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Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. They are often structured as floating-rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They 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 they might wish to pass some of this risk on so that they can remain solvent after a large hurricane. They could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or they could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, they would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus 4%. If no hurricane hit Florida, then the investors made a healthy return on their investment. But if a hurricane hits Florida and triggers the cat bond, then the principal initially paid by the investors is forgiven, and is instead used by the sponsor to pay their claims to policyholders.
Investors
Investors choose to invest in cat bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification. Investors also buy cat bonds because the bonds can pay a relatively healthy coupon (as long as they are not triggered).
Ratings
Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A cat bond is rated based on its probability of default due to an earthquake or hurricane triggering loss of principal. This probability is determined with the use of catastrophe models. Many cat bonds are rated BB+ by S&P, which is just below investment grade.
Trigger types
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 million, then the bond is triggered.
Modeled loss: instead of dealing with the company's actual claims, an exposure portfolio is constructed for use with catastrophe modeling software, and then when there is a large event, the event parameters are run against the exposure database in the cat model. If the modeled losses are above a specified threshold, the bond is triggered.
Indexed to industry loss: instead of adding up the insurer's claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS.
Parametric: instead of being based on any claims (the insurer's actual claims, the modeled claims, or the industry's claims), the trigger is indexed to the natural hazard caused by nature. So the parameter would be the windspeed (for a hurricane bond), the ground acceleration (for an earthquake bond), or whatever is appropriate for the peril. Data for this parameter is collected at multiple reporting stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered.
Market Participants
Examples of cat bond sponsors include insurers, reinsurers, and government agencies.
Examples of cat bond investors include institutional investors, insurers, reinsurers, and hedge funds.
Examples of investment banking groups that are active in the issuance and secondary market trading of cat bonds are Aon Capital Markets, BNP Paribas, Goldman Sachs, Lehman Brothers, MMC Securities Corp. (an operating unit of the Marsh and McLennan Companies) and Swiss Re Capital Markets.
See also
"Catastrophe bond"