From Hurricane to Payout: The Lifecycle of a Cat Bond

When a large-scale natural disaster occurs, whether it's a hurricane that rips through a coastal town or an earthquake that devastates an entire country, billions of dollars in damages can occur overnight. When this floodgate opens, insurance companies absorb the influx of claims and are impacted by insured losses. Thankfully, the market has developed ways to help insurers spread this risk of these losses and improve their stability and financial security.

Insurance companies offset these risks by way of reinsurance, which is essentially a method of moving prospective losses outside of the company to protect itself. And one such method of reinsurance protection is through the issuance of catastrophe (“cat”) bonds.

So what is the lifecycle of a cat bond? Let’s take a look:

Transferring Risk to Investors

A cat bond is created long before the threat of a devastating event and its subsequent damages. When an insurance or reinsurance company or municipality (etc.) wants to protect itself from the potential of large-scale losses, it looks to create a special purpose vehicle (SPV) which can then issue bonds to investors. On the backend, the insurer pays premiums into the bond. The SPV, then, issues bonds that inventors can buy - which in turns helps supply capital to the SPV and essentially supports the insured-loss coverage that the SPV was created to provide (if needed).

Length of Investment

If an investor is interested in a cat bond, they typically invest for a period of three to five years, which balances the insurer’s coverage needs and the investor’s desire to limit exposure to unpredictable natural events. (Many cat bonds do have some secondary market liquidity, though, and can exchange hands as buyers and sellers create supply and demand.)

There are a few reasons most cat bonds mature within this 3-5 year period.

• Catastrophe risk is seasonal and cyclical. Natural disasters tend to have seasonal patterns (like how Atlantic hurricanes peak between June and November). A cat bonds’ multi-year structure gives insurers consistent protection without having to negotiate each year, and investors get a steady yield stream while limiting exposure to a finite amount of time. 
• Alignment with insurance and reinsurance contracts. While most insurance and reinsurance contracts are renewed annually, those tied to catastrophic event protection typically cover a few years at a time; cat bonds sync with those timelines in turn.

Cat bonds are intended to be designed in such a way that there are mutual benefits for both the issuers and the investors.

When Disaster Strikes

Every cat bond has specific conditions that can activate it, allowing the SPV to access investor funds that will be used by the issuer to cover event-driven losses. These triggers may be based on the insurer’s actual losses, damages sustained across the industry, or by physical parameters, such as hurricane wind speed or earthquake magnitude. 

If an event meets or exceeds these requirements, some or all of the bond’s principal is transferred from the SPV to the insurer to help pay claims.

The Outcome: Risk and Reward

If no qualifying event occurs and the cat bond’s term lapses, the investor receives their full principal back plus a floating-rate interest and a risk premium. (This is in addition to the regular coupons they have received as they’ve owned the bond, which aim to provide a steady yield for investors.)

Cat bonds have become a powerful vehicle for insurers to tap into in an effort to protect their financial future, while giving investors an exciting opportunity to accumulate high yields and own bonds that don’t add to more common market-related risk exposures like in most other areas of the fixed income landscape. However, it’s important for investors to understand the risks they’re taking when investing in cat bonds as well as the duration they’ll be exposed to those potential risks.

Sources:

Brookmont Capital Management Internal Research.

Artemis, “What is a Catastrophe Bond”.

CAIA, “Cat Bonds, An Important New Financial Instrument”.

Federal Reserve Bank of Chicago, “Catastrophe Bonds, A Primer and Retrospective”

Finra, “Insurance Linked Securities”