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.

Cat bonds are issued through a special purpose vehicle (SPV), which contains a reinsurance agreement with the sponsoring insurance company. The proceeds from the bond sales are invested in a segregated collateral account, such as a highly rated cash or money-market-type investment. The SPV then issues the floating rate note to investors, the default provisions of which mirror the terms of the reinsurance agreement.

The returns for the collateral account, combined with an insurance company’s premium, allow the bond to pay a substantial spread over risk-free, money-market returns as a coupon to the investor. If no cat events trigger the bond’s default under the reinsurance contract’s provisions during the risk period, the SPV returns the principal to investors with the final coupon payment. If an event triggers the default terms of the bonds, all or part of the principal is transferred to the insurance company to help cover the losses. Insurers are still the primary sponsors of cat bonds, followed by reinsurers. But there is an increasing share of public insurers and corporations that want to access alternative reinsurance capital through cat bonds.

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

The next video in this series will explain what bond triggers are—and how they affect price volatility.

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