Catastrophe bond

Catastrophe bonds (also known as cat bonds) are a subset of insurance-linked securities (ILS) that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.

Catastrophe bonds emerged from a need by (re)insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not cover with the invested premiums. An insurance company issues bonds through an investment bank, which are then sold to investors. Catastrophe bonds are non-investment grade (roughly equivalent to B or BB),^[1][2] and have an average maturity of 3 years but range from 1-year Zero-Coupon Notes to 5 year interest-bearing notes.^[3][4] If no catastrophe occurred, the insurance company would pay a coupon to the investors. But if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. Investors include hedge funds, ILS-dedicated funds, pension plans, (re)insurance companies, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered, the principal is paid by the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds 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 it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of SOFR plus a spread. If no hurricane hits Florida, then the investors will make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors.^[5]

Michael Moriarty, Deputy Superintendent of the New York State Insurance Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance securitizations through cat bonds in the United States instead of off-shore, through encouraging two different methods—protected cells and special purpose reinsurance vehicles.^[6] In August 2007 Michael Lewis, the author of Liar's Poker and Moneyball, wrote an article about catastrophe bonds that appeared in The New York Times Magazine, titled "In Nature's Casino."^[7]