The Derivative - Hurricanes, Cat Bonds, and the Billions at Risk with Dr. Jeff Masters and Chris McKeown

Episode Date: September 29, 2022

Otherworldly forces can affect the market and hurt it just as much. Hurricane Ian continues to bring surges, winds, and flooding to Florida, and we have our own hurricane swirling around the set. That's right, we're bringing two forces together this week in a mashup of two previous pods with Hurricane Hunter Dr. Jeff Masters and Re-Insurance pro Chris Mckeown. We're revisiting what Dr. Jeff has to say on hurricanes and how you can track them, and we're also talking catastrophe bonds with Chris McKeown. You'll want to add this special episode to your playlist to learn more about; building weather models, the financial impacts of a storm, fat tails outside of financial markets… yes they are there too (let's just say it's a complex system), off-loading risk via reinsurance, CAT bonds, structural issues in an upside market, and so much more — SEND IT! Chapters: 00:00-01:58 = Intro 01:59-20:41 =  Hurricane Hunting, “The Final Flight”, & Weather Underground 20:42-32:10 = Building Weather Models w/ 15km Global Grids 32:11-46:47 = Storm Financial Impacts, Catastrophe Bonds & Fat Tails ( It’s a complex system) 46:48-50:57 = Favorite Hurricane 50:58-51:22 = *** break *** 51:23-01:06:00 = Off-loading Risk via Reinsurance, Capital Deployment & Investor portfolio protection 01:06:01-01:13:14 = Cat Bonds & Structural Issues in an Upside Down Market From the episode: Check out Dr. Jeff Masters on Yale Climate Connections blog Eye on the Storm, follow him on Twitter @DrJeffMasters, and visit wunderground.com Visit VantageRisk.com for more information on Re-Insurance, Chris McKeown and his team Don't forget to subscribe to The Derivative, follow us on Twitter at @rcmAlts and our host Jeff at @AttainCap2, or LinkedIn , and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Welcome to the Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Okay, hi everyone. Got a little something different today. I'm from Florida, as I've probably let on on some of the past pods. I got family down in Fort Myers, and our eyes have all been peeled on Hurricane Ian battering Florida yesterday and today.

I can't stop watching the coverage, and I like talking about hurricanes and digging into the details of how the paths are modeled, how the insurance and cap-on work, and all the rest. So I tell everyone I know to follow Dr. Jeff Masters, formerly of Weather Underground and the Cat6 blog, now of Yale Climate Connections and the Eye on the Storm blog, where he weaves in data and modeling and graphs and charts and everything else when looking at these things. When we started the pod, I knew I wanted him on it. We made that happen shortly after the pod launch recording with Jeff in October of 2020. And with the hurricane hitting yesterday, I thought,

let's go back and revisit what Dr. Jeff had to say on hurricanes and tracking them. A year after that, we had on Chris McCown to talk about cap bonds, which is short for catastrophe bonds, where reinsurers package risk like Tampa getting 10 billion in insured hurricane losses into a bond that pays the investors a yield up and until that happens, if it ever happens. That's surely interesting, selling the mother of all tales. So with the hurricane happening yesterday, we went back and grabbed the best parts of the pods with Dr. Jeff and reinsurer Chris to give you in today's pod. Send it. Hi, everyone. Welcome back. It's not only tweets and retail option traders that affect the day-to-day movement of the markets. Other worldly forces can affect the market and hurt it just as much.

On today's topics, one of those worldly phenomenons, hurricanes. Billions of dollars in damage, oil refinery shutting down, crops crops destroyed all from the wrath of a giant storm we named sally or teddy or something uh so to break down the who what why of these storms and the math and modeling involved in protecting us from them we've got the hurricane master dr jeff masters joining us for today's podcast jeff's a hurricane scientist who's hunted down and reported on them for over 34 years. Also co-founded the Weather Underground and authored one of my favorite blogs on the internet back in the day, the Cat 6 blog, which I used to read like a kid with his first Harry Potter novel anytime there was a storm brewing. So Jeff now writes for the nonprofit website Yale Climate Connections, and we're excited

to have him on today's podcast. Welcome, Jeff. Well, thank you very much. So I have to start with your old job of flying hurricane hunters. Tell us everything. How'd you get into that? What was it like? Was it as insanely dangerous as it sounds? What kind of person you got to be to fly into the storm? Yeah, I started that way back in 1986. I was just a young fearless kid, age 25, and had a master's in green meteorology and wanted to go, you know, see the world's most impressive weather. And I thought it was a dream job. And what I did is I worked as a meteorologist

on two weather research aircraft that flew out of Miami, Florida, run by NOAA, the National Oceanic and Atmospheric Administration. And in the summer, we'd chase hurricanes. In the winter, we'd go do winter storm projects. In the spring, we'd look at severe thunderstorms. So it was really an ideal job for a meteorologist. I mean, you got to fly all over the world and see the most incredible weather phenomena and work with the greatest scientists in the field because each of these field projects featured some of the biggest names in weather. And early on, I got to work with Dr. Ted Fugita, inventor of the Fugita scale for tornadoes. And then when I flew into hurricanes, I worked with all the top hurricane scientists, including Bob Burprey, who went on to become the director of the National Hurricane Center, and some of the other heads of the NOAA's research division. So really a dream job, and

really wasn't as dangerous as you might think flying into the eye of a hurricane. When you're out over the water, there isn't that much that you have to worry about with respect to intense thunderstorms. You don't get the kinds of shearing motions and large hail that you see in a Midwest severe thunderstorm. All over the water, it's not cold enough generally. Just pure wind speed is the issue there, but that's fine? The plane just handles it? Well, planes don't like wind shear. I mean, wind shear when you're flying is bad because that means you've got a different loading on one part of the aircraft versus the other. Say you've got a 100-mile-per-hour wind blowing on the nose and a 40-mile-per-hour wind blowing on your tail, then that's going to skew the aircraft.

It's going to kind of, yeah, it's going to kind of skid through the air. And even worse is in the vertical if you get kind of updrafts and downdrafts. If your tail's in a downdraft and your nose is in an updraft, that really gives you a bucking motion. And in a hurricane, you can get some pretty intense G-forces if you go into the eye wall, which is the most intense part surrounding the calm eye. And there have been a few missions in the past before I joined the Hurricane Hunters where the plane got in trouble in intense turbulence in the eyewall. And you worry if you're flying too low and the pilot can't control the aircraft, then you'll splash into the ocean.

Not ideal. Generally, you don't fly in at low altitude. You go in at 10,000 feet. And that gives you a lot of room for error if you get a big downdraft. I mean, a lot of times you'll hit a downdraft, and the pilot can't control it. You know, you go down 500 feet or 1,000 feet in just a few minutes. Wow. So if you're flying at, you know, 1,000 feet, then you're in the ocean.

