How cat bonds work
- Cat bonds are issued by a specially formed company that takes out an insurance agreement with the risk carrier (sponsor). This construction reduces counterparty risk for both the investor and the sponsor.
- The money invested in the cat bond acts as a security for the insurance agreement and investors get interest on the investments and a premium on the insurance agreement.
- Cat bonds can be issued with several different trigger mechanisms.
How a cat bond works
A cat bond transfers insurance risks from the risk carrier (usually an insurance company, but it could also be a country or a regional government) to the financial markets. The investor provides capital that acts as a security for the insurance and in return receives interest. To protect both the investor and the risk carrier the investment is placed in a Special Purpose Vehicle (SPV) that has as its sole purpose to manage the security and to pay claims to the risk carrier if the terms of the insurance are fulfilled. There is a reinsurance agreement between the SPV and the risk carrier that defines the terms and conditions that must be fulfilled in order for some or the whole security to be paid out.
In the picture above the investor (1) places the security in the SPV, which in turn invests the security in low-risk money market instruments. The most common investments are short-term government bonds and especially American T-bills. During the term of the bond, the investor receives income in the form of a coupon that is usually paid every third month. This consists of a small return on the security and the premiums paid by the risk carrier (2). When the insurance agreement runs out the bond matures and the security is repaid (3) to the investor, assuming that the insurance conditions have not been met. The bond normally matures after three years, but there are bonds with both shorter and longer terms.
The use of an SPV is meant to protect both the investor and the risk carrier. The risk carrier does not issue the cat bond itself, but instead creates a special company for this that is normally called a sponsor for a cat bond. For the investor the SPV means that other risks are limited, such as that the risk carrier goes bankrupt or is subject to other losses. For the sponsor the SPV means that the security is ear-marked and available if the natural catastrophe the insurance is designed to cover actually occurs
The insurance agreement
There is a reinsurance agreement between the SPV and the sponsor. This specifies in detail the terms and conditions for when the insurance will cover a claim and which triggers will activate the policy. These each have specific advantages and disadvantages.
The most common agreements today cover the sponsor’s indemnity for the natural catastrophe where the insurance will pay out once claims pass an agreed level. The alternative type of trigger is based on parametric measures of for example air pressure or wind speed in a specific place regardless of the actual damage incurred. Alternatives are a trigger based on an industry claims index that is an independent calculation of the insurance industry’s losses following an event, and modelled losses, where a mathematical model is used to calculate how large the claims will be.
|Sponsor’s indemnity||Low risk that the reimbursement from cat bonds is larger or smaller than the sponsor’s actual damage costs.||Requires insight into the risk exposure of the sponsor’s insurance stock, which can be complicated and relatively costly. Claims settlement can take longer than for other trigger types. It may entail a more tangible moral hazard than other triggers, as the sponsor, for example, may have weaker incitements to reduce damage costs.|
|Parametric||Transparent to investors and minimizes moral hazard. Claims can be settled fairly quickly. Useful also in regions lacking qualitative data, such as developing economies with low insurance penetration.||High basis risk compared to other trigger types, as the reimbursement from a cat bond is not directly linked to actual damages suffered by the sponsor.|
|Modelled losses||Transparent to the investor and protects the sponsor from investors’ need to gain insight into the sponsor’s insurance stock. Claims settlement can be fairly quick. Relatively lower basis risk than for parametric and industry claims triggers.||Risk that the model over- or underestimates the sponsor’s losses for an insurance event.|
|Industry Claims Index||Transparent to investors, relatively low moral hazard and symmetric information between the investors and the sponsor. Relatively lower basis risk than for parametric triggers.||Relatively high basis risk to the sponsor, as actual costs may be higher or lower than the reimbursements from cat bonds. The risk increases for larger geographical areas.|
|Hybrid||A combination of the advantages of other trigger types.||A combination of the disadvantages of other trigger types.|