A catastrophe bond (CAT) is a high-yield financing instrument designed to help insurance companies raise money in the case of a natural disaster. A CAT bond allows the issuer to obtain funds only if certain events, such as an earthquake or tornado, occur. The need to pay interest and refund the principal is either suspended or totally canceled if an event covered by the bond triggers a payout to the insurance provider.
A CAT bond is issued by WHO?
Since 1997, the catastrophe (CAT) bond market has offered insurance companies with protection against more common and costly natural disasters. This article describes how CAT bonds function before examining how the market has evolved in size, coverage, and sophistication over the last two decades. It also looks at how and why various organizations employ CAT bonds to transfer insurance risks.
The catastrophe bond market arose at a particularly trying time for the property and casualty (P&C) insurance industry. Hurricane Andrew hit Florida and the Gulf Coast in 1992, causing $27 billion in damage, $15.5 billion of which was covered by insurance. 1 Andrew was the most expensive hurricane to ever hit the United States at the time, causing the failure of eight insurance companies and pushing others to the brink of bankruptcy. 2 Insurers reevaluated their risk exposure to coastal locations across the country as a result of the losses sustained during Hurricane Andrew. To account for the likelihood of major losses, homeowners’ insurance costs in coastal districts increased dramatically, and many large insurers and reinsurers3 originally restricted their exposure to catastrophic catastrophes in coastal locations.
A CAT bond is an instrument that pays the issuer if a preset disaster risk occurs, such as a hurricane with insured losses of $500 million or an earthquake with a magnitude of 7.0.
In order to increase insurance capacity, insurers purchased more reinsurance from reinsurers that were not affected by Andrew. Furthermore, state-funded insurance schemes were established to cover a portion of the losses associated with catastrophic disasters. The demand for natural-disaster insurance by consumers and businesses, on the other hand, necessitated the infusion of new capital into reinsurance. The insurance sector invented a new financial instrument called a catastrophe bond to augment available cash. A CAT bond is an instrument that pays the issuer if a preset disaster risk occurs, such as a hurricane with insured losses of $500 million or an earthquake with a magnitude of 7.0. (on the Richter scale). 4 In 1997, the first CAT bonds were issued, giving insurers access to broader financial markets and providing institutional investors, such as hedge funds, pension funds, and mutual funds, with the opportunity to earn an attractive return on investment uncorrelated with other financial market instruments in exchange for taking on catastrophe insurance risks.
This Chicago Fed Letter explains how catastrophe bonds function, how the CAT bond market has evolved over the last two decades, and how and why insurers, reinsurers, and state catastrophe funds use them.
How CAT bonds work: The case of Mariah Re Ltd.
Let’s look at a CAT bond issued by Mariah Re Ltd. on behalf of American Family Mutual Insurance Co. (AFMI) in November 2010 to see how they function. Mariah Re Ltd. was a special-purpose vehicle (SPV) that served as a conduit between CAT bond investors and AFMI, the CAT bond issuer (see figure 1). This agreement allowed AFMI to move insurance risks from its balance sheet to investors, notably those associated to severe thunderstorms and tornadoes across the United States. If the anticipated losses to the P&C insurance sector from severe thunderstorms and tornadoes across the United States surpassed $825 million, AFMI was entitled to up to $100 million in compensation. The bond’s attachment point is the contractually agreed-upon threshold. AFMI would get $1 for every $1 of additional covered losses up to the $100 million limit after the $825 million attachment point was reached. Over the bond’s three-year tenure, investors received a 6.25 percent yearly coupon in exchange for taking on this risk. 5
Catastrophe bond structure
Mariah Re Ltd. facilitated the catastrophe risk transfer between AFMI and the CAT bond’s holders as the SPV in this arrangement by arranging the financial transfers between the two parties (see figure 1). Investors that acquired the bond collectively gave the SPV with $100 million in cash (i.e., the bond’s principle) to be utilized if payouts to AFMI were due, according to the conditions of the contract. The proceeds from the bond sales were then put in a Treasury money market fund. In exchange, AFMI provided the SPV with annual premiums of $6.25 million (0.0625 $100 million), which were passed on to the investors along with the profits on the invested capital from the Treasury money market fund. If no payouts to AFMI were required, the $100 million in proceeds would have been liquidated from the collateral account and returned to investors at the end of the bond’s three-year period. Investors in the Mariah Re Ltd. CAT bond, on the other hand, were not so fortunate.