Did you ever lose your lunch? Did you ever get sick? Was it kind of bucking all the time? You know, I personally did not, but we certainly carried barf bags on every flight. And, you know, we always had reporters on board. They always went, you know. Oh, really? Right. Yeah, they ride in the back and take photos and, you know, report on what it's like to fly through a hurricane. And there were a few reporters who weren't used to the turbulence, so we'd lose their lunch. And that's still to this day, they got reporters on them? Oh sure, pretty much, yeah.

I mean, you can get in line and fly down to Florida and get on a hurricane hunter flight if you're a journalist. I don't know if you qualify there, but. Right, I can do that. Yeah, right. Yeah, go for it. What kind of planes are we talking? Are these specialized planes or they're? They're four engine turboprop planes. And they were originally built for anti-submarine warfare for the Navy P3 Orions. That's what NOAA flies and the Air Force flies C-130s, which are also

four engine turboprops. And a turboprop is really pretty ideal for hurricane flying because you've got the power of a jet engine, that's the turbo part, but you've also got a propeller blade, which means that it flies slower and it gives you more control. So it's better to fly slower through intense turbulence because that means that the wind shear on the airplane is less. If you're flying faster, that means you're going through intense changes in wind more quickly and it provides more shear on the aircraft surface, which is more dangerous. So the P-3s are really ideally suited for hurricane flying.

All right, awesome. So then you hung up your spurs on that and started Weather Underground. What drove that decision? Well, the thing that drove me to leave the Hurricane Hunters was my final flight, which you didn't ask about. I don't know if you read my story of flying into Hurricane Hugo. What wasn't your final, final flight since your... Well, in a very permanent sense, it very well could have been. We were flying into what we thought was going to be a Category 3 hurricane out over the Atlantic. And we went in at low altitude, 1,500 feet, thinking it was going to be a Category 3. And it turned out to be a Category 5. And you shouldn't

be in a Category 5 1500 feet, very dangerous. And sure enough, as we were penetrating through the eye wall, we quickly realized we were in over our heads. We started getting, you know, two G accelerations where you're twice the force of gravity pushed into your seat, then zero G's where you're dangling weightless. But once you're in the eye wall, you got no choice but to gut it out and make it all the way through to the calm eye because you really can't do much maneuvering. You've just got to go for it and get through it. So during this two-minute penetration, it started getting worse and worse.

The winds were 140, 150, 160 miles per hour, 170. And we're just hanging on. The pilot's having trouble controlling the aircraft. We're bucking all around. We're skewing through the air. And at times, I don't think he was really in control of it. But finally, we got right near the eye, which of course is calm, and you can start to see it brightening up. And I said, oh, it's brightening up out there. We're going to make the eye. But right then, the plane hit the most catastrophic updrafts and downdrafts ever

encountered by the hurricane hunters. We hit a 40-mile-per updraft followed by a 20 mile per hour down draft followed by a 30 mile per hour updraft all in the space of seven seconds wow and that's a tremendous amount of wind shear and at the same time in the horizontal the winds went from about oh 180 miles per hour down to 70 miles per hour so the plane's skidding through the air and bucking. We hit 5.7 Gs of acceleration. The plane's only rated to 6 Gs. The pilot lost control of the aircraft. We started plunging down towards the ocean. And our number three engine caught on fire at that time too.

So fortunately, yeah, I was thinking this is it. I was thinking like, you know, this is what it's like to die in battle. I was saying this is it. I was thinking like, you know, this is what it's like to die in battle. I was saying my prayers, literally. Fortunately, we popped into the calm eye right then. The pilot was able to pull us out of the dive about 900 feet above the ocean and extinguish the fire in the engine that had caught on fire. But then you had to go back through the wall. What was that? Well, yeah, that's not good. We're saved, except we have to do it all again. Yeah, you barely made it through in four inches. Now you got to get out on three.

And we looked over and not much. There wasn't much room because the eye was only about 10 miles in diameter. And a big plane like the P-3 needs about a seven-mile circle in order to circle. And as it turned out, we weren't really sure where we were in the eye. And we saw a wall of clouds in front of us. And we had to turn to avoid that thinking it was the eye wall. Well, we were off to one side and the pilot turned us right into the eye wall again. And he was able to bank us over at a really steep angle, like a 30 degree angle. So we stayed out of the eye wall. But, you know, we're sticking one wing in the eye wall, one wing out.

The plane's bouncing around. We're like going, oh, crap. And the engine needle on the one good engine on that wing is going into the red. But fortunately, he was able to pull us out of that sharp turn, level us out in the eye. And then for an hour, we circled inside the eye trying to gain altitude to get out of the eye at a calmer spot. Wow. So that was that? You said enough of this nonsense? Yeah, that was my last flight. And yeah, we managed to exit out of the eye thanks to some help from the Air Force Hurricane Hunters who actually sent a plane in to find a soft spot for us. They penetrated in and out of the eye a bunch of

times for us. We finally, you know, followed them out where they found the comma spot. Why are there two sets? Why don't they just have one, the NOAA, right? Why does the Air Force also do it? You know, they were there for the National Hurricane Center for operational data, you know, to help them with their real-time forecast. And we were doing a research mission. So we were doing a nonstandard flight pattern going in and out of the hurricane to take data to better understand how they work and to, you know, help hurricane researchers make better forecasts in the future. Have you ever flown commercial again? Did you say no more flying ever, or you just said no more hurricane flying? No more hurricane flying. No, I was happy to fly commercial again, but to this day, I don't like getting on a roller coaster.

I bet. The ultimate roller coaster. So then hung up those wings, so to speak, and started Weather Underground. Well, I went back to PhD school back at the University of Michigan, and I was majoring in air pollution science. And while I was in PhD school, this was back in the early 1990s, I found out about, hey, we got this cool thing here called the internet, which I'd heard of, but didn't know much about. And so I found out we had a satellite dish in our roof that brought in all the world's weather data And there wasn't really any good way to look at it. So as part of a graduate University of Michigan you're saying yeah, yeah So as part of a course I was taking I wrote a little C program to take the incoming data

