Catastrophe bond
Catastrophe bonds are a subset of insurance-linked securities that transfer a specified set of risks from a sponsor to investors. If a specified catastrophe occurs, the bond pays the invested principal to the sponsors as a way of funding the recovery from the disaster; otherwise, it pays the investors a return.
They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake. Catastrophe bonds emerged from a need by insurance and reinsurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damage that they could not cover with the invested premiums. Though present since the 1990s, the increases in disaster risk related to climate change caused many governments and insurance companies to turn to cat bonds when reinsurance is not available or too expensive.
In order to create a bond, an insurance company issues bonds through an investment bank, which are then sold to investors, such as hedge funds or other kinds of investment vehicles. Catastrophe bonds are non-investment grade corporate bonds with floating interest rates, and have an average maturity of 3 years with some up to 5 years but are uncommon. If no catastrophe occurred, the insurance company would pay a coupon to the investors. But if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. If triggered, the principal is paid by the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of SOFR plus a spread. If no hurricane hits Florida, then the investors will make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors. Investors include hedge funds, ILS-dedicated funds, pension plans, insurance companies, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met.
History
The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Kenneth Froot, and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market. The first experimental transactions were completed in the mid-1990s by AIG, Hannover Re, St. Paul Re, and USAA.The market grew to $1–2 billion of issuance per year for the 1998–2001 period, and over $2 billion per year following 9/11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of reinsurance sidecars. Issuance continued to increase through 2007, despite the passing of the post-Katrina "hard market", as a number of insurers sought diversification of coverage through the market, including State Farm, Allstate, Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Following the Tohoku Earthquake and April 27, 2011 Super Outbreak, issuance hovered around $6–8 billion per year from 2012–2016. In 2017, Hurricanes Harvey, Irma, and Maria all impacted the market. This spurred yet another increase in issuance, now to the $10 billion per year mark. At year end 2023, Swiss Re Capital Markets estimates the market size is $43.1 billion with a record $15.4 billion issued in 2023 alone.
The cat bond market has withstood a multitude of catastrophes, both natural and manmade. These include September 11 attacks, Hurricane Katrina, the 2008 financial crisis, 2011 Tōhoku earthquake and tsunami, Hurricanes Harvey, Irma, and Maria, the COVID-19 pandemic, Hurricane Ida, and Hurricane Ian. Following each of these events, the market has increased the volume of primary issuance. Moreover, it is estimated that the market suffers from a historical loss rate between 2.69% and 3.00%. This loss rate is generally quite close to the estimated loss rate given by the catastrophe models broadly used in the market.
Investors
Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates than comparably rated corporate instruments, as long as they are not triggered.Key categories of investors who participate in this market include hedge funds, ILS-dedicated funds, and asset managers. Life insurers, reinsurers, banks, pension funds, and other investors have also participated in offerings.
A number of specialized fund managers play a significant role in the sector, including Fermat Capital Management, K2 Advisors, Leadenhall Capital Partners, Nephila Capital, Aeolus Capital Management, Elementum Advisors, Schroder Investment Management, Neuberger Berman ILS, Twelve Capital, AXA Investment Managers, Plenum Investments, and Tangency Capital. Several mutual fund and hedge fund managers also invest in catastrophe bonds, among them Stone Ridge Asset Management, Amundi US, and PIMCO.
Ratings
Cat bonds are sometimes rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to a qualifying catastrophe triggering loss of principal. This probability is determined with the use of catastrophe models. Most catastrophe bonds are rated below investment grade, and the various rating agencies have adopted moved the view that securities generally must require multiple events before an occurrence of a loss in order to be rated investment grade.For all cat bonds regardless of rating, a third-party modeling agent is hired as part of the transaction. This agent will generate a risk analysis of the bond taking into account the underlying structure of the notes using a catastrophe model. This risk analysis will generate an attachment probability, an expected loss probability, and an exhaustion probability. The two most commonly utilized modeling firms are Verisk AIR, and Moody's RMS.
Structure
Most catastrophe bonds are issued by special purpose reinsurance companies domiciled in the Cayman Islands, Bermuda, or Ireland. These companies typically participate in one or more reinsurance treaties to protect buyers, most commonly insurers or reinsurers. This contract may be structured as a derivative in cases in which it is "triggered" by one or more indices or event parameters, rather than losses of the cedant or retrocedent. Cat bonds are generally issued under rule 144A and are commonly listed on the Bermuda Stock Exchange.Cover types
The sponsor and investment bank that structures the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorized into four basic cover types. The cover types listed first are more correlated to the actual losses of the insurer sponsoring the cat bond. The cover types listed farther down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investors would not have to worry about the insurer's claims adjustment practices.Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance.
Modeled loss: instead of dealing with the company's actual claims, an exposure portfolio is constructed for use with catastrophe modeling software, and then when there is a large event, the event parameters are run against the exposure database in the cat model.
Industry toss: instead of adding up the insurer's claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS or PERILS. "Modified index" linked securities customize the index to a company's own book of business by weighting the index results for various territories and lines of business. Common "modified index" structures are the state-weighted industry loss and the county-weighted industry loss.
Parametric: instead of being based on any claims, the trigger is indexed to the natural hazard caused by nature. So the parameter would be the windspeed, the ground acceleration, or whatever is appropriate for the peril. Data for this parameter is collected at multiple reporting stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered.
Parametric index: Many firms are uncomfortable with pure parametric bonds due to the lack of correlation with actual loss. For instance, a bond may pay out based on the wind speed at 50 of the 150 stations mentioned above, but the insurer loses very little money because a majority of their exposure is concentrated in other locations. Models can give an approximation of loss as a function of the speed at differing locations, which are then used to give a payout function for the bond. These function as hybrid Parametric / Modeled loss bonds, and have lowered basis risk as well as more transparency.