What Are Catastrophe Bonds?

Definition & Examples of Catastrophe Bonds

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Catastrophe bonds are insurance-linked investment securities that can be used to manage risks that are associated with catastrophic events, such as hurricanes or earthquakes. Companies issue catastrophe bonds to insure themselves against major disasters, and investors who buy catastrophe bonds profit if the underlying catastrophe does not occur.

These bonds are unlike conventional bonds and investors would be wise to completely understand them before investing. Here's what potential investors need to know about these unique bonds.

What Are Catastrophe Bonds?

Catastrophe bonds are investment securities that incorporate aspects of insurance products. Companies use these bonds to protect themselves from financial losses in cases of major natural disasters like hurricanes and earthquakes. Investors buy these high-yield bonds in hopes that the underlying disasters don't occur. If the disasters don't occur, they can keep the profits without having to pay to cover the company's disaster-related losses.

  • Alternate name: Cat bond

How Do Catastrophe Bonds Work?

To understand how catastrophe bonds work, it may be helpful to start with a refresher of how bonds work in general. Bonds are debt obligations issued by entities, such as corporations or governments. When you buy an individual bond, you are essentially lending 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, the investor is repaid the full amount of the original investment (the "loan" or the "principal").

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 lifetime of the bond. 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 perspective of the company. From the perspective of the investor, the principal is simply 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 it may cover thunderstorm damage to a specific region.

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

An Example

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.

If two years go by without catastrophe, but then 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 the covered company, and those payments will reduce the interest payments that cat bond investors get. The investor may not get any interest payment that third year.

If the hurricane damages are incredibly severe, then 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 the covered company, then 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 average Treasury bonds.

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

Above all, investors are wise to maintain a properly diversified portfolio of investments that are suitable for the individual investor's objectives and risk tolerance.

How to Get Catastrophe Bonds

Individual investors don't commonly buy cat bonds. Most catastrophe bond investors are 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. Individual investors looking for exposure to cat bonds may consider buying shares in those mutual funds. This way, the investor can hold a basket of many different cat bonds, rather than buying just a handful. This method of mutual fund investing reduces risk 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 other kinds of bonds.
  • If a covered catastrophe occurs, the catastrophe bond investor could lose their entire principal investment.