Format it and make a nice little menu based text system where you could type in a three-letter Airport code and get the latest national weather service forecast so you type in you know ord and you get the forecast for chicago from the national weather service and that was cool enough that uh you know we launched it as a service available not only just to the university but we figured out how to make it available worldwide just because because of the magic of Unix, you can have anybody on the Internet access your computer. So we did that. And, you know, within a few months, it was going viral, basically, back in 1991, 92. And we were getting people from all over the world, you know, accessing this little it was called a telnet session for weather. So from that humble beginning, you know, my PhD advisor, Perry Sampson said, hey,

you know, I bet I can get a grant proposal from National Science Foundation to take this idea and expand it. And over the course of the next few years, yeah, from that humble beginning, we made an educational project called Weather Underground that did K through 12 weather education based on the internet. And it was kind of the perfect marriage of science education and the internet because, you know, what better way to do real-time science than to do weather stuff on the internet. And the National Science Foundation was very enthusiastic about it. And we got several million dollars worth of grants up until 1995 and started doing graphics. And in 95, when the commercial web came along, we said, hey, you know, let's make a business out of it. And the university and National Science Foundation were both very supportive of

that. In fact, you know, that's kind of one of their missions is to spin off companies like that. And that was the genesis of the Weather Underground as a company. It was a university-based project that got its start from a little program I wrote. Predate the weather.com and black skies and all this stuff. Yeah, we were there before the Weather Channel was online. In fact, they sent, you know, some of their people up to the University of Michigan campus to talk to us to figure out, you know, how do these guys do that? And, you know, we ended up probably giving away more than we should have because they ended up founding a very successful website that was

then our competitor. Right. And then they ended up buying you, right? Yeah. I mean, that was the ultimate tribute to your opponent is to not only imitate them, but actually take them over. And they did buy us back in 2012. And then so somewhere in there, you started writing the Category 6 blog. Was that from the beginning or that was just just always part of weather underground i don't remember exactly when i first started coming across it but um yeah loved all the deep dives on everything to do with which i would call hurricanes would you call them tropical cyclones yeah sure i mean the blogs weren't around back when we founded the company. Really, that didn't start until the early 2000s. And in 2005, some of my coworkers said, hey, you know, Jeff, why don't you start writing a blog? And I'm like,

what's a blog? That sounds really dumb. I hate that word. What's a blog? And they said, oh, you just write online about current topics and people comment on it and it's social media. Well, I thought this was a dumb idea. And my first few posts showed very low effort. I think my second post was only two sentences. I basically wrote about the atmospheric phenomena like rainbows and halos. And I didn't know what to write about. Who cares about this stuff? Yeah, right. And then finally, I figured out, oh, hey, I know a topic to write about. Because back then, our competitor AccuWeather tried to pressure the legislature to pass a law to basically make it so only private companies

could issue weather forecasts, outlaw the National Weather Service for making weather forecasts. And I thought that was a horrible idea. And so I used the blog as a platform to agitate against that. Yeah, which is, that was the genesis of our blog back in the day of complaining about regulators missing some frauds in our industry and whatnot. Like when you have a bee in your bonnet, so to speak, the words just flow out, right? Yeah. I mean, that was a great platform because, you know, a lot of people were interested in that. It was very, I was talking about, okay, we got Arlene. Then a whole cascade of the 2005 hurricane started coming. We had Cindy. We had Dennis. We had Emily. Then eventually, Katrina came, and Rita, and Wilma. It was just nuts. I spent the whole rest of the year basically blogging and didn't do much else.

And over time, it seemed to become more data-driven, more – maybe it was always that way. But in my mind, it seemed to become more data-driven, and you started getting more into heat content and wind shear and all the rest. Was that from from the beginning or did it become more data-driven as time went by? It became more data-driven as time went by. I mean, I was not trained as a tropical meteorologist. My background was in air pollution. So I was kind of feeling my way along very carefully, not knowing exactly what I was doing. And I focused mostly on putting storms in a historical context, which is something I really like doing. And to this day, that's kind of my forte is putting extreme weather events in historical context. You know, how unusual is this?

How extreme is this? So, yeah, as time went on, I gradually learned more and more and got more technical because I wanted to share with people just what I was understanding and, you know, make it so they can make their own forecast, draw their own conclusions. Right, which I've always appreciated. I felt that. So you succeeded in that because I would read the stuff and make my own conclusions of, you know, not from a weather standpoint, but like, okay, this could build and you kind of had that probability as well function of this could become something much more dangerous than currently getting credit for and what I'd like to do is I like to take people to other sites I mean what you see typically at back in the day

whether sites would only showcase their own stuff. But I wanted to really take people, okay, here's, you know, this researcher with the Hurricane Research Division of NOAA and what they're doing. Here's what the National Weather Service says. Here's what a colleague at a university is doing. Really tried to make it to show you, you know, the cutting edge stuff that was happening in all of meteorology, to get people excited about research going on, and get people to understand about how climate change was affecting storms. So let's talk about that a little bit of the research that's going on in the modeling. I saw your post a while back on how successful were the 2019 models and kind of analyzing the tracking error, so to speak.

So maybe first just give us a general overview of what those models are doing, who came up with them, and we can dig in from there. Okay. We've got about five or six main computer models that are used by the National Hurricane Center to generate their forecasts. They're singular. So is it an ensemble of those five, you're saying? Well, typically, if you look at the National Hurricane Center forecast they put out, it's never all that different from if you average together four or five of these top models. It's called a consensus forecasting technique. And it's one of the things that they learned over the past 20 years as to how to make a better forecast. Don't rely on one model. Take a combination of models,

average them together, maybe throw out one that's kind of an outlier. And if you go with that, then you can make a really successful forecast. And over the past 20 years, NHC has cut down their forecast error by over a factor of two. and that sort of ensemble or consensus forecasting technique is a large reason why. The other reasons why are computer power has improved massively over the last 20 years, and also we've learned a lot more about how to make models of the atmosphere and more about what's going on inside of a hurricane. So improved understanding of the storms. Also factoring into that is improved data from satellites and buoys and ground stations, things like that. So a lot of factors have come together to make these successful forecasts.

So better processing, better inputs, and better modeling equal better outputs. Yeah, and you were asking about what these models are and where they come from. I mean, there's one that comes from the European group. That's the best model out there, the European Center model. The American model is not quite as good, but still pretty top-notch. It's called the GFS model and then we've got some labs run by NOAA like the GFDL lab which does the two of our top intensity models one called hwrf and one called the they keep changing the acronyms on me the name escapes me now yeah we're not, we're masters of acronyms.

Yeah, we won't write it down. And so how many inputs are going into these models? It's hundreds or thousands, or is it relatively simple? What, what's it look like? I mean, you've got millions of points of data to, to start out the model. So you subdivide the atmosphere into a grid, a three-dimensional grid, and each of these grid cells is a few kilometers on a side, say 15 kilometers on a side, covering the entire globe, and then vertically in the atmosphere, you've got like 50 or so layers too. So if you multiply all that out, you're talking somewhere, I can't do the math right now, but we're talking millions of different grid points. And each of those different grid points, you have to solve the fundamental physical equations that govern the flow of the atmosphere.

So you're doing these calculations every few seconds and pushing them through time out to seven days or so. And at the very start, you're taking data from satellites, from ships, from aircraft, from ground stations, from buoys, and come up with an initial picture of what the atmosphere is. And that's really a hard problem. And it's something the Europeans are doing the best. It's called data assimilation, because you've got all these heterogeneous sources of data that aren't being taken all at the same time. And you have to get all that together and come up with an initial point for your model to start making its forecast from. So that's kind of an internet of things type of problem, right? Of like, yeah, you have all these connected devices and connected things, but how do I bring all that data into one repository and model it? That's right. So how are you doing that?

