys who insure the insurers

The reason leading insurers are able to meet payments and avoid bankruptcy lies behind the scenes. Backing up large commercial insurance contracts is a complex web of reinsurance. That is, a market where the insurers can reinsure their contracts against catastrophe. You may have heard of the big boys in this sector such as Munich Re, Swiss Re, Lloyd’s of London, or even Warren Buffet’s own Berkshire Hathaway (General Re). That’s where the ‘Re’ comes from.

As well as the big ‘Re’s, insurers also insure one another, and some investment funds dedicated to reinsurance have been established.

And it is one such fund that I want to show you today. Specifically, the CATCo Reinsurance Opportunities Fund which is a £250m investment trust trading in London (LON: CAT). Though it trades in London, for tax reasons it’s domiciled in Bermuda – as is much of the insurance industry –and it’s quoted in US dollars.

As I say, the idea behind the fund is to provide a backstop for insurers should catastrophe claims go beyond a certain level. In return for this backstop, the company receives premiums at the beginning of the year – and then sits back and waits to see what happens. Alright, so they’re not sitting around the office twiddling their thumbs, they’re out seeking new contracts – but you get the idea.

In fact, the fund aims to spread its portfolio as wide as it can. It targets what they call 42 non-correlated ‘risk pillars’ such as US Wind, Japan Quake and European Wind. The following chart shows the range of contracts CATCo has reinsured.

TRS01

Source: CATco

Of course, you can spread risk about all you like, but when it comes down to it, it’s very much a game of some you win, some you lose. But overall, the fund expects to earn Libor plus 12%-15%. Now, in today’s environment that really would be a respectable return, don’t you think?

But like I say, what you want and what you get are two entirely different things.

Over the last couple of years of existence, the fund lost 7.4 cents per share in 2011 and 1.9 cents a share in 2012.

But the last couple of years have been stinkers for the industry. It’s worth remembering that past performance is no guide to the future…

On course for a 28% return

As I wrote in a recent article about Amlin, one of my favourite insurers, 2011 was a ‘freak’ year. Hurricanes, earthquakes and floods on a biblical scale. 2012 didn’t start off much better when some bungling Italian captain ran the Costa Concordia aground!

In the words of broker Numis: “The number of major catastrophes since CATCo was launched in late 2010 has been unprecedented. Since then, the fund has been hit by the Japan tsumami/quake and the NZ quake, as well as Costa Concordia and Hurricane Sandy. In addition, there have been floods in Australia and Thailand, as well as Hurricane Irene in the US.”

But as for 2013, things are looking up. During the first six months of 2013, the fund returned 7.9%. It now looks like the tide may have finally turned for CATCo.

As it reported its half-year figures to the end of June, it said: “Assuming a hypothetical basis of no losses for the second half of 2013, the company is on course to deliver a shareholder net return of 28%.”

This shows what sort of money can be made in the reinsurance game. Did you ever wonder why Buffet likes reinsurance? Remember, so long as losses stay below a given level, CATCo doesn’t have to pay out anything on its contracts.

Though the fund aims to earn Libor plus double digit returns, when it comes to dividend payments, it targets a return of Libor plus 5%. And indeed, over the last couple of years, the fund paid its dues despite losses. This is a fund very much targeted at income seekers.

Of course, over the long run the aim is to add capital value too. And assuming less carnage in the ‘catastrophe’ space, I expect them to do so.

As well as all the usual risks, the fund also opens investors up to currency risk. Still, pop on your rose-tinted specs and you could say that you get the benefit of currency diversification.

The fund is an investment trust and can therefore be purchased through your regular stockbroker. That said, the fund is not very liquid (ie not highly traded) and some stockbrokers may be less willing to participate than others.

Fund management fees come in at a reasonable 1.5% a year, with an extra performance fee paying the manager 10% of gains should the fund return more than Libor plus 7.5%.

As I write, the fund trades at $1.12 and has a net asset value of $1.09.

I should think the major risk with this investment is quite obvious – catastrophe! That said, the fund takes extraordinary steps to mitigate risk. I would advise a moderate investment as part of a balanced portfolio, and look forward to income generated from a sector uncorrelated with the business, or stock market cycle.


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