What is a Catastrophe Bond?
Sometimes referred to as a CAT bond, the catastrophe bond is a type of security in which the risk associated with the issue is transferred from the sponsor or originator of the security to the investors. Essentially, a catastrophe bond creates a situation where the principal of the security is voided if certain specified conditions should occur during the period that the investor remains the holder of the security. It is not unusual for insurers to employ the approach of a security bond as an alternative to utilizing catastrophic reinsurance coverage to cover the risk. One of the best examples of how a catastrophe bond works is to think in terms of providing some degree of protection for the issuer in the event of some natural disaster. For example, the owner of a great deal of property in the American Midwest may wish to issue catastrophe bonds that will provide protection from a financial loss in the event that tornadoes or floods render the properties unusable. A business entity tha
A catastrophe bond, usually abbreviated as a ‘cat bond’ is a mechanism for transferring insurance risk to the capital markets. The cat bond is issued by a Special Purpose Vehicle (SPV) established to support the transaction; the sponsor transfers risk to the SPV through a reinsurance arrangement. The SPV funds itself by issuing a cat bond to the market. Cat bonds are structured so that principal repayment is reduced if certain trigger conditions, usually related to events that would cause significant loss to the sponsor, are met. Sponsors of cat bonds effectively receive a capital injection when it is needed most -immediately following a loss. Cat bonds are typically priced as a spread over the London Interbank Offered Rate (LIBOR) where the spread is determined by market pricing for the risk. The premiums paid by the ceding insurer fully fund the spread plus any other expenses associated with the structure. The proceeds from the issu-ance are placed in a collateral account and invest-
In the current age of grand natural and manmade catastrophes, such as the 2005 hurricanes Katrina and Rita impacts on the Gulf Coast of the USA and 2001 al Qaeda attacks on the World Trade Center and Pentagon, businesses are seeking insurance coverage for future loss events of similar magnitude, which is increasingly difficult to find. Catastrophe bonds, first used in 1996, are a new type of private sector financial instrument that taps into capital markets to help fund payouts to insureds for future grand catastrophes. How do catastrophe bonds work? Suppose that you own a car in, say, Mississippi for which you purchase auto insurance from, say, United Services Automotive Association (USAA). (1) As a car owner with insurance, you are at the base of a triangle of stacked private sector stakeholders who cooperate via various ingenious arrangements to manage the risk (uncertainty) of your car sustaining damage, say, from a future hurricane. The triangle looks something like this (adapted
