- Cat bonds are securities that transfer natural catastrophe insurance risks to the capital market.
- To investors, cat bonds offer an asset class with very low correlation to equity or interest bearing instruments.
- To home and business owners in exposed areas, cat bonds can provide for improved insurance protection, enable investments and supply funding for reconstruction.
What are cat bonds?
Cat bond is an abbreviation of “catastrophe bond”. It is a financial instrument that transfers insurance risks to the capital market, offering investors to deposit money as collateral for a catastrophe insurance. As long as a predefined event (such as a hurricane or an earthquake in a certain place) does not occur, the investor gets a return (coupon) for providing the collateral. If, however, the predefined event occurs, money from the collateral is used to reimburse the issuer of the cat bond to cover, for example, reconstruction or insurance liabilities. If this does not happen, the investor gets the initial investment (the principal) back when the bond matures, usually after three year (though the duration can be shorter as well as longer).
Cat bonds from the investor’s perspective
To investors, cat bonds offer an asset class that is highly uncorrelated with other asset classes, meaning that price variations on cat bonds have little or no connection to price variation for stock equity or corporate bonds. Thus, they improve the diversification of a traditional investment portfolio. Historically, cat bonds have yielded a good risk adjusted return. As the collateral is reinvested, usually in government bonds, cat bonds also provide a certain protection against inflation and increased interest rates.
Cat bonds benefit to individuals and society
To insurers, large catastrophe risks are difficult to handle, as they require a very large amount of capital, not only when they occur, but already when offering the insurances. A large enough catastrophe could jeopardize the entire insurance operation, as was the case in Florida in 1992 (see below). Cat bonds are one solution to this problem by tapping into the vastly larger financial markets. Thus, insurers are able to offer coverage in areas exposed to large natural catastrophes.
Furthermore, cat bonds can be a valuable instrument to provide insurance coverage in developing economies, where the traditional insurance market is weak, and so facilitating investments and economic development.
Cat bond history
In the aftermath of Hurricane Andrew in 1992, eleven insurance companies defaulted and millions of people lost their insurance protection. Furthermore, it became almost impossible to buy policies covering hurricane damages as the Florida insurance and reinsurance market couldn’t bear the risks. Meanwhile, investors on the capital market where searching for investment opportunities with good return and low correlation to traditional asset classes, such as stocks and corporate bonds. In the 1990’s a number of inventions were made to facilitate investments in reinsurance instruments, such as cat bonds, which emerged to be the most successful instrument. the first cat bond was issued in 1997 and the market volume has since year 2000 grown by some 15% annually.