Catastrophe bonds are a way for capital markets to provide reinsurance to the insurance industry and they essentially cover catastrophic events such as major hurricanes, earthquakes and bushfires in areas where such events present a low but genuine risk.

New Zealand Superannuation head of communications Paul Gregory says New Zealand Superannuation will mostly invest in securities that cover United States hurricanes and earthquakes, with some products covering European wind storms and Japanese earthquakes.

The investment is being managed by Chicago-based Elementum Advisors, LLC who have expertise in insurance linked securities.

“We have invested in catastrophe bonds as they are a strong diversification play and offer attractive risk-adjusted returns.

“We have also invested because risk can be mitigated and capped.” Gregory says for an investor, the rationale is the income stream derived from the premiums paid on the policies in the pool.

The insurance industry values this back-up insurance, and pays attractive premiums to investors to provide it. Should a relevant catastrophe occur, the bond may be triggered.

Triggering depends on the size and severity of the catastrophe and constitutes a requirement to pay out, but the size of the payment is capped to a maximum agreed by the investor.

Eriksen & Associates managing director and actuary Jonathan Eriksen says we like catastrophe bonds for two reasons:

1) The risk is uncorrelated with equity markets and it’s uncorrelated with other asset classes – unless there’s a catastrophe you’re making quite a lot of money.

2) The risk of a catastrophe by its nature is very low but the cost is very high, for example hurricane Katrina where the cost of sorting New Orleans was massive. Therefore the risk premium is high. So in a year where there’s not a major catastrophe the return is very high and of course that’s most years.

Eriksen says usually you write over three types of catastrophe, so you might get one that happens, but it’s unlikely to get three catastrophes happening at once, “so normally it’s a very good investment and it’s ideal for the NZ Superannuation fund”.

“I think it’s a shrewd move because to put it in context, the global financial crisis is not over yet and the equity markets are likely to be the most volatile asset class, but this type of investment carries on regardless.”