What Is a Catastrophe Bond – CAT?

A catastrophe bond (CAT) is a high-yield debt instrument designed to raise money for companies in the insurance industry in the event of a devastating natural disaster. A CAT bond allows the issuer to receive funding from the bond only if specific conditions occur such as an earthquake or tornado. However, if the special event protected by the bond triggers the payout to the insurance company, the obligation to pay interest and repay the principal is either deferred or completely forgiven.

CAT bonds have short maturities not exceeding three to five years. The primary investors in these securities are hedge funds, pension funds, and other institutional investors.

Catastrophe Bonds Explained

Catastrophe bonds are used by property and casualty insurers as well as reinsurance companies to transfer risk to investors. First marketed in the 1990s, these bonds provide insurance and reinsurance companies with another method to defer risk associated with underwriting policies.

In return, institutional investors receive a higher interest rate than most fixed-income securities over the life of the bond, which could have a maturity of up to five years.

CAT bonds are a type of insurance-linked security (ILS)—an umbrella term for financial securities that are linked to pre-specified events or insurance-related risks. CAT bonds are only paid to the insurance company if a triggering event happens.

Key Takeaways

  • A catastrophe bond (CAT) is a high-yield debt instrument designed to raise money for companies in the insurance industry in the event of a natural disaster.
  • A CAT bond allows the issuer to receive bond payment only if the specific conditions—such as an earthquake or tornado—happen.
  • Investors receive a higher interest rate than most fixed-income securities over the life of the bond.
  • If the special event triggers a payout, the obligation to pay interest and return the principal is either deferred or completely forgiven.

Pay Outs From CAT Bonds

When the bonds are issued, the proceeds raised from investors go into a secure collateral account. The secured funds might be invested in other, various low-risk securities. Interest payments to investors—usually at a higher rate than other fixed-income products—come from the secure collateral account.

A CAT bond might be structured so that the payout only occurs if total natural disaster costs exceed a specific dollar amount over the specified coverage period. Bonds may also be pegged to the strength of a storm or earthquake or the number of events such as more than five named hurricanes striking Texas. If a series of natural disasters happen the payout to the insurance company is triggered. The insurance company receives bond proceeds from the secure collateral account.

Investors lose their principal if the costs of the covered natural disasters exceed the total dollar amount raised from the bond issuance, and stored in the secured account. However, if the costs to cover the disaster do not exceed the specified amount during the bond's lifetime, investors get the return of their principal at the bond's maturity. The investor also benefits from receiving the regular interest payments in return for holding the bond.

Catastrophe Bond Benefits

The interest rates paid by CAT bonds are not usually linked to the financial markets or economic conditions. In this way, CAT bonds offer investors stable interest payments even in times when interest rates are low and traditional bonds are offering lower yields. Further, institutional investors may use CAT bonds to help diversify economic and market risk for a portfolio. The reduction of portfolio risk comes from these investments not necessarily correlating to economic performance or stock market moves.

CAT bonds offer a competitive yield compared to other fixed-income bonds and dividend-paying stocks. Investors in CAT bonds receive fixed interest payments over the life of the bond. Also, the maturities of the bonds are typically short-term decreasing the likelihood of a triggering event.

CAT bonds benefit the insurance industry since the capital raised lowers their out-of-pocket costs for natural disaster coverage. CAT bonds also provide insurance companies with much-needed cash when they need it the most preventing them from going into bankruptcy due to a natural disaster. As a result, insurance companies have more cash on their balance sheets that could be used to issue additional insurance policies.

Pros

  • CAT bonds can offer investors stable, high-yield interest payments over the life of the bonds

  • CAT bonds can help diversify a portfolio since natural disasters don't correlate to moves in the stock market

  • CAT bonds have short maturities of one-to-five years reducing the risk of a payout to the insurance company and loss of principal

Cons

  • CAT bonds have risk of losing the principal amount invested if a payment is triggered to the insurance company

  • Natural disasters can occur during stock market declines and recessions, which can reduce the diversification benefit of CAT bonds

  • The short-term maturities of CAT bonds might not reduce the probability of a triggering event if the frequency and costs of natural disasters increases

Catastrophe Bond Risks

Although CAT bonds reduce risk to insurance companies, the risk is borne by the buyers of the securities. The risk of losing the principal amount invested is mitigated somewhat by the short maturity of the bonds.

According to the Insurance Information Institute (III), 2017 was a costly year for insurers. Worldwide they experience a total loss of US$330 billion from 710 events. In comparison, during the previous year losses from natural disasters were only $184 billion. Hurricanes and floods have comprised of the vast majority of the costliest natural disasters in U.S. history. Considering the costs can run into the billions of dollars, investors holding CAT bonds are at risk of losing all or part of their investment. Investors need to weigh the risks versus the return of the attractive yields offered by CAT bonds.

CAT bonds can offer diversification from economic and market risk since natural disasters don't usually correlate with economic events and stock market movements. However, there could be exceptions if a natural disaster caused a recession and subsequently a stock market decline. Investors holding CAT bonds would be at risk of losing their principal if the event triggered a payment to the insurance company. If the triggering event occurs during a recession, the consequences could be compounded if some of the investors lose their job and source of income while also losing their investment in the CAT bond.

Real World Example of a Catastrophe Bond

As an example, let's say State Farm Insurance, one of the largest insurance companies in the U.S., issues a CAT bond. The bond has a $1,000 face value, matures in two years and pays a 6.5% interest rate each year to investors. An investor who buys the CAT bond will be paid $65 each year while the principle will be returned at maturity. The proceeds raised from the issuance total $100 million and are placed in a special account.

The bond is structured so that a payout to State Farm only occurs if the total of natural disaster costs exceeds $300 million for the two years. Any remaining funds are returned to investors at the bond's maturity.

During the course of the second year, a series of natural disasters occur, and the total costs are $550 million. The payout to State Farm is triggered, and $100 million is transferred to the insurance company from the special account.

Investors who held a $1,000 CAT bond earned $65 in interest in year one and lost their principal in year two. State Farm reduced their cost for the natural disasters from $550 million to $450 million by issuing the CAT bond.