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 Insurance

    Insurance to protect businesses and residences against natural ...
  2. Catastrophe Excess Reinsurance

    Insurance for catastrophe insurers. Because of the unpredictable ...
  3. Insurance Derivative

    A financial instrument that derives its value from an underlying ...
  4. Reinsurance

    The practice of insurers transferring portions of risk portfolios ...
  5. Reinsurer

    A company that provides financial protection to insurance companies. ...
  6. Hourly Clauses

    A clause in a reinsurance contract requiring the time at which ...
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

    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.
  7. 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 ...
  8. Insurance

    Extreme Mortality Bonds: High Risk and High Reward

    Insurance companies issue extreme mortality bonds to cover their losses in the event of a large-scale disaster. Here's a look into these high-risk, high-reward bonds.
  9. Investing

    How to Manage Risk With Bonds in Your Portfolio

    Bonds are not immune to risk, so be sure to diversify your portfolio with proper asset allocation.
RELATED FAQS
  1. 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 >>
  2. 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 >>
Hot Definitions
  1. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  2. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  3. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  4. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  6. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
Trading Center