Catastrophe bond

Catastrophe bonds (also known as cat bonds) are a subset of insurance-linked securities (ILS) that transfer a specified set of risks from a sponsor to investors. If a specified catastrophe occurs, the bond pays the invested principal to the sponsors as a way of funding the recovery from the disaster; otherwise, it pays the investors a return.

They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake. Catastrophe bonds emerged from a need by insurance and reinsurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damage that they could not cover with the invested premiums. Though present since the 1990s, the increases in disaster risk related to climate change caused many governments and insurance companies to turn to cat bonds when reinsurance is not available or too expensive.

In order to create a bond, an insurance company issues bonds through an investment bank, which are then sold to investors, such as hedge funds or other kinds of investment vehicles. Catastrophe bonds are non-investment grade corporate bonds (roughly equivalent to B or BB) with floating interest rates, and have an average maturity of 3 years with some up to 5 years but are uncommon. If no catastrophe occurred, the insurance company would pay a coupon to the investors. But if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. If triggered, the principal is paid by the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.

For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of SOFR plus a spread. If no hurricane hits Florida, then the investors will make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors. Investors include hedge funds, ILS-dedicated funds, pension plans, (re)insurance companies, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met.