Catastrophe Bond

A catastrophe bond, or cat bond, is a debt security through which an insurer, reinsurer, government or company passes the financial risk of a specified disaster to capital market investors. Investors receive a relatively high coupon. If a qualifying event such as a major hurricane or earthquake occurs during the life of the bond, some or all of their principal is used to pay the sponsor, and they lose that amount.

Cat bonds are the best-known form of insurance-linked securities. They developed in the mid-1990s, after Hurricane Andrew in 1992 and the Northridge earthquake in 1994 caused losses that strained the capacity of the reinsurance market. For sponsors they supplement traditional reinsurance; for investors they offer returns that do not depend on the economic cycle.

The sponsor sets up a special purpose vehicle, usually in a jurisdiction with a dedicated regime such as Bermuda, the Cayman Islands or Ireland. The vehicle enters into a reinsurance contract with the sponsor, under which it agrees to pay if the defined event occurs, and receives regular premiums in return. It funds this promise by issuing bonds to investors.

The money raised is placed in a collateral account and invested in very safe assets, such as a money market fund holding government securities. Investors are paid a coupon made up of the return on the collateral plus the premium from the sponsor, so the bond behaves like a floating-rate note with a large spread. If no trigger event occurs before maturity, typically three to five years, the collateral is released and investors are repaid in full. If one occurs, collateral is paid to the sponsor and the bond's principal is written down by the same amount.

Because the cover is fully funded from the start, the sponsor does not depend on a reinsurer's ability to pay after a disaster.

The definition of the event that causes a loss is the most important term of the bond. Four main types are used:

• Indemnity. The bond pays according to the sponsor's own actual losses above a set level. This matches the sponsor's needs most closely but requires investors to trust its underwriting and claims handling, and settlement can be slow.
• Industry loss. Payment depends on the total insured loss for the whole market from an event, as estimated by an independent reporting agency.
• Parametric. Payment depends on measured physical characteristics, such as wind speed or earthquake magnitude at defined locations. It is fast and transparent.
• Modelled loss. The event's physical parameters are run through an agreed catastrophe model to produce a notional loss.

Triggers other than indemnity leave the sponsor with basis risk: the bond may pay less than its real losses, or not at all, even after a damaging event. Bonds may cover a single event or the aggregate of events over a year, and cover begins only above an attachment point, in the same way as excess of loss reinsurance.

Most sponsors are insurers and reinsurers managing peak exposures, especially United States hurricane and earthquake, European windstorm and Japanese typhoon and earthquake. Reinsurers use cat bonds as a form of retrocession. Public bodies also sponsor them: state-backed insurance pools in the United States, and governments of countries exposed to earthquakes and storms, in several cases through bonds arranged by the World Bank.

Buyers are specialist insurance-linked funds, pension funds, hedge funds, asset managers and reinsurers. The bonds are sold privately to qualified institutional buyers. The main attraction is diversification: whether a hurricane strikes has little to do with share prices or interest rates, so cat bonds tend to hold their value when other assets fall.

Each bond is analysed by an independent modelling firm, which estimates the probability that investors will suffer a loss and the expected loss as a percentage of principal. The coupon spread is set as a multiple of that expected loss, so that investors earn a risk premium for bearing an infrequent but severe risk. Spreads rise after years with heavy losses, when capital is scarce, and fall when it is plentiful.

Returns are highly skewed. In most years investors collect the full coupon; in a bad year they can lose most or all of their investment in a bond. Other risks include errors in catastrophe models, the possible effect of climate change on the frequency and severity of events, long delays in determining losses under indemnity triggers, and limited trading in the secondary market. A credit rating, where one is assigned, is usually below investment grade and reflects the modelled chance of a trigger, not the sponsor's creditworthiness.

The technique has been extended beyond natural disasters to extreme mortality, pandemic, cyber and terrorism risks, with mixed results. A pandemic bond issued by the World Bank in 2017 was criticised when its payout after the outbreak of COVID-19 proved slow and small relative to need.

Insurers that sponsor cat bonds can count the protection when calculating their regulatory capital, provided the transfer of risk is effective and the collateral secure. Related instruments include collateralised reinsurance, industry loss warranties and the weather derivative, which pays on temperature or rainfall and is used mainly by energy and agricultural companies.