What is an Event-Linked Bond
An event-linked bond is a type of bond whose interest and principal payments are determined based on the non-occurrence of certain events that can cause extraordinary losses, such as earthquakes and hurricanes. These bonds transfer some risks from the issuer, in this case insurance companies, to investors. Because of the high level of risk involved, these bonds offer a high rate of potential return. These bonds are also known as catastrophe bonds or cat bonds.
BREAKING DOWN Event-Linked Bond
An event-linked bond means an investor is essentially hedging against the likelihood that certain events will happen. These events are outlined in the prospectus of the bond issue. Event-linked bonds help insurance and reinsurance companies obtain funding. At the same time, these bonds mitigate risks against major claims or catastrophe. This is a way for insurance companies to transfer some of the risks they incur in case of a major catastrophe, which might cause such significant losses that claims might not be able to be covered through the amount collected vis premiums. The insurance company would be the issuer of these bonds, which would typically be managed and sold by an investment bank.
If a specified event, which is usually referred to as a trigger event, should occur, then the holder of the bond could see a loss of all future interest payments or a loss of most principal.
History of Event-Linked Bonds
The popularity of event-linked bonds is expected to increase as home and asset values climb and the strength and frequency of natural disasters increase. Event-linked bonds came on the scene in the mid-1990s as insurance companies and reinsurance companies found themselves looking for ways to offset risks associated with major events, such as damage caused by a major hurricane. In fact, Hurricane Andrew, which struck Florida in 1992 and caused over $20 billion in related claims, is said to have been a major reason behind the existence of these bonds.
More recently, when Hurricane Irma struck Florida in 2017, many financial observers feared massive losses that would have a major impact on event-linked bonds in that region. Fortunately, the initial estimates appeared to be overly pessimistic, so the end result on these bonds was less costly than early predictions. Still, with a series of major catastrophes striking the southeast U.S. and other nearby regions in rapid succession in 2017, this potential for devastating losses may have promoted some investors to reconsider their decision to take a chance with event-linked bonds.