It's interesting that a big part of that data source is data from commercial aircraft. And ever since the COVID-19 pandemic hit, we have fewer aircraft up there flying, taking vertical soundings of the atmosphere. And that has degraded the quality of our models over the past six months or so. Really? That's something you don't think about every day. So how does that work? The airplanes are logging that and then it gets downloaded when they land or it's real time going to some real time. They send the data real time. They've got sensors on the most important data. They take our takeoff and landing sounding through the atmosphere. And probably we're seeing, you know, a few percent degradation in the models, maybe as much as five percent in some situations due to that lack of data.

And then the data's all free? Anyone can build a model and use it, right? Or everyone's putting it out there? Or is it government by government? How does that work? Mostly it's free. If you're making your own model, certainly it'll be free. But if you're a commercial entity, then you usually have to pay for the European Center

data. The US data is always free. Any hedge funds reaching out to you saying, hey, can you build a model for us so we can do this on our own? It's a big thing in our space of alternative data is what they call it, right? There's a satellite counting how many cars are in a target parking lot, things like that. But it seems this would be right up their alley of, hey, we're going to build a model that's better than any of them. Yeah, I mean, the data is free and out there, and the techniques are well known. Certainly, you could build a better model with the investment. And it's so funny to me. Why is it called the European model? There's a bunch of Europeans

in a room, or it's like their European weather service or something? Right. It's a consortium. It's called the European Center for Medium-Range Weather Forecasting. And all the countries in the EU got together and provided funding to have this laboratory that goes and runs supercomputers and makes modeling efforts. And this is for the entire climate and weather patterns, not just for hurricanes? It's for the whole world weather patterns, not just for hurricanes? That's for the whole world.

It's not just for hurricanes. It's for all kind of weather forecasts, anything you might want to look at. Okay, so the European model is not just when that hurricane is coming in towards New Orleans, it's going to hit six miles east or west. And the cone of uncertainty, all that is just part of their normal model that's saying there's going to be rain in frankfurt tomorrow yeah i mean it's a global model that's got grid boxes 15 kilometers on a side so all you got to do is look at the 15 kilometer grid box over new orleans where they expect to see a hurricane and there you've got your forecast right but we're

talking so are those different things though than tomorrow's forecast and the intensity models and the hurricane track and the cone of uncertainty, all that? You know, yeah, there are specialized hurricane models. Okay. There are two kinds of models that the National Hurricane Center uses for their hurricane forecasts. What are these so-called global models? Okay. That includes the European model. It includes the American GFS model. Those models subdivide the entire globe into a 3D grid. And those models are also used by everyone to, you know,

make forecasts for wherever they happen to be in the world. But there's also a specialized hurricane model that only zooms in on the hurricane itself. For instance, this HWRF model, it's got a nested grid that goes down to, I think, like a kilometer and a half, zoomed right in around the core of a hurricane. And then it's got another grid of course resolution going out a few hundred miles from the hurricane, and then a third grid at even course resolution covering, you know, most of the globe. So that that's very specialized and they use very special techniques to initialize what the hurricane is doing the european model doesn't have any of that it's not specialized it just runs a forecast for the whole globe and that is and some of these hurricane hunters are

dropping instruments into the eye wall? That's right. The one specialized hurricane model, HWRF, takes data from the hurricane hunters and puts it into its model. And that data, some of it will get into the European model and the global GFS model, but not all of it. So the hurricane hunter data is absolutely critical for making a good intensity forecast. And the best source of intensity forecasts we have is one of, are some of these specialized models that can utilize the hurricane hunter data. And let's talk about that intensity for a minute seems to me from reading your stuff there in my naive view of this all it used to just be all about the wind speed and at least as i've

become more educated on it that's just one of you know three main factors which is the surge the flooding possibility i think we've seen more and more recently right if that storm's just stalled over texas it seems but any area, the flooding is the worst. The rain is the worst threat. So do we need a new scale instead of Cat 5, right? That takes all these pieces into effect? Because it seems like you could have a fast-moving Cat 5 that might hurt a little teeny place on the landfall, but then it's rather a non-event for everywhere else. Whereas you could have a Cat 1 that dumps tons of rain and is a way bigger issue. Absolutely. Yeah, the 1, 2, 3, 4, 5 Saffir-Simpson scale we use to rate hurricanes

is based only on wind and doesn't take into account some of the chief hazards, which can be storm surge and flooding rains. So it's wholly inadequate. We really need to go away from rating it 1, 2, 3, 4, 5, just based on winds. Because as you noted, well, for instance, during Hurricane Harvey, I mean, that stalled for days over Texas and dumped up to 60 inches of rain and caused a hundred plus billion dollar disaster. Most of the time while it was doing that, it was just a tropical storm. So catastrophic impacts and just a tropical storm. Hurricane Florence back in 2018, similarly,

only a category one at landfall, but it also set all time rainfall records in multiple states, 20, 30 inches of rain in some of the Carolinas, and over $20 billion in damage. Again, very slow moving, dumped a lot of rainfall. There really should have been a different warning put out for it. I was saying in my blog, hey, it only says Category 1, but this is a Category 5 flood threat. We really got to come up with a better system of making that known. Yeah, my vote would be basically average the three threats and give that it's a cat four, because it's only a cat one win, but it's the cat five flood event. So we're calling it a cat four,

whatever. Yeah, I mean, the Europeans have a simple system that maybe we could go to. They just got yellow, orange, and red alert. And basically, red alert is unprecedented. So for Florence, we would have given a red alert for North Carolina and said, you know, this is going to be unprecedented rains. You're going to see a rainfall flooding event like you've never seen before. There's these hedge fund world catastrophe bonds. Are you familiar with them? Some, yeah. So essentially the insurance companies don't have the balance sheet or the desire to write all this insurance on all this high-priced real estate in coastal regions. So these financial gurus came around and said, hey, we'll help you sell catastrophe bonds,

which basically the investors in those bonds, if there's no hurricane damage, they'll get a yield and they'll get a return. If there is, they could lose the whole value of the bond. So instead of a company going bankrupt, there's a catastrophe, their bond goes bankrupt. But the fine print there, so in a Florence or a Harvey,

it was flood damage, not hurricane damage. And so the bond doesn't pay. So it seems like a pretty big mismatch between what's trying to be done there. And you've been very good at quoting the financial impacts. Do you see that growing dramatically? Is that because just inflation overall? So I threw a lot at you there, but let's start with the financial impacts. What are you seeing over time?

Yeah, it's a difficult problem to figure out just how much of the increase we're seeing in financial damages is due to storms getting stronger and how much is just due to the fact that more people live by the coast, they have more stuff, and therefore the losses are higher. I think that's the dominant influence, the fact that we're more prosperous, more people are in harm's way, but storms are getting stronger. I mean, it is an expected consequence of climate change. You put more energy into a system, you're going to get stronger events. And particularly with respect to hurricanes, that means higher winds and bigger storm surge and more flooding rains. So yeah, we're already seeing an increase in damages, and that's going to

continue, particularly with respect to storm surge, because not only are the winds that are going to pile up the storm surge get stronger, but we got sea level rise going on too. I mean, it's only about three millimeters per year now, but it's accelerating. And I expect by mid-century, we're going to see sea level rises on the order of a foot, maybe a foot and a half over most of the coast, and stronger storm surges are going to be coming in on top of that, causing incredible amounts of damage. I remember seeing a study by Lloyds of London on Hurricane Sandy's damage in New York City. They found that if it hadn't been for sea level rise over the past century, the storm surge in New York City would have had $2 billion less damage.

