What Are Catastrophe Bonds?

Definition & Examples of Catastrophe Bonds

Definition

Catastrophe bonds are insurance-linked investment securities that can be used to manage risks associated with catastrophic events, such as hurricanes or earthquakes.

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Definition and Example of Catastrophe Bonds

Catastrophe bonds are investment securities that incorporate aspects of insurance products.

  • Alternate name: Cat bond

Companies use these bonds to protect themselves from financial losses in major natural disasters like hurricanes and earthquakes. Investors buy these high-yield bonds hoping that the underlying disasters don't occur. If the disasters don't happen, they can keep the profits without paying to cover the company's disaster-related losses.

How Do Catastrophe Bonds Work?

To understand how catastrophe bonds work, it may be helpful to start with a refresher on how bonds work in general. Bonds are debt obligations issued by entities, such as corporations or governments. When you buy an individual bond, you essentially lend your money to the entity for a stated period.

In exchange for your loan, the entity will pay you interest until the end of a set date (the bond's "maturity date"). At maturity, you're repaid the full amount of the original investment (the "loan" or the "principal").

Note

Bonds are usually classified by the entity issuing them. T-bills and T-notes come from the U.S. Treasury. Corporations issue "corporate bonds." State and local governments issue "municipal bonds."

In the case of catastrophe bonds, the issuing entity is an insurance company that acts as an intermediary between the company seeking insurance and the investors seeking cat bonds.

Cat bond investors will allow the issuing company to hold their principal in return for interest payments throughout the bond's lifetime. In the event of a covered catastrophe, the issuing company may temporarily halt interest payments, or it may not be responsible for paying back the principal at all. In other words, the principal is "forgiven" from the company's perspective. From the standpoint of the investor, the principal is lost.

Catastrophe bonds can be broad, but they usually cover a specific disaster, and they may also impose a threshold of damages. For instance, a cat bond may cover earthquake damages beyond $10 million or thunderstorm damage in a specific region.

Examples

Consider these examples of a catastrophe bond. The issuing entity, XYZ Insurance Company, issues three-year catastrophe bonds at a par value of $1,000 and annual interest payments of 8%. The bond insures a company from hurricane damages that exceed $1 million. The cat bond investor buys 10 bonds by sending $10,000 to XYZ Insurance Company.

If there isn't a hurricane that affects the insured company, or if the hurricane damages to the company don't exceed $1 million, then the bond works perfectly for the investor. The bond investor gets 8% interest payments every year, or three annual payments of $800 for a total of $2,400. After three years without the underlying catastrophe occurring, the bond matures, and the investor is repaid their initial investment of $10,000.

Note

Like conventional bonds, catastrophe bonds are typically held until maturity.

If two years go by without catastrophe, but a major hurricane hits the covered company in the third year, the investor could be impacted. If the damages exceed $1 million, the insurance company will have to pay out to the covered company, and those payments will reduce the interest payments that cat bond investors get. As a result, the investor may not get any interest payment that third year.

If the hurricane damages are incredibly severe, the covered company may get a massive payout from the insurance company. The money for that payout will not only eat into the investor's interest payment, but it may also eat into the investor's principal. If the insurance company uses all $10,000 of the investor's principal to pay out to the covered company, the cat bond investor loses their entire principal—they only keep the interest payments from the first two years.

Risks of Investing in Cat Bonds

The most obvious risk of investing in catastrophe bonds is that a catastrophe would occur, and the investor may not receive their interest or principal. However, the trade-off for this level of risk is a higher yield than Treasury bonds.

The relatively short maturity periods mitigate some risk, but catastrophic events are even more difficult to forecast than capital markets. Therefore, buying catastrophe bonds is not unlike making a bet that a major catastrophic event will not occur in the next few years. That's like betting against a stock market crash—it's not a matter of if it happens, but when.

Above all, investors are wise to maintain a properly diversified portfolio of investments suitable for their objectives, risk tolerance, and ability to absorb a loss.

How to Get Catastrophe Bonds

Most retail investors don't commonly buy cat bonds. Instead, catastrophe bond investors are generally hedge funds, pension funds, and other institutional investors.

Some mutual fund companies invest in cat bonds by tracking an underlying index like the Swiss Re Cat Bond Performance Index. Retail investors looking for exposure to cat bonds may consider buying shares in mutual funds that include these bonds. This way, the investor can hold a basket of many different cat bonds rather than buying just a handful. This method reduces the risks of cat bond investing through diversification.

Key Takeaways

  • Catastrophe bonds combine elements of bonds and insurance products.
  • Companies can insure themselves against major disasters through catastrophe bonds.
  • Investors can earn higher yields with catastrophe bonds than with other kinds of bonds.
  • If a covered catastrophe occurs, the catastrophe bond investor could lose their entire investment.
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