Why Buffett is steering clear of catastrophe bonds - by Gillian Tett

When Warren Buffett held his annual shareholders meeting last weekend in Nebraska, investors obsessively discussed everything that the Sage of Omaha said about the equity market and his succession plans. 

But another intriguing issue, buried deep in corporate filings, went largely ignored: Berkshire Hathaway has quietly "constrained the volume of business" it does in the reinsurance world because of "management's assessment of the adequacy of premium rates". In plain English, this means Mr Buffett is more reluctant to insure people against natural disasters – because it no longer pays. 

Investors and central bankers alike should take note.

In part, cat bonds appeal because they offer better returns than the current ultra-low yields on risky corporate bonds. But they have another attractive feature: they are seen as "uncorrelated" with other asset classes. This is highly prized since the 2008 financial crisis, when many markets fell in tandem, making it hard to hedge risks. 

But as investors have rushed in, the inevitable has occurred: yields have plunged. The average yield in recent months on a basket of cat bonds has hovered just over 5 per cent, about half the level seen two years ago. In some ways this is good news: falling yields helped cut the cost of buying insurance for consumers by about 15 per cent last year. The fact that the insurance sector is gathering a diversified pool of capital could make it more resilient. So much so that Jay Gelb of Barclays Capital says "alternative capital", such as pension funds, could in the coming years represent "up to 30 per cent" of the $300bn US property catastrophe reinsurance market, up from 15 per cent today. 

But the key, as ever, is risk and reward. Many investors rushing to embrace cat bonds have never seen these instruments produce big losses; for while Superstorm Sandy caused damage two years ago, Florida and California have recently escaped severe shocks. This sense of relative calm means that investors seem unconcerned about the sharp fall in yields. Experienced insurers such as Mr Buffett, however, think this looks complacent; to them, the returns have fallen too low, in this era of low interest rates, to justify taking on catastrophe risk. 

Of course, that might mean Mr Buffett and his like are being too conservative; more likely, it suggests pension funds could face a shock if or when the next disaster hits. Either way, it is a reminder of how easy money can create unexpected consequences.