What is a 'Catastrophe Bond - CAT'

A catastrophe bond (CAT) is a high-yield debt instrument that is usually insurance-linked and meant to raise money in case of a catastrophe such as a hurricane or earthquake. It has a special condition that states if the issuer, such as the insurance or reinsurance company, suffers a loss from a particular predefined catastrophe, then its obligation to pay interest and/or repay the principal is either deferred or completely forgiven.

BREAKING DOWN 'Catastrophe Bond - CAT'

CAT bonds are used by property/casualty insurers and reinsurers to transfer risk to investors. This lowers their reinsurance costs and frees up money for the company to invest, including potentially underwriting more insurance. The structure of the CAT bond provides for a payout to the insurance company if a defined event occurs, such as a certain magnitude earthquake or a total insurance loss greater than a particular amount.

Advantages

There are advantages of CAT bonds for investors. These are generally not closely linked with the stock market or economic conditions. The bonds also typically offer a competitive yield compared to their risk, including relative to alternative investments. The low correlation with equities and corporate bonds with insurance risk securitization means the bonds provide diversification benefits.

Risk to Buyers

Although CAT bonds reduce risk to insurance companies, this is borne by the buyers of the securities. It is mitigated somewhat by the short maturity, which is typically three to five years. In the approximately 20-year history of the security, there have been 10 transactions that have resulted in a loss to investors as of April 2016, according to the National Association of Insurance Commissioners (NAIC).

Most Popular Type of Risk

CAT bonds are primarily used by insurance companies to lower hurricane risk in the United States. This accounted for the majority of CAT bonds issued in 2015, according to the NAIC. Standard & Poor's also stated that other new issuances in 2014 and 2015 covered items such as Japanese typhoons and earthquakes, Canadian earthquakes, hurricanes in the Caribbean and health claims payments.

Buyers of CAT Bonds

Traditionally, pension funds have been major buyers of CAT bonds. Other institutions have also been attracted to the market, and the NAIC reported that rates remain marginally higher than corporate bonds as of April 2016. While insurance companies are the issuers of the securities, the insurers invest in CAT bonds on a limited basis for diversification purposes.

Other Insurance-Linked Securities

CAT bonds account for the majority of insurance-linked securities. However, insurers and reinsurance companies also use non-CAT bonds, including life insurance securitization and sidecars.

Life insurance companies use life insurance securitization to reduce their risk, including risk from unexpectedly large payouts stemming from natural disasters, pandemics and other unanticipated events. Sidecars are used primarily by reinsurance companies following natural disasters.

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