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Catastrophe bond



Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. They are often structured as floating-rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They are typically used by insurers as an alternative to traditional catastrophe reinsurance.


 


For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then they might wish to pass some of this risk on so that they can remain solvent after a large hurricane. They could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or they could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, they would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus anywhere from 3 to 20%. If no hurricane hit Florida, then the investors made a healthy return on their investment. But if a hurricane hits Florida and triggers the cat bond, then the principal initially paid by the investors is forgiven, and is instead used by the sponsor to pay their claims to policyholders.


History

The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market. The first experimental transactions were completed in the mid-1990's by AIG, Hannover Re, St. Paul Re and USAA. The market grew to $1-2 billion of issuance per year for the 1998-2001 period, and over $2 billion per year following 9-11. Issuance has doubled again to a run rate of approximately $4 billion on an annual basis in the period following Hurricane Katrina, and has been accompanied by the development of Reinsurance Sidecars.


Investors

Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments as long as they are not triggered.


Ratings

Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to an earthquake or hurricane triggering loss of principal. This probability is determined with the use of catastrophe models. Most catastrophe bonds are rated below investment grade (BB and B category ratings) and the various rating agencies have recently moved toward a view that securities must require multiple events before occurrence of a loss in order to be rated investment grade.


Market Participants

Examples of cat bond sponsors include insurers, reinsurers, corporations and government agencies. Over time, frequent issuers have included USAA, Hartford, Swiss Re, Munich Re, SCOR, Hannover and Tokio Marine & Fire.


 


To date, all direct catastrophe bond investors have been institutional investors since all broadly distributed transactions have been distributed in that format. These have included specialized catastrophe bond funds, hedge funds, investment advisors (money managers), life insurers, reinsurers, pension funds and others. Individual investors have generally purchased such securities through specialized funds.


 


Examples of investment banking groups that are active in the issuance of catastrophe bonds are Aon Capital Markets, BNP Paribas, Goldman Sachs, Lehman Brothers,and Swiss Re Capital Markets. Some of these groups also make secondary markets in these bonds.

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