How Cat Bonds Work—and Our Investable Universe

A cat bond is typically structured as a floating rate bond whose principal is impaired if losses associated with a catastrophic event exceeds a predefined limit. Investors are paid a premium for assuming the reinsurance risk in a cat bond and can potentially earn attractive yields relative to other investments.

 

The Cat Bond Universe

We look across the entire cat bond universe, which is typically tracked by the Swiss Re Global Cat Bond Index. We consider cat bonds across three regions—North America, Europe and Asia. The bonds we consider generally fall within one of the four following categories for risk:

  1. Wind-related risks, such as hurricanes and European windstorms.
  2. Earthquake risk.
  3. Life and health risks, which are associated with mortality from various causes.

Multi-peril risk, which applies to cat bonds that cover multiple catastrophic events.

Cat Bond Triggers and Event-Loss Determination

Every cat bond has a different definition of what counts for an event that could trigger a loss. That definition is called an “event trigger.”

Triggers are defined within the terms of the underlying reinsurance contract that specifies the peril—such as a hurricane, earthquake or flood—and the geographic region, such as the United States or Japan.

Most triggers fall into the following categories:

  1. Indemnity triggers, which are based on an insurer’s book of business.
  2. Index triggers, which take effect when industry losses for a certain region exceed a specified level.

Parametric (or statistical) triggers, which are based on statistical assessments of loss.

Cat Bonds and Insurance-Linked Securities

Cat bonds are a subset of the broader asset class of securitized reinsurance called insurance-linked securities (ILS).

Cat bonds are typically linked to the most remote risks of an insurer, such as hurricanes or earthquakes in densely populated areas of the United States. In contrast, other ILS securities are linked to a broader range of coverage risks up and down an insurer’s so-called “risk tower” beyond just the remote layer.

Other ILS types can help to offer additional diversification, but they’re structured differently from cat bonds because the risks they cover may be too small to be transferred to investors through bonds.

How Do Cat Bonds Compare with High-Yield Bonds?

Both cat bonds and high-yield bonds can potentially deliver substantial spreads over U.S. Treasuries in exchange for higher risk. And, like high-yield bonds, cat bonds have the potential to default if the underlying asset sustains a major loss.

However, there are three key differences between the two types of bonds.

1. Frequency and severity of events

High-yield bonds are generally tied to market and economic cycles that have usually lasted about 10 years. On the other hand, cat bonds are tied to low probability catastrophic disasters. As a result, the frequency of loss from high-yield bonds is greater than it is for cat bonds.

2. Volatility

The second major difference between cat bonds and high-yield bonds concerns their volatility profiles. Because economic downturns and financial crises happen more often than major natural catastrophes, high-yield bonds have historically defaulted more frequently than cat bonds.

3. Liquidity

For both cat bonds and high-yield bonds, the ratio of trading volume to outstanding overall issuance—or market size—is generally about 1%. However, cat bonds are a significantly smaller market than their high-yield counterparts. The smaller capacity and scale of the cat bond market can limit trade volumes, whereas the high-yield credit market can accommodate larger allocations, given its bigger size.

5 Factors that Can Affect Cat Bond Prices

Five key factors typically affect cat bond prices:

  1. Catastrophic events, which could trigger a loss.
  2. Extension features, which present cat bondholders with the risk of having capital unexpectedly locked up for a longer period of time at a lower interest rate, during which the bond may also default.
  3. Redemption features, which present the risk of an issuer exercising the right to call a bond prior to maturity for whatever reason that benefits the issuer economically.
  4. Issuance volume, which can cause price weakness right before new cat bonds hit the market.

Seasonal weather patterns, which may decrease or increase the probability of a catastrophic event occurring.