When multiple tornadoes struck the Southeast and Midwest in the spring of 2011, the Mariah Re Ltd. venture swiftly went south for investors. In the months of April and May alone, 983 tornadoes struck the United States, resulting in 498 deaths and $21 billion in damage. 6
The amount of P&C insurance sector damages covered under the contract was determined by AIR Worldwide, an impartial third-party catastrophe modeler. Losses quickly built up during the 2011 tornado season, which was the deadliest and most expensive in US history, according to the National Oceanic and Atmospheric Administration; by October 31, AIR Worldwide’s estimate of industry losses had reached $836.6 million. Given the bond’s attachment point of $825 million, this meant investors would lose at least $11.6 million in principal. The problem exacerbated for investors on November 28, 2011, when AIR Worldwide revised the designation for damages caused by a Kansas storm from “non-metro” to “metro.” Because AIR Worldwide’s industry loss projections gave metro-area losses a larger weighting, expected industry losses increased to $954.6 million, wiping out the investors’ equity and giving AFMI the full $100 million in loss coverage provided under the transaction. 7
The advantages of CAT bonds
Catastrophic bonds are a type of reinsurance that allows insurers to shift catastrophe risk to a larger group of investors. But why do insurers utilize CAT bonds in the first place, and what makes them attractive to investors?
Insurers are interested in CAT bonds for a variety of reasons. CAT bonds are 100 percent collateralized and constructed to remove counterparty risk, unlike typical reinsurance, where the reinsurer may fail to pay up following a loss event. Today’s most popular structure involves depositing investment funds in a secure collateral account and then investing cash from that account in Treasury money market instruments (again, see figure 1). CAT bonds also allow for multiyear commitments, although typical reinsurance contracts are only for a year. Issuers of CAT bonds can lock in prices for a long time with a multiyear commitment. Finally, CAT bonds have reduced the costs of diversifying insurers’ natural disaster risk exposure: CAT bonds lower reinsurance prices (and price volatility) by attracting alternative sources of capital (e.g., hedge funds, sovereign wealth funds, pension funds, and mutual funds) to compete with traditional reinsurance (typically backed by equity capital from reinsurers’ shareholders). This increases the total capital available for the transfer of insurance risks. 8
The appeal of CAT bonds to investors is twofold. To begin with, CAT bonds’ returns are essentially uncorrelated with those of other financial market instruments. Hurricanes and tornadoes have little to no correlation with economic and financial activities. CAT bond prices were practically untouched by the financial crisis. The price collapse of CAT bonds with Lehman Brothers as a counterparty was a remarkable exception. 9 However, there are also instances where CAT bond losses occur together with a broader economic crisis. If a huge earthquake struck the San Francisco Bay Area, for example, there could be significant losses on many catastrophe bonds as well as significant declines in stock prices. Second, CAT bonds have historically produced high yields, which has aided in attracting other sources of money to the insurance markets. 10
The development of the CAT bond market
The CAT bond market has evolved from a modest element of the insurance landscape to a critical tool for controlling insured natural disaster losses over the last 20 years. While Hurricane Andrew in 1992 prompted the establishment of the CAT bond market in 1997, it has been shaped by three major events since then: Hurricane Katrina in 2005, the financial crisis of 2008, and the post-crisis low-interest-rate period.