So a storm surge can make a big difference in your damages. And how are they calculating these damages, or how do you get those numbers? That's insured losses or just total estimated damage? That's total because insured losses, a lot of people don't have flood insurance, and they aren't required to carry it for places, for instance, behind levy systems where they supposedly have one in 100 year protection. So the National Flood Insurance Program requires you to carry flood insurance if you're going to get a mortgage, if you're in a one in 100 or greater risk area. But those risk areas are not very well delineated now. Those maps are old in a lot of cases.

They haven't been updated for multiple years, even though they're required to be. And they don't give you the true risk because climate change is continually adding to that risk. So there's a lot of flood insurance that isn't being carried. So I always just look at total damages, not insured damages.

It gives you a truer picture of what's going on. Nobody really knows what the total damage, right? It's still some sort of estimate? Yeah, it is. I mean, the rule of thumb that the Hurricane Center always uses is that total damage from a hurricane is double the insured damage. So that's probably within a factor or two, but in some cases it won't be, I'm sure. Do you personally have issues with like the insurers not covering, right? Oh, that was a flood caused by a hurricane. Still seems like it should be covered by your hurricane insurance.

You want to weigh that? threat storms, I mean, it should be made clear what the insurance is for. I mean, yeah, if you're not getting flood coverage as part of your damage, then it invites abuse of the system. Yeah. What about you living in Michigan and we see 10 years of increased activity on the coast and the federal government has to keep rebuilding and bailing these people out, like there's societal issues there. Like why are we covering, why do they keep rebuilding there? And we keep-

Exactly. As a country. I mean, I had a meeting with my rep in the House of Representatives where I brought up to her, hey, you know, we're subsidizing these people to live in risky areas along the coast, us in Michigan. We don't have hurricane exposure here, yet we're taking our tax dollars and paying for people to build on barrier islands, paying for people to build in

floodplains, paying repetitive less lost properties. I mean, I remember reading about one place on Dauphin Island in Alabama, a barrier island offshore, where some of these properties, which are rental properties, the owner doesn't even live there, had been rebuilt four or five, six times over the past 20 years. And the amount of money that taxpayers have put into it are several times the value of the property. It just doesn't make sense. We should be retreating from barrier islands, not rebuilding. That's probably an unpopular opinion in the developer world, right? Yeah, well, it's very unpopular. I mean, politics is king and money talks. But what's going to be happening is pretty soon, we're not going to be able to spend the money to defend everywhere along the coast

that's going to need it. We're going to get storms hitting over wider stretches of coast at higher intensity, causing more damage, and there simply won't be enough money in the pot to rebuild everywhere. I mean, the National Flood Insurance Program is already over $20 billion in debt, and that's after multiple debt forgivenesses over the past few years. So to protect or to rebuild, you're saying, or both? Both. We're going to need to do a lot of protecting. We're going to need to build a lot of seawalls in the future. We already have a few. I mean, New Orleans, they spent $14.6 billion after Katrina to rebuild that levy system. There are several in New England as well that were all built in response to hurricane disasters in the 1950s. Providence, New Bedford,

for example. We're going to need one in Galveston. We're going to need one in Tampa Bay. We're going to need some in Florida. There's going to be a lot of coastal defenses that are going to be needed because if we don't do it, we're going to suffer astronomical losses. But is that even realistic, right? So let's take New Orleans. So they spent $14 billion. What can it withstand? It can withstand a Category 3 hurricane. So basically, it's something that's got a 1 in 100 chance of happening in a given year, which means over a 30-year period, it's got about a 26% chance of happening. So not great protection, but better than it was. So it's questionable whether that money was worth it. I mean, so far it's worked out good. I mean, New Orleans has withstood a

couple of storms since the rebuild, but it's not going to last forever. I mean, it's going to get overwhelmed at some point and we're going to have to abandon New Orleans. Right. And like I grew up in Vero Beach, Florida, which was that 05 or 04 when they had two hits right there. 04, yeah. Yeah. So every year they add sand to the beach, every year it gets swept away and they, right, they kept trying to defend the boardwalk there. I don't know what the cost of taxpayers was there but it was like it's just insanity it seems like of keep adding sand keeps getting washed away um and whole houses our house was on the beach we eventually sold moved awake and it's was maybe 300 feet between the front of the house and the boardwalk down to the beach now is maybe 50 feet, which is just natural

erosion. But that seems insane. And I wanted to touch on one in a hundred year storm. That gets used a lot in finance, and I think incorrectly perhaps. Usually when someone's saying, oh, we could have never foreseen this loss this month. There was a one in a hundred year move in XYZ asset. Do you feel like that's a true thing in the weather and climate, or is it kind of used in the same thing of just kind of meaning unlikely? You know, a better way to look at it is that it's a 1% chance of occurring in a given year. So in a hundred years, odds are it'll happen once. But you have to understand that if you keep on adding together that 1% chance each year, it accumulates. Like I said, over a 30-year period, a 1% chance

yearly event is going to happen at 26% of the time. So that's probably a better way to look at the risk. And the risks aren't stationary, they're shifting. I mean, a one in 100 year storm due to climate change is going to be more like a one in 20 year storm maybe in 30 years from now. It's going to be that bad that the risk will increase because you're making stronger storms. Sea level rise is happening. So the damages are going to go up and we're going to see a lot more damaging storms, one in 100 year storms in the future. But do you think even extreme weather hurricanes are normally distributed? So one in 100 year probability is based on a normal distribution, right? So if we're talking about the height of

people, right, that works. If we're talking about financial markets, it doesn't work, right? One in 100 year things happen way more frequently. The tails are fatter. So I guess is weather, are the tails fatter than what we would expect and what we're building levies based on a one in a hundred year storm? Yeah, the fat tails are the big issue here. It's not the everyday sort of somewhat extreme events. It's the tails that are going to kill us. And those tails are a lot fatter than we think. And there's synergistic effects that we don't understand That are gonna bite us that are making those tails fatter. Let me give you an example. Okay This this summer we had a just insane wildfire event in California and Oregon

