CAT Bonds

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Key Takeaways:‍

• CAT bonds were introduced in the 1990s after Hurricane Andrew caused billions of dollars' worth of damage to insured properties, stretching the insurance industry thin.
• CAT bonds pay the issuer when a specified disaster risk, such as an earthquake or hurricane of a particular size, takes place.
• Unlike traditional reinsurance, CAT bonds attract a diverse set of investors by offering unique benefits as financial instruments uncorrelated with the broader markets.

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“Who watches the watchdogs?” is a common refrain when it comes to regulators. But when it comes to natural disasters, the better question is: who insures the insurers?

Catastrophe bonds, known as CAT bonds, offer one answer. In 1992, Hurricane Andrew caused over $15.5 billion in insured property loss, causing sixteen insurance companies to go bankrupt. This devastation prompted the insurance industry to think more critically about how to protect itself from catastrophes like hurricanes. Insurers could, of course, purchase traditional catastrophe reinsurance. But in Andrew’s wake, the industry was undercapitalized across the board: demand had soared for ways to protect against the risks associated with natural disasters, while insurers’ ability to offer coverage remained highly limited. CAT bonds, which were first issued in 1997, offered one solution by transferring the risk out of the insurance industry entirely—namely, to investors instead.

Let’s say you’re an insurer, and you want to prevent the next Hurricane Andrew from causing you to go bankrupt. To issue a CAT bond, you would issue bonds that pay you (the issuer) when a predefined disaster risk—for instance, a tsunami causing $100 million in losses—is realized. You would do so through an investment bank, who would then sell the bonds to investors. If no catastrophe occurs, great! You simply pay a fee to the investor. But if the specified catastrophe does occur, you are protected: per the terms of the bond, the investor would forgive the principal, at which point you, as the insurance company, could use that money to pay your claim holders.

Investors gravitate towards such bonds for a few reasons. First, CAT bonds typically carry high interest rates to incentivize investors to pick these bonds over similar corporate instruments. Additionally, CAT bonds are relatively uncorrelated with the returns of other common financial market instruments, meaning they represent a unique method of diversifying portfolios. Finally, by attracting a diverse set of investors—from hedge funds to sovereign wealth funds to pension funds to mutual funds—CAT bonds compete with traditional reinsurance prices, preventing premiums from skyrocketing and increasing the total capital available to reallocate the risks of natural disasters.

Moreover, as global warming exacerbates the risk and rate of natural disasters, CAT bonds are only growing more attractive. Just as in regular futures market, traders have the opportunity to capitalize on their ability to correctly forecast future events—including perhaps the next Hurricane Andrew.

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