Catastrophe Bond
AdvancedA catastrophe bond is a type of bond, usually issued for an insurer or reinsurer, that pays investors a high interest rate but can lose some or all of its principal if a specified disaster, such as a major hurricane or earthquake, occurs.
Catastrophe bonds, often called cat bonds, transfer the risk of large natural disasters from insurers to investors in capital markets. The money raised is held in a secure account. If no qualifying disaster occurs during the bond's life, investors receive interest and their principal back. If a qualifying disaster occurs, part or all of the principal is used to pay the insurer's claims.
Triggers vary. Some pay out based on the insurer's actual losses, some on industry-wide losses, and others on physical measures, such as earthquake magnitude or wind speed at a specific location.
For example, an insurer might issue a three-year catastrophe bond covering hurricane losses in a particular region above a certain level. Investors receive a high yield, but would lose their principal if a severe hurricane caused losses above the trigger.
Catastrophe bonds attract investors because disaster risk is largely unrelated to financial market movements, offering diversification. The market has grown significantly since the 1990s. Investors face the risk of large, sudden losses, and climate change makes estimating disaster risk more uncertain.
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