We had you know Yeah, still going on really intense drought intense heat, some of the hottest temperatures ever recorded, and bad fires. Okay, well, you'd expect to see that with climate change warming up things and drying out vegetation. Okay, yeah, we're going to get worse fires. But these were so much more worse than even those expectations brought us to believe because of the winds that came. Now, why was it so windy? Well, we had a really unusual jet stream behavior during that event. The jet stream kinked into this position where you had a really intense ridge over the western U.S. and a deep trough over the Rockies. So intense, in fact, that two days after Rapid City, South Dakota,

recorded 102 degrees Fahrenheit, they had snow on the ground. So we're talking weather whiplash of the most extreme variety you can imagine. They don't do climate change in Rapid City, South Dakota, either. No, they don't. Colorado also, they had five, six inches of snow two days after getting 100 degrees. And that extreme event, what it did is generate this really powerful once in a generation sort of wind event over Oregon, where you had incredibly strong tropical storm force winds blowing offshore, fanning these fires, causing the firestorm that we saw in this ridiculous air pollution episode, catastrophic losses. Okay, so why did the jet stream do that? Okay, well, now here's where we get into the synergy between what climate change may be doing to us to fatten the tails of these distributions, these extreme events. For one thing, Arctic sea ice was at its second lowest value on record this year. We saw a massive heat event in Siberia over the summer, ridiculous temperatures. It got to 100

degrees in Siberia for the first time on record this summer, north of the Arctic Circle. All that heat caused a lot of melting and made the Arctic sea ice coverage the second lowest next to 2012. Now, there's a lot of research showing that when you take away that much Arctic sea ice, it has a synergistic effect on the atmosphere and climate that causes the jet stream to do weird stuff. Could it have caused the jet stream to do the weird thing we saw in South Dakota and drive this offshore wind event over Oregon? Perhaps. The jury's still out on that. But what we do know what caused the jet stream to behave that oddly was the fact that there was a huge typhoon that hit South Korea three or four days before that. And that typhoon

moved all the way up into Russia and it caused a ripple effect on the jet stream. So it made the jet stream kind of go boing and cause this oscillation. Okay. Well, typhoons do that all the time, but what was unusual about this typhoon is it was at near record strength because of near record warm waters. In fact, record warm waters off the coast of Japan and Korea. Japan had its hottest temperature on record this summer in August. They hit an all time high over 105 degrees. And those record warm waters caused a near record strength typhoon, which then jumped into the jet stream, causing it to go Boeing, causing this weird oscillation over North America that drove this offshore wind event in this catastrophic firestorm that we saw.

So you're saying it's a complex system. It's a complex system that we're pushing hard in really unknown ways that are going to combine together to cause crazy things that we didn't know could happen. In the financial world, when we talk about these complex systems, we're increasing the fragility, right? So the more complex it is, the more little things can cause something else to break elsewhere, essentially. Yeah. And the complexity is also in the human systems that we have. Now, if we've got, for instance, a pandemic going on, right, that changes our response and our risk and our vulnerability. We didn't see, you know, the pandemic coming. That's caused a lot of troubles that we didn't anticipate in some of these natural disasters that have come at the same time as the pandemic.

There are all these interlocking systems that have failure points that we don't understand, and they're going to come bite us. Favorite hurricane, if that could be such a thing. I don't know. Well, my least favorite was Hugo, obviously, since it nearly killed me. You know, hurricanes are fascinating. And certainly the stronger they are, the more fascinating they are. The one that kind of boggles my mind is Hurricane Patricia of a few years ago, 2016, off the coast of Mexico, 215-mile sustained winds. That's like if there were a Category 7, it would be a Category 7. So that's what we have to look forward to in the future or plan for in the future, more Hurricane Patricius

because eventually one of those is going to form and hit the coast and it's going to be a real eye-opener. I mean, we're talking once it comes in, that's like EF4 tornado damage over a path 30 miles wide, something like that. And that's going to come was in the Gulf of Mexico? No, no, it was in the eastern Pacific off the coast of Mexico. Okay. And it turned out that it weakened right before landfall.

It only hit with 150 mile per hour winds, but still caused a lot of damage. And it didn't hit a very populated section of the coast. But something like that could have just as easily formed in the Gulf of Mexico, hit Tampa Bay or Houston. And the day is coming when we're going to see a half a trillion dollar storm hitting the coast of the US. It's a lot of dollars. Well, it's going to cause a recession. I mean, the day is coming. I mean, Hurricane Katrina was 1% of GDP, and that was a $150-ish billion storm. So think about maybe a 5% GDP storm. That's going to come. And you can't solve that with debt, right? The Fed can't solve a hurricane. The Fed can't. What about some people's idea to detonate a nuclear bomb inside the hurricane?

You know, it seems to me like you'd get a lot of radiation spread all over the world. Probably a bad idea. Plus the fact that hurricanes generate like 100 nuclear bombs of energy per second. The hurricane's just going to look at that and go, huh, what's that?

It's a little pinprick. It's nothing. It's not going to do a thing except cause a mass catastrophe of nuclear contamination. And is there any way to cool down the waters? There is. Yeah, you could potentially cause a hurricane to weaken by running it over an area of ocean where you pump up cold water from deep using pumps at the surface. There have been some modeling studies done on it. It is feasible, but I worry about what's that going to do when there's not a hurricane or how's it going to affect weather patterns. Is it going to cause a drought? It could very well cause circulation patterns that cause drought. Drought is as big a deal as a hurricane,

more so. Like I said, drought is the main enemy of civilization. It's caused more civilization to collapse than any other thing. So you'd get the New Orleans people would vote for a complex system of underground underwater pumps, but the Midwest might say, no thanks,. We need our grain. We need no droughts. Yeah. The day may be coming where we got to resort to the Hail Mary, and that's geoengineering, which we're talking about now, to deliberately modify the climate to reduce the impacts. We can cool down the climate. We can cool down the ocean, reduce hurricane strength. Should we do that? Oh, boy. we don't know what we're doing now.

It's really risky to be deliberately messing with things on that scale. Maybe we'll have to do it to save ourselves, but I sure hope not. I am not an advocate of geoengineering, but I think it's okay to be studying it for now. There's a lot of research being done on it. And, I mean, maybe one of these schemes will work out, spraying salt into the air over the oceans to reflect sunlight and cool the planet, spreading sulfur in the stratosphere to reflect sunlight and cool the planet. These are some of the geoengineering ideas out there and they can work and they would work, but boy, we

better know what we're doing and we better not have any other choice. Okay, that was Dr. Jeff Masters of Yale Climate Connections. Google that and check out his Eye on the Storm blog for more from Jeff. Next, we've got some excerpts from our pod with Chris McCown on the rarely talked about and super interesting world of reinsurance and how betting against hurricanes like this is actually packaged into a yield paying alternative investment. Send it. And that would it be fair to say like in parts of Florida or Louisiana or Texas, like you either couldn't get it, hurricane insurance would be prohibitively expensive for individuals if there weren't reinsurance, if the insurance companies couldn't offset that risk. Yeah, there, over the years, the reinsurance pricing has become part of how insurance companies manage their risk and manage their own pricing.

