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.
BREAKING DOWN Act of God Bond
An act of God bond provides insurance companies a mechanism to exchange a portion of earned premiums for debt funding contingent upon an unexpected disaster. Catastrophic events occur unpredictably. This makes it 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 independent 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. 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.
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 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 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.