Catastrophe Bond (CAT) Meaning, Benefits, Risk, Example

What Is a Catastrophe Bond (CAT)?

A catastrophe bond (CAT) is a high-yield debt instrument that is designed to raise money for companies in the insurance industry in the event of a natural disaster. A CAT bond allows the issuer to receive funding from the bond only if specific conditions, such as an earthquake or tornado, occur. If an event protected by the bond activates a payout to the insurance company, the obligation to pay interest and repay the principal is either deferred or completely forgiven.

CAT bonds have short maturity dates of between three-to-five years. The primary investors in these securities are hedge funds, pension funds, and other institutional investors.

Understanding Catastrophe Bonds

Catastrophe bonds are used by property and casualty insurers as well as reinsurance companies to transfer risk to investors. First marketed in the 1990s, these bonds offer insurance and reinsurance companies another way of offsetting the risk associated with underwriting policies. Institutional investors can receive a higher interest rate from CAT bonds than from most other fixed-income securities.

CAT bonds are a type of insurance-linked security (ILS)—an umbrella term for financial securities that are linked to pre-specified events or insurance-related risks. CAT bonds are paid to insurance companies only if a catastrophe—that is protected by the bond—occurs.

How CAT Bond Payouts Work

When CAT bonds are issued, the proceeds raised from investors go into a secure collateral account, where they may be invested in various other low-risk securities. Interest payments to investors come from the secure collateral account.

A CAT bond might be structured so that the payout occurs only if the total natural disaster costs exceed a specific dollar amount over the specified coverage period. Bonds also can be pegged to the strength of a storm or earthquake, or to the number of events, such as more than five named hurricanes striking Texas. A series of natural disasters would trigger a payout to the insurance company, which funds also would come from the secure collateral account.

Investors would lose their principal if the costs of the covered natural disasters exceed the total dollar amount raised from the bond issuance. However, if the costs to cover the disaster do not exceed the specified amount during the bond's lifetime, investors would get their principal returned at the bond's maturity. The investor also would benefit from receiving the regular interest payments in return for holding the bond.

The Benefits and Risks of CAT Bonds

Potential Benefits

The interest rates paid by CAT bonds are not usually linked to the financial markets or economic conditions. In this way, CAT bonds offer investors stable interest payments even when interest rates are low and traditional bonds are offering lower yields. Further, institutional investors may use CAT bonds to help diversify a portfolio to protect against economic and market risk. The reason for this potentially reduced risk is that these investments do not necessarily correlate to economic performance or stock market moves.

CAT bonds offer a competitive yield compared to other fixed-income bonds and dividend-paying stocks. Investors in CAT bonds receive fixed interest payments over the life of the bond. Also, because these bonds' maturities are typically short-term, there is less probability that an event triggering payout would occur.

CAT bonds benefit the insurance industry because the capital raised lowers their out-of-pocket costs for natural disaster coverage. CAT bonds also provide insurance companies with cash when they need it the most, which could prevent them from needing to file for bankruptcy because of a natural disaster.

Potential Risks

Although CAT bonds can reduce risk to insurance companies, the risk is borne by the buyers of the securities. The risk of losing the principal amount invested is mitigated somewhat by the short maturity of the bonds.

According to the Insurance Information Institute, in 2019 overall losses from world-wide natural catastrophes totaled $150 billion dollars, which was roughly in line with the inflation-adjusted average of the past-30 years, and down from $186 billion in 2018. In 2019, 820 events caused losses, compared with 850 events in 2018. Insured losses from the 2019 events totaled $52 billion, down from $86 billion in 2018. So, although overall losses were down in 2019 versus 2018, the costs from damages can run into the billions of dollars, and investors holding CAT bonds are at risk of losing all or part of their investment. Investors need to weigh the risks versus the returns of the attractive yields offered by CAT bonds.

CAT bonds can offer diversification from economic and market risk because natural disasters don't usually correlate with economic events and stock market movements. However, there could be exceptions if a natural disaster were to cause a recession and subsequently a stock market decline. Investors holding CAT bonds would be at risk of losing their principal if the disastrous event spurred a payment to the insurance company. However, if the catastrophic event occurred during a recession, the consequences could be compounded if some of the investors also lost their sources of income (jobs) concurrent with losing their investment in the CAT bond.

Example of a Catastrophe Bond

Let's say that State Farm Insurance, one of the largest mutual insurance companies in the United States, issues a CAT bond. The bond has a $1,000 face value, matures in two years, and pays an annual interest rate of 6.5%. An investor who buys the CAT bond will receive $65 each year and the principal will be returned at maturity. Issuance of the CAT bond raised $100 million in proceeds, which was placed in a special account.

• The bond is structured so that a payout to State Farm occurs only if the total natural disaster costs exceed $300 million for the two years. Any remaining funds would be returned to investors at the bond's maturity.
• During the course of the second year, a series of natural disasters occur for a total cost of $550 million. This activates the payout to State Farm, and $100 million is transferred to the insurance company from the special account.
• Investors who held a $1,000 CAT bond earned $65 in interest in year one then lost their principal in year two. State Farm reduced their cost for the natural disasters from $550 million to $450 million by issuing the CAT bond.