What is a catastrophe bond (or cat bond)?

Catastrophe bonds, also called cat bonds, are an example of insurance securitization to create risk-linked securities which transfer a specific set of risks (generally catastrophe and natural disaster risks) from an issuer or sponsor to investors. In this way investors take on the risks of a specified catastrophe or event occuring in return for attractive rates of investment. Should a qualifying catastrophe or event occur the investors will lose the principle they invested and the issuer (often insurance or reinsurance companies) will receive that money to cover their losses.

Catastrophe bonds were first issued in the mid 1990's, we have a comprehensive list and details of all catastrophe bond transactions. Major catastrophe events which hit the U.S. such as the Northridge eartquake and Hurricane Andrew were seen as events of such magnitude that the insurance industry began to look for alternative methods to hedge their risks and through collaboration with capital markets companies catastrophe bonds were born.

One of the key elements of any catastrophe bond is the terms under which the securities begin to experience a loss. Catastrophe bonds utilise triggers with defined parameters which have to be met to start accumulating losses. Only when these specific conditions are met do investors begin to lose their investment. Triggers can be structured in many ways from a sliding scale of actual losses experienced by the issuer (indemnity) to a trigger which is activated when industry wide losses from an event hit a certain point (industry loss trigger) to an index of weather or disaster conditions which means actual catastrophe conditions above a certain severity trigger a loss (parametric index trigger).

Some catastrophe bond transactions work on a multiple loss approach and so are only triggered (or portions of the deals are) by second and subsequent events. This means that issuers can issue a deal that will only be triggered by a second landfalling hurricane to hit a certain geographical location, for example.

Catastrophe modelling is vital to catastrophe bond transactions to provide analysis and measurement of events which could cause a loss as well as to define the exposed geographical region.

Catastrophe bond structures have been used to hedge risks of hurricane, earthquake, typhoon, European windstorm, thunderstorm, hail and even life insurance related risks such as longevity and health insurance claims.

Read about recent and historic catastrophe bond transactions.

Keep up with the latest catastrophe bond news on our blog.