Catastrophe Bonds (or CAT Bonds) are high-yield, risk-linked securities used to transfer explicitly to the capital markets major catastrophe exposures such as low probability disastrous losses due to hurricanes and earthquakes. It has a special condition that states that if the issuer (Insurance or Reinsurance Company) suffers a particular predefined catastrophe loss, then payment of interest and/or repayment of principal is either deferred or completely waived. These bonds were first introduced as a solution to problems resulting from traditional insurance market capacity constraints, excessive insurance premia, and insolvency risk due to catastrophic losses.
Catastrophe Bonds or CAT Bonds are complex financial tools which transfer peril specific risks to the capital markets instead of an insurance company. The peril risk is transferred through a complex system of events which include creation of a special purpose vehicle by a sponsor, modeling event scenarios by qualified risk management firms, drafting of a bond contract for investors, marketing the bond to investors i.e. institutional investors, collecting issuance funds from investors, and maintaining issuance funds in a trust established by the sponsor until a triggered loss occurs or bond expiration
Catastrophe Bond Structure
The sponsor of a catastrophe bond is an insurance company, a government agency or any organisation exposed to claims resulting from catastrophe. Catastrophe bonds are issued by a Special Purpose Vehicles (SPV) that has been established by the bond’s sponsors. The SPV’s only purpose is to issue the catastrophe bonds and provide catastrophe coverage for the sponsor.
Once the catastrophe bonds are issued to the investors by the SPV, the sponsor enters a reinsurance or derivative contract with the SPV for which it pays a premium. Then, the bond proceeds from the issuance are deposited into a trust account to collateralize the transaction where the funds are then invested in low risk short-term investments and swapped with a highly-rated counterparty with returns based on the London Interbank Offered Rate (LIBOR) or another acceptable index. This process creates floating rate bonds that are virtually interest rate risk-free.
During the catastrophe bond’s contract term the interest payments made to investors include the premium paid by the sponsor plus returns earned on the bond proceeds. If an event occurs that triggers the coverage, the bond proceeds become available to the sponsor in total or in part and are released from the SPV to assist in the payment of covered claims. If the occurrence triggers only a partial loss to the bond proceeds, then the catastrophe bond face value is reduced and the interest payment to investors is recalculated based on the reduction in bond proceeds. Most catastrophe bond contracts provide for the principal to be entirely at risk: the investors bear the risk that they could lose the entire principal amount and interest payments.
Payments on catastrophe bonds may be triggered in a number of ways, such as:
- An Indemnity trigger is based on the actual losses of the sponsor.
- An Industry Index trigger is based on an industry-wide index of losses.
- A Pure Parametric trigger is based on the actual reported physical event.
- A Parametric Index trigger is a more refined version of a pure parametric trigger using more complicated formulas and more detailed measuring locations
- For Modeled Loss trigger, losses are determined by inputting actual physical parameters into an escrow model which then calculates the loss.
Cat bonds typically have a one-year maturity period. Investors who buy these bonds take a chance that during a particular period a catastrophe may not strike the regions covered by the insurance firm(s) issuing the bonds. If good weather prevails during the period (usually a year), investors win big money. They get back their principal plus a hefty interest payment. On the other hand, if a catastrophe occurs, investors lose their principal amount and get back only the interest earned on their money.
How Catastrophe Bonds Work?
Catastrophe bonds are a form of insurance risk securitisation. They are used to transfer an insurance risk from a sponsor (generally an insurance or reinsurance company) to investors. CAT bonds are not expected to replace reinsurance but rather complement the reinsurance market by providing additional capacity. The mechanism of CAT bonds is explained below.
Let us assume that there is an insurance company, and it has done well in extending its business in say, Michigan. The premium incomes are with the company. It could so happen that a catastrophe in Michigan could lead to claim amounts that could wipe out this insurance company. The conventional method of dealing with such risk would be elements of re-insurance, where part of the premium would be ceded by the insurer to the reinsurers, taking a proportionate amount of risk also off its balance sheet. However, it must be appreciated that there could be some catastrophic events which make even so-called normally anticipated losses are exceeded. To avail of contingent financing for contingent events, the device of CAT Bonds has been innovated. Here, CAT Bonds are issued at a high coupon rate for the contingent amount, to cover the perceived under-financed claim-losses. Catastrophic losses beyond the threshold level trigger the appropriation of CAT Bonds principal proceeds to settle claims, the principal now not being repayable to the CAT Bonds investor. If no claim arises on CAT Bonds, the entire proceeds are refund on expiry of the term of the risk insured against, in which case the interest is a clean profit for the investors. The redemption amount is secured against stream of premium payments, as insurance companies gain credibility (hence business and premium inflows) when they successfully settle claims over a period of time. Thus, CAT Bonds represents the conversion of risk, packaging them into a tradable commodity and garnering capital markets solutions to safeguard against losses from natural calamities.
Catastrophe bonds have made a significant impact on the insurance industry and it is expected that there will be corporate catastrophe bonds in which a non-insurance company will securitize a portion of its risk profile, thus adding a new dimension to the markets. With the success of CAT Bonds, the insurance industry is going in for a major overhaul and in the process, putting investors, insurers and re-insurers on a roll.
- Catastrophe Bonds – The Birth of a New Asset Class (The British Chamber of Commerce Shanghai)