Hurricane Katrina, the worst natural disaster in US history, caused the first major upheaval in the CAT bond market. CAT bond issuance was consistent but low from 1997 to 2005, averaging $1.2 billion per year. 11 Insurer issuance prior to Katrina was similarly concentrated within a small number of companies. Swiss Re and USAA accounted for 20% and 17% of total issuance, respectively, between 1997 and 2005. However, after the $62 billion in insured losses from Hurricane Katrina drained reinsurance capital and led reinsurance premiums to rise, CAT bonds became popular as a risk diversifier. 12 The rise in reinsurance premiums drew a large amount of money into the CAT bond market. This infusion of cash helped CAT bond issuers to set two new annual issuance records: $4.7 billion in 2006 and $7.1 billion in 2007. (see figure 2).
Catastrophe bond issuance and amount outstanding, 19972017
However, following the September 2008 bankruptcy of Lehman Brothers, which had acted as a counterparty in some key agreements, CAT bond issuance plummeted amid the financial crisis. The underlying collateral structures that were common for CAT bond sales at the time exposed investors to too much counterparty risk, according to investors. Between September 2008 and January 2009, CAT bond issuance was completely halted due to these issues, pending the development of more safe counterparty structures. Following the failure of Lehman Brothers, SPV arrangements that invested collateral in US Treasury money market funds became commonplace. 13 Investors returned to the CAT bond market in the fourth quarter of 2009, resulting in $1.6 billion in new issuance in that quarter alone.
During the post-crisis years, the CAT bond market grew rapidly. For example, between 2010 and 2017, the number of outstanding CAT bonds more than doubled (see figure 2). Non-insurance industry capital has poured into the CAT bond market as a result of the low interest rate environment. With long-term Treasury bond yields at record lows and corporate bond spreads at historic lows, many institutional investors have been drawn to catastrophe bonds because of the relatively higher yields and uncorrelated risk they offer. Furthermore, advances in catastrophe bond modeling have made it easier for CAT bond issuers to collateralize a wider variety of risks and for institutional investors to assess the underlying risks. 14
Which types of institutions use CAT bonds and why
In general, three types of institutions issue CAT bonds: insurance firms, reinsurers, and state catastrophe funds. To unload their specific insurance risks, these three types of organizations use CAT bonds in their own unique methods. The triggerthat is, the method used to decide when payouts to the bond issuer must be madeis an important component of CAT bonds that varies by issuer type.
Indemnity, industry loss, and parametric triggers are the three most prevalent forms of CAT bond triggers. Indemnity triggers are similar to regular reinsurance in that they rely CAT bond payouts on the issuer’s real insurance losses. Industry loss triggers use a third-party modeler to offer an unbiased estimate of covered losses and base payouts on aggregate losses to the insurance industry. Finally, parametric triggers base payouts on the measured strength of the covered disasterfor example, the magnitude of an earthquake or the wind speed and barometric pressure of a hurricane.
Insurance companies are the most common CAT bond issuers, accounting for 60% of all CAT bond issuance (in terms of dollar amount) from 1997 to 2017. (see figure 3). Indemnity triggers are the most prevalent triggers for CAT bonds issued by insurers. CAT bonds are used by insurance firms to lower the risk associated with a specific group of policies that they cover. When compared to other types of triggers, an indemnity trigger ensures that the CAT bond will pay up when the insurance company’s real losses reach the bond’s attachment point, giving the insurer greater precision in its risk-management strategy. A bond with an indemnity trigger, on the other hand, takes longer to pay out since actual losses must be witnessed and proved before the bond can be triggered. Following a triggering loss, CAT bonds with indemnity triggers typically take two to three years to pay out, compared to three months for CAT bonds with industry loss or parametric triggers. 15
Global catastrophe-bond issuance, by issuer and trigger type, 19972017
The second-largest group of CAT bond issuers is reinsurers. Reinsurers, in general, do not issue insurance policies; instead, they accept the risk of policies underwritten by others. As a result, in the event of a disaster, they will have to wait for the original underwriters to calculate their losses before they can calculate their own, which may cause compensation delays. Furthermore, because reinsurers’ risk portfolios are based on a diverse cross-section of the insurance industry, their loss experience is more closely linked to that of the industry as a whole than that of a single primary insurer. Given these considerations, reinsurers primarily rely on industry loss and parametric triggers, which can be assessed more quickly than indemnity triggers and do not rely on individual insurers’ loss estimates.
