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.

RELATED TERMS
  1. Catastrophe Reinsurance

    Reinsurance purchased by an insurance company that reduces the ...
  2. Insurance Derivative

    A financial instrument that derives its value from an underlying ...
  3. Catastrophe Loss Index - CLI

    An index used in the insurance industry to quantify the magnitude ...
  4. Reinsurer

    A company that provides financial protection to insurance companies. ...
  5. Reinsurance

    The practice of insurers transferring portions of risk portfolios ...
  6. Clash Reinsurance

    A type of reinsurance that provides additional coverage to the ...
Related Articles
  1. Investing

    Elements of Insurable Risks: A Quick Guide

    Explore the elements of insurable risk: due to chance, measurable and definite, predictability, noncatastrophic, random selection and large loss exposure.
  2. Insurance

    Insurance, Excess Insurance and Reinsurance: What's the Difference? (ALL)

    Understanding the differences might help you avoid being overinsured or underinsured.
  3. Insurance

    The Reinsurance Industry: An Inside Look

    Low demand and high regulatory pressures may be problematic for the global reinsurance market following the shrinking margins and declining demand of the first half of 2016.
  4. Investing

    5 Reinsurance Stocks To Watch

    Due to the decline in the reinsurance sector, many stocks within the sector are now trading at historic lows relative to book value. For investors, the time may be right to pounce on the values. ...
  5. Investing

    Event-Linked Bonds: Competing Against A Catastrophe

    These debt instruments can blow new wind into your portfolio, but only if you can handle the risk.
  6. Insurance

    When Things Go Awry, Insurers Get Reinsured

    Guru Warren Buffett is making this sector popular. Learn more here.
  7. Insurance

    Facultative vs. Treaty Reinsurance: Differences and Examples

    Reinsurance companies offer insurance to other insurers in case the traditional insurer does not have enough money to pay claims against its written policies.
  8. Tech

    The Reinsurance Industry: An Inside Look (BRK.A)

    Warren Buffett has a major influence on the global reinsurance market, which has seen momentum in 2016 for higher revenue.
  9. Insurance

    How To Invest In Insurance Companies

    Knowing the special circumstances that insurance companies operate under helps in evaluating whether or not a listed insurance company is a good investment and whether the economic environment ...
RELATED FAQS
  1. What is Warren Buffett's relation to "Supercat" insurance?

    Understand the concept of catastrophe reinsurance and learn how Berkshire Hathaway makes billions providing such insurance ... Read Answer >>
  2. What is the average return on total revenue for the insurance sector?

    Learn about the three main segments of the insurance industry, and find out what the average return on revenues is for the ... Read Answer >>
  3. Who or what is backing municipal bonds?

    Learn about the basics of municipal bonds, including the various revenue sources that are utilized to back or secure municipal ... Read Answer >>
  4. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
  5. What risks do I face when investing in the insurance sector?

    Read about the unique challenges faced by insurers, and learn how those challenges manifest themselves as risks for equity ... Read Answer >>
Hot Definitions
  1. Contango

    A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation ...
  2. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  3. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  4. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  5. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
  6. Impaired Asset

    A company's asset that is worth less on the market than the value listed on the company's balance sheet. This will result ...
Trading Center