There are, as you know, in the United States, every state has an insurance commissioner that protects consumers and thinks about the regulatory framework for those insurance companies. So having taken care of that aspect of the business insurance companies, then think about how the pricing of the risk and including the reinsurance price gets passed on to consumers. In some places it's too burdensome, honestly, and states step in. You have states with state mechanisms like Florida and other states have wind pools that are endorsed and sponsored by the states to, but also in most cases to encourage private capital deployment to the extent that we can find that balance. Sometimes there's

not enough price to pass on and they are not insurable. But in those cases, the state steps in. But generally speaking, again, the insurance business strives to rationalize the pricing for the risk and find product that consumers can buy. And then who are the investors? So family offices, pensions, endowments, like big institutional investors we're talking? Yeah. I mean, you think about, so if you wanted to invest in insurance companies, you have a few choices, right? You could be a large private equity firm with a long runway of watching valuation grow, or you could buy a lot of reinsurance companies that are publicly traded. You could buy the public equity too.

That gives you, that's another equity, right, that you're purchasing, or it's a long-term private equity play. To access the actual risk, the investors, as you mentioned, have created and the business has created what we call ILS, insurance-linked securities, which is a broad term. And securities, you need to put in quotes because while some of it is securitized, that is cap bonds, which are 144A securities, a lot of it is not. They're just private transactions that are crafted as securities, but they're not necessarily liquid securities. But the idea is that you as an investor, whether you're a pension fund, a sovereign wealth fund, a family office, a large asset aggregator, can invest specifically in the insurance risk, bypass the market risk, bypass the execution risk, the management risk, and really sort of laser in

focus to say, I want to be exposed to Florida windstorm or Louisiana windstorm, and I will take the premium that you collect as a reinsurer. I'll take a share of that premium and provide you capital to participate in that risk specifically. Right. But yeah, like nobody wakes up and say, I want to be exposed to Texas wind. Right. So they're, they're having, they're saying, oh, I love this constant flow of income. And I know that there's this risk on the other side of it. Right. Yeah. The benefits, I'm sorry, go ahead, Joe. Yeah, go ahead. The benefit to investors is really on the portfolio. It's, it's directionally non-correlating risk. When you think about the classic case we

bring up is 2008. In 2008, with everything going on, and there were losses, by the way, in the insurance business that we had Hurricane Ike in 2008, which was a fairly large hurricane, but it worked in a sense that since it wasn't correlated, the insurance sector and the ILS business did very well in 2008. So it's a protection. I think of it as an investment portfolio protection. And it does create yield. It does create positive premium as well, which is a benefit for the risk that you're taking. But as a proportion or as a component piece, excuse me, of your investment portfolio, it's quite compelling because it is directionally non-correlating to equities, to debt, to other alternatives. And it's super interesting to me because it's essentially what we deal with guys all the time,

selling options, right? You're selling these far out of the money, very unlikely to happen options, collecting a premium, able to reinvest that premium into, like you say, in 2008 would have been great to be getting coupons in to put back into the market at the lows. So I can see the desire for the institutional investors. Yeah, it's just how do you guys view that? If it's a short option, how do you view the probability of it having to pay out? How do the investors view that probability of it having to pay out? Yeah, that's reinsurance. Generally, when you think about collecting all the volatility from the balance sheets of the large insurance companies around the country and around the world, that creates

a very asymmetric business. And so it doesn't lend itself to sort of normal metrics for a lot of investors. It's a bit of a head scratcher to understand because you're collecting a number of tails. You're diversifying, hopefully, those tails, but they are all, you know, so it's a right-sided outcome. So many, many years, eight, nine years out of 10, you're collecting the premium. The one year out of 10, and what makes it challenging is that the one or the one and a half to two years out of 10, whatever it is, you have a loss and, or you think you have a loss. So part of the liquidity premium that you get is because, or illiquidity premium, if that's the way you refer to it, is because you could have a year where you aren't sure that the contract is going to pay,

but your collateral is still held against the risk until it develops fully and is known. And so you can take the losses this year, Hurricane Ida that occurred earlier this year, a lot of complexities to that event that will create a long timeframe in which we will finally understand the full economic impact of that event. So you lose, because it's illiquid, that money stays in the contract until the finality of the underlying reinsurance contract, which could take up to three years. And so they sort out of people's claims and what the damage was actually caused by him. That's right. I was going to save that for later when we talk cap bonds, but I'll dive into it now. Like to me, you wrote, and I read the,

what's the website, the Bermuda AM, whatever, like they're saying reinsurers could lose 20 billion on hurricane Ida, right. You're reading those articles. And then it turns out to be much less usually. whatever, like they're saying reinsurers could lose 20 billion on Hurricane Ida, right? You're reading those articles and then it turns out to be much less usually. And it seems like there's this thing of like, oh, the losses weren't from the hurricane. It was from a flood. That's right. So how does that work?

It seems a little like parlor gamey, but I mean, I guess it's all just contracts are contracts. They delineate what gets paid out and why. They do, although there's still a little bit of flexibility in how the contract wordings can work. And we're learning with every event. But generally, insurance companies expect to pay the claims and have their reinsurers pay, you know, peri-pursuant to how those claims are paid. And, you know, if it's not clear in the contract wording exactly what is covered, what isn't, you know, you can have some issues. But Hurricane Ida is a good example, Jeff, where you've got wind damage

and then you've got flood damage. They happen to, the flood damage is generally seen as the Northeast. It's almost two different events in a way. The Northeast was a flooding event. And then in Louisiana, it was more of a wind event, although there was a lot of rain that was dumped in the state of Louisiana on a very already saturated, unfortunately saturated area of the country that will exacerbate the actual settlement of those claims. So the estimates come out, you're right, the estimates come out from these models that the industry uses and industry sources, centralized industry sources that do a survey of insurance companies and say, you know, this is what we think it might be. But until the claims professionals get on the ground and start settling claims and looking at the property and saying that's water damage, if it's a homeowner's coverage and it's flood, that typically goes into the National Flood Insurance Program and the homeowner's insurance company doesn't pay that. So you have to it kind of claim by claim until you get a clear sense of where the loss sort of manifests itself, whether it's on the insurance policy, whether it's in the flood program run by the federal government.

And that just takes a while to sort out. exacerbated this year because with COVID as everything else, things are slower and the slower it takes, the longer it takes for you to settle a claim, generally speaking, it becomes more costly. You think about if you can get in and assess it quickly and agree with the homeowner or the business owner in what the claim should be paid. But as time goes on, things tend to deteriorate and then the loss can escalate. So the amount of time is a problem because of COVID, because of lack of labor, supply chain disruption, infrastructure issues.

