From the outside, catastrophe bonds might seem complicated and exotic. After all, they are an investment vehicle whose returns are ultimately determined by randomly-occurring natural disaster events. But at a high level, their purpose is straightforward: they help insurance companies measure and transfer risk to capital market investors.
For investors interested in owning cat bonds, it might be helpful to understand how these bonds are created and what happens before they land in a portfolio. In this blog post, we’re going to explore that process.
When an insurer or reinsurer wants to protect against potential losses generated by catastrophes, they don’t sell bonds directly into the capital markets. Instead, they establish a Special Purpose Vehicle (SPV), typically offshore, which in turn issues bonds to investors. The SPV holds the proceeds of these bond sales in a secure collateral account. If a qualifying disaster event occurs, the SPV will use the investor capital from the collateral account to help to offset the insurer’s losses. If no qualifying disaster event occurs over a predetermined period of time, the SPV returns principal back to investors, with high yield floating rate interest. Besides facilitating transactions between issuers and investors, an important purpose of the SPV is to help move disaster risk off of the company’s balance sheet.
Securitization is the method through which the SPV’s underlying assets are packaged into an investible financial product. In the case of cat bonds, the SPV holds the premiums collected by the issuer, and the SPV in turn issues interest-paying bonds to investors. The securitization action here is (in a very simple explanation) the sale of bonds promising the potential for future distributions from the assets held by the SPV…so long as certain events don’t happen that would require the SPV to transfer investor capital back to the issuer to cover anticipated losses.
When an insurer identifies a peril, such as an earthquake in California, they also define the precise conditions under which investors will lose all or part of their investment, and the SPV will need to return the principal to the insurer to cover losses. These conditions - called triggers - are generally very specific.
A trigger is a condition that must be met for the bond to activate and pay out the sponsor. Put another way, when a trigger event occurs, cat bond investors are facing losses as their invested capital is returned to the insurer. They are the levers that will define when the issuer can tap into investors’ capital and to what extent.
There are four main trigger types:
It’s important to note that these triggers are also placed within a coverage layer determined by attachment and detachment points, markers that signal at what loss amount payouts start and stop. The variety and complexity of cat bond triggers are another reason why early cat bond investors were typically sophisticated investors with the resources available to do the adequate research on them prior to allocating.
Understanding how cat bonds are created is important for revealing two truths. First, that cat bonds aren’t simply high-yield bonds – they are insurance-related risks repackaged in bond form. And second, that despite their increasing availability to investors, cat bond investing should be carefully done by knowledgeable specialists who understand their complex structure and variety of potential triggers.