This is not a metaphor, it could be your retirement. Photograph: Victor J. Blue/Bloomberg
This is not a metaphor, it could be your retirement. Photograph: Victor J. Blue/Bloomberg

One of the best ways to blow yourself up in financial markets is to sell lots of cheap insurance against risks you don’t fully understand. Traders call this “picking up pennies in front of a steamroller,” since the strategy appears profitable right up until you lose everything.

It’s therefore somewhat concerning to read, per Bloomberg News, that pension funds are attempting to boost their returns by putting more money in catastrophe bonds and other insurance-linked securities. (The pension plan for Ontario’s teachers, which is renowned in the industry for its size, savvy and aggressiveness, has been trading catastrophe bonds for years.) While their involvement in the market is still small compared to the specialty investors that currently predominate, pension funds could end up creating systemic risk by distorting the price of insurance and exposing savers to large losses.

On the surface, catastrophe bonds look like regular bonds that pay coupons and return principal after the end of a specified period. The difference is that issuers get to keep a portion of the principal in the event of natural disaster. Buying a catastrophe bond exposes you to the same kinds of risks that insurers and reinsurers face whenever they provide coverage against floods, earthquakes, and other causes of widespread property damage. This can be attractive because these instruments pay very high yields and are basically uncorrelated with other assets. (Risk Management Solutions has a good overview of how the bonds work and who buys them if you want more details.)

The market first developed after Hurricane Andrew inflicted punishing losses on insurers and reinsurers in the early 1990s. Traditional sources of protection were unwilling (or unable) to provide coverage to coastal borrowers after the storm, so clever bankers decided to tap a few savvy investors outside of the reinsurance industry. The market is still tiny -- there are fewer than $20 billion in catastrophe bonds outstanding as of last month, according to the Economist -- but the combination of low real interest rates and more destructive natural disasters has caused it to nearly quadruple in size over the last decade. The total market for insurance-linked securities, which includes sidecars and derivatives, is closer to $45 billion.

Offloading some catastrophic risk to the capital markets is a good thing. The reinsurance industry would have a tough time covering the losses caused by an earthquake that hit a big city in California or Japan, or a hurricane that landed on Miami. There might not be enough loss-absorbing capital available to deal with several major disasters in short succession, especially if the frequency of major storms is permanently increasing due to climate change. Specialist hedge funds with sophisticated weather models can usefully complement the big reinsurance firms by bearing and pricing these risks.

Significant direct investments by pension funds could create problems, however. These institutional savers currently control about $30 trillion in assets, while there is currently about $510 billion of loss-absorbing capital in the reinsurance industry, according to Aon Benfield. Even tiny pension fund allocations to insurance-linked securities could threaten to crowd out the reinsurers that currently sell disaster protection to insurance companies. This is one reason why the chairman of Lloyd’s of London has started warning about the downsides of outside money entering the sector.

While we shouldn’t cry for the reinsurers just yet, some pension funds may end up buying these high-yielding assets before they fully understand how to model their risks, just as some loaded up on subprime mortgage securities during the mid-2000s. (On the bright side, investors won’t have to worry about fraud when calculating the probability of another Hurricane Sandy.)

Initially, this would depress the cost of disaster insurance, which might lead to overbuilding in risky areas and laxer enforcement of building safety codes. It could also push the insurers and reinsurers to underwrite new risks they are less familiar with in an effort to prop up margins, a danger that was highlighted by the UK’s Prudential Regulation Authority last month. The Bank for International Settlements, based in Basel, Switzerland, has also been looking into the impact of the reinsurance business on financial stability.

In the event of disaster, outside investors who didn’t appreciate what they had been buying might get so spooked by losses that they would cut their allocation to the entire sector. Small shifts from the perspective of pensions could have big effects on insurers’ ability to protect against future catastrophes. The result would be much greater volatility in the cost of insurance, to say nothing of the impact on pension beneficiaries. Plan sponsors and regulators should be careful.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)