There are all sorts of things that will create a more complex claim outcome in IDA and that's why it's going to take some time to sort out. All right. And then two more on reinsurance. Why Bermuda? Why are all these things in Bermuda? Go ahead. Sorry. Why Bermuda? No, that's okay. I mean, Bermuda became sort of the jurisdiction of choice, really. I mean, not all reinsurance is done in Bermuda, by the way. I guess if you wanted to go all the way back 300 years plus, reinsurance started at Lloyds of London. Lloyds of London still plays a very prominent role, as do a number of large reinsurance companies in Europe, like Munich Re, Swiss Re. But Bermuda became a jurisdiction of choice really

in 1992 after Hurricane Andrew, where the Bermena Monetary Authority is there with a jurisdiction framework, which is very, very strong. It's part of the UK from a court and legal standpoint. And so it was seen as a place that has, it's closer to the United States. It is a low tax environment. So the idea was to write volatile lines of business and attract talent to Bermuda that has then just created a market in and of itself. So the class of 92 was six or seven companies that started. It was a class of 2001, as we call as referred to it. Not as many companies, but larger and more successful companies over time. And then there's a marketplace there with people, with solid regulatory framework. And now it's self-fulfilling almost.

And it's self-fulfilling, exactly. And hence, these were generally the model was private equity built, drive to a certain liquidation event and move on. Along the way, it has also become the place for asset managers who are dedicated to insurance linked securities. So they also have with the stock exchange and the BMA have found a home there to participate in the marketplace alongside the traditional balance sheets. And then what, I don't know if you know, but like Third Point and Greenlight had set up their

reinsurance companies that they were going to invest back into their hedge funds. Is that still a game being played? It is, but it's sort of, I think, less so of a model, honestly, going forward. But the idea is that you can write longer tail lines of, going back to my point, there are lines of insurance about sort of how losses develop over time. I just used a property cat example where it's going to take months and months to understand what Hurricane Ida, but there are liabilities out there that sometimes take years and years to understand. And so, those long tail lines mean you can collect the premium for a number of years,

invest in alternative strategies that get you extra yield on the investment portfolio. And the combination is more powerful. I think I've never worked for that type of a company because I like to focus on the risk on the liability side and I think that you know if you get if you focus and you know you're getting paid for that risk then it's it's a better outcome than trying to minimize that risk but maximize the risk on the asset side and so yeah there are still companies out there pursuing that strategy. But it's mostly now, when I think of a traditional, at least advantage, the balance sheet is very, very conservative, very boring assets, all high level of, sorry, T-bills and short-term duration and very highly liquid. And that's the majority of investment assets that go against the insurance, reinsurance business today. Well, you don't want to get upside down, right?

Like if they were selling short IDA or not IDA, but Ike in 2008 and their hedge fund was down 40%, they've got a cash problem. They've got a cash problem. Yeah. You need to be somewhat, you know, you need to be liquid in the reinsurance business, I guess, it's because you don't know when the events are going to happen. And then that, you know, the contracts are due. So it's, it's, it's hard to get that right, that balance, right. So that's, I think that you've said it's been proven by, you know, the folks who've done, who have tried and continue to try and, you try. We'll see how it all plays out.

And so we mentioned CAT bonds, that's short for catastrophe bonds. That's hurricanes. What else? Does it cover all sorts of catastrophes? Seems like we have an ever increasing number of catastrophes in the world. Yeah, it does, unfortunately. No, they're fairly prescribed in. They rely on a third party objective view of what the risk is. And so there are model vendor models out there that provide that that view of risk. And it's really in places like US hurricane, US quake, some Japanese risk as well, both quake and typhoon. And in certain cases, Europe, it's a more highly concentrated portfolio of risk where there's modeling available and there's third-party validation.

And the pricing is such that it's attractive to cap-on investors. So we advantage, we've already issued a cap-on, for instance, on an industry basis. So you buy it on a derivative basis that those investors are keen to find that yield, but it's very, very limited in terms of what coverage does it afford. So the one structural issue overall with the business is that we talk about insurance companies. You mentioned your insurance company, USA. You think of it's the best rated company, one of the best rated companies in the country. It's got a huge balance sheet.

You add up all those insurance balance sheets. I lost track, but it's somewhere between $2 and $3 trillion. The global reinsurance marketplace is capitalized to about six hundred and sixty billion. And then that secondary market I talked about, the retro market is about one hundred billion. And the cap bond market is is just shy of one hundred billion in notional. Sorry, when I talk about the collateralized reinsurance, the ILS space is about a hundred billion and a portion of that is cap bonds. So what you have is sort of an upside down market really in terms of access to capital because pension funds and just the general

investment community is much larger than what that, you know, that shape of that structure I just referred to. So we need to find ways to bring more investment investors in to grow the business and build a more sustainable structure that's not sort of upside down in terms of a trillion dollars buying from a $660 billion to a $100 billion marketplace. But the cap bonds and the cap bonds are just a portion of that $ hundred billion up until now, at least. We'll help with that. Hey, pensions, instead of selling uncapped variant swaps on the S&P, buy some cap bonds. Sure. Yeah. Yeah. There's a learning curve involved, but, you know, we're doing our all of us are doing our best to try to explain and demystify the business and provide quantitative output that, you know, is comfortable for investors to digest. So speaking of the quantitative output in the modeling.

So right on. I don't know if you can talk specifics of that bond you mentioned or just in general. Like, what are the probabilities that get assigned and what sort of yield are we talking about? And what does all that look like? Yeah, I mean, generally speaking, the cap on market participates even further out the curve than so it's at the tail end of the reinsurance. So they're really picking up what we call expected loss or in our jargon of, you know, very small very small percentage outcomes. So the coupon on that tends to be a single digit, low to mid to upper single digit coupon. It's a floating rate instrument. So you post your collateral, it makes what it does in terms of the underlying asset,

and then you get the coupon above. And so. But that's where it's been oriented. And as I say, it's been very singular in terms of the type of peril that the cap on investors are willing to take. And it's certainly out the curve. It's at the tail end. So it's beyond where the reinsurance marketplace is going to provide efficient capital to its customers. And you mentioned the retrocessional trades. Can I go long these if someone's buying it? Can I go long the outcome? Like most of our, a lot of the people we have on the pod and some of our investors, they want to profit on a left tail event, right?

Like here we're selling short the left tail event. So yeah, I'm just, how can I buy it? Yeah. You can buy it. There are derivative instruments called ILWs, which are industry loss warranties. So you can buy those in an ISDA form that says, you know, I think the likelihood of a Category 5 into Miami is much higher than the industry has priced it at or has modeled it at, excuse me. So, you know, I'd be willing to buy that risk. It's available.

It's a very small market. It's single billions of dollars. And it's a, you'd have to be very patient, right? Because the 1926 hurricane that hit Miami was in 1926. And we all, it seems like everything's happening about every a hundred years. We have a pandemic, it's a hundred years. So maybe we're due in 2026 for the Miami hurricane, but that's, you'd have to be patient on that, on that trade. And what would you be spending? Who knows? 1% a year or some, like, not even that much? No, you'd be spending more than that. You'd be spending more than that.

All right. So, yeah, it doesn't make sense on any normal, realistic time frame. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at RCM Alts and visit our website to read our blog or subscribe to our newsletter at rcmalts.com. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits.

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