What Is an Act of God Bond?
An act of God bond is an insurance-linked security issued by an insurance company to establish a reserve against unforeseen catastrophic events. Act of God bonds can help insurers raise funds since it can be challenging building enough reserves or money to cover the costs of large-scale disasters. However, act of God bonds have embedded contingencies in which investors could lose a portion or all of their original investment if a major disaster occurs.
- An act of God bond is a debt instrument that insurers issue to establish a financial reserve to fund claims from catastrophic events.
- The repayment terms for act of God bonds are contingent on whether or not an unforeseen catastrophic event occurs.
- Due to the high risk of default, issuers offer higher yields than bondholders would receive for other types of debt securities.
How an Act of God Bond Works
Insurance companies offer policies to their customers to hedge against their risk of financial losses. An insurance policy might cover losses that result from damage to the insured's property or limit the insured's liability (resulting from sued) for injury or damage caused to a third party or another person.
In return, policyholders pay the insurance company a fee or premium, which is usually paid monthly. Insurance companies invest those premiums and earn income. If an insurance claim is filed by a customer, meaning some financial loss occurred, the insurer pays the customer according to the policy. If a major event occurs, many claims could be filed in a short period of time. As a result, insurers might issue an act of God bond to raise money to strengthen their reserves.
A bond is an I.O.U. or a debt instrument that's issued to raise money for various purposes. Corporations, governments, and insurance companies issue bonds when they need access to capital or money. Typically, an investor who buys the bond pays the company the principal amount upfront (i.e., $1,000), which is called the face value of the bond. In return, the company pays the investor a fixed interest rate over the life of the bond.
At the bond's maturity or expiration date, the investor is paid back the principal amount, or the original amount, that was invested. Bond investors take on risk since the company could default or not pay back the principal amount. Typically, the greater the chance of default, the higher the interest rate paid by the bond since investors command a better return for bonds with the added default risk.
When insurance companies issue act of God bonds, they make their repayment terms contingent on whether or not an unforeseen catastrophic event occurs over the life of the bond. In the event of a disaster, bondholders forego part or all of their expected repayment. As an enticement to take on such an unpredictable and potentially high risk, issuers typically offer higher yields than bondholders would receive for other types of debt securities.
Benefits of Act of God Bonds
An act of God bond provides insurance companies with a mechanism to exchange a portion of earned premiums for debt funding contingent upon an unexpected disaster. Catastrophic events occur unpredictably. As a result, it can be difficult for insurance companies to establish reserves to cover one-off, large-scale disasters.
Such disasters incur high costs for insurance companies, but they occur independently of other variables that make other types of insurance claim costs relatively foreseeable. Act of God bonds offer an alternative to establishing a needlessly high reserve to cover potential disaster payouts that may not occur in the near future.
Paying for Catastrophes
A widespread, large-scale natural disaster creates massive issues for insurers. For example, a large hurricane can generate flooding, structural damage, and automobile losses, in addition to the loss of life, all of which can cause claim volumes to jump well above any normal actuarial expectation. The high volume of claims in a short period of time could potentially exceed the reserves insurance companies have available to pay claims.
Act of God bonds serve as a contingent loan. Suppose an investor has interest in a high-yielding debt instrument and can tolerate the risk of a natural disaster over the next three years. A major insurance carrier issues a round of catastrophe bonds at an average coupon significantly higher than the three-year Treasury yield, and the investor makes a purchase.
During the duration of the bond, the insurer will use a portion of the premium payments it collects to make coupon payments to bondholders. Coupon payments generally include both interest and a portion of the principal, as opposed to a normal bond that would return principal only on the maturity date.
If no catastrophes take place over the next three years, by the maturity date of the bond the investor will have received all the original principal plus interest at the designated coupon yield. If a disaster strikes, however, the investor will forfeit some portion of the remaining payments based upon the amount of funding necessary for the insurer to cover claim losses. Given the structure of such bonds and the amounts involved, catastrophic events that cut into principal repayment tend to be relatively rare, though they can and do happen.