Catastrophe Bonds

Catastrophe bonds, which were developed in the mid 1990s, are risk-linked securities issued by insurance or reinsurance companies. The return an investor receives from holding these bonds is linked to the incidence of a pre-specified catastrophe within a particular time period. The occurrence of the catastrophic event triggers the loss of the investor’s principal, which passes to the insurance company and helps them pay claims arising in the aftermath of the disaster. On the other hand, if the insured event fails to take place within the predetermined period (a more likely scenario) the investor earns a good return on their bond – usually between 8% and 15%.

Catastrophe bonds can be designed to cover any natural disaster. Some popular issuances

As there is a chance that investors may lose their principal investment, catastrophe bonds tend not to be investment grade. Bonds triggered by extremely unlikely combinations of events – known as multiperil cat bonds – are often an exception to this rule, as the reduced likelihood of losses leads them to be rated more favorably.

The catastrophe bond market currently has around US$13 billion of capital outstanding – a mere fraction of the total debt outstanding on the worldwide bond market. Despite the limited market depth there is a secondary market in catastrophe bonds which trades daily and provides a reasonable level of liquidity. However, the spread on catastrophe bonds is relatively large compared to that on conventional assets, and while it is possible for sophisticated investors to access the catastrophe bond market through specialist funds or via the secondary market, this asset class is currently inaccessible for smaller investors.

2. History

1990-2000: Innovation and an Emerging

This reflects a fundamental characteristic of Cat Bonds; they are about specific risks (or combinations of risks) within one or more defined geographic areas. This could be considered strength as well as a weakness. However it is fundamental to isolate the insurance risk and make the bonds interesting to investors. Interest from institutional investors has increased with a growing market. In 2013, the first large scale deals were closed in UK with pension funds buying large shares in Cat Bond funds.

3. Types of CAT Bond

The sponsor and investment bank who structure the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorized into four basic trigger types. The trigger types listed first are more correlated to the actual losses of the insurer sponsoring the cat bond. The trigger types listed farther down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investors would not have to worry about the insurer's claims adjustment practices.

Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance. If the layer specified in the cat bond is $100 million excess of $500 million, and the total claims add up to more than $500