The third group of CAT bond issuers is state disaster funds. The California Earthquake Authority (CEA) and the Florida Hurricane Catastrophe Fund are the two largest state disaster programs in the United States (FHCF). Both of these government agencies work to keep a functioning catastrophe insurance market in place for citizens of their respective states.
In reaction to catastrophic natural catastrophes in California and Florida, the CEA and FHCF were established: Insured losses from the Northridge earthquake in 1994 totaled $12.5 billion, far exceeding all earthquake insurance premiums collected in California over the previous 80 years; and Hurricane Andrew devastated Florida and its insurance markets in 1992. Prior to the Northridge earthquake and Hurricane Andrew, private insurers in both states were required by law to cover damages caused by natural disasters before issuing any type of property insurance. Because of the perceived increased risk and lack of proper reimbursement, many private insurers have reduced coverage or pulled out of the state entirely as a result of these restrictions. 16
The CEA and FHCF began taking on the catastrophic risks previously handled by private insurers in order to entice them back into their states. The CEA began selling earthquake insurance directly to householders, eliminating the need for private insurers to do so. To compensate private insurers for severe storm losses, the FHCF established a reinsurance-like facility (see note 16). These state funds, on the other hand, accumulated insurance portfolios laden with disaster-related tail risk by taking on the catastrophe insurance risks of several private insurers. 17 The state funds began using CAT bonds to lower their risk exposure. State funds in the United States, like main insurers, use indemnity triggers to ensure that the risk coverage they receive from CAT bonds equals the losses in their portfolios. This risk-management method ensures state funds’ long-term viability by ensuring that they have sufficient resources to settle claims in the event of an expensive calamity.
State funds outside the United States, such as Mexico’s FONDEN, employ CAT bonds in a different way than their counterparts in the United States. Their purpose is to provide emergency funding for disaster recovery following a catastrophic occurrence, not to ensure a functional insurance market. Since 1980, private insurance has paid fewer than 11 percent of natural disaster losses in developing countries outside of North America and Europe (compared to 44 percent in North America and 29 percent in Europe), leaving governments and residents to face the costs of rehabilitation. 18 Governments can provide multiyear access to insurance protection and swiftly access disaster money when their CAT bonds are triggered by employing CAT bonds with parametric triggers. Parametric triggers may be calculated rapidly, and they don’t necessitate a country’s technical competence or infrastructure to calculate natural disaster costs. For example, the Caribbean Catastrophe Risk Insurance Facility (CCRIF), which was created with the help of the World Bank, has aided member governments by using CAT bonds with parametric triggers. Within 14 days of Hurricane Matthew’s landfall in the Caribbean in the fall of 2016, the CCRIF had paid out a little more than $20 million to Haiti and nearly $1 million to Barbados. 19
The CAT bond market today and tomorrow
Even having unquestionably the worst period for CAT bond investors in the market’s 20-year history, the CAT bond market showed robust growth in the first half of 2018. In the third quarter of 2017, 19 unique CAT bond tranches were triggered, mostly due to losses from Hurricanes Irma, Harvey, and Maria, leaving as much as $1.4 billion in outstanding issues vulnerable to losses (the actual loss amount is not yet known given that many insurance claims still need to be resolved). Despite the extraordinary level of losses at the end of 2017, new CAT bond issuance reached $9.4 billion in the first half of 2018, matching 2017’s record start. 20 CAT bond modeling is now being improved by the insurance sector to address new categories of risk, such as cyberattack and terror risks. As a result, it appears that CAT bonds will continue to gain popularity, providing issuers with new ways to transfer a range of risks.
What is the structure of cat bonds?
Figure 1 shows the basic structure of a CAT bond. It involves a sponsor (for example, an insurer, reinsurer, or the government) who wants to transfer risk to investors who are willing to take on the risk in exchange for higher predicted profits.
What is the best way to price a CAT bond?
Within a risk-pricing paradigm that deals with both systematic and non-systematic risk, a formula for the spread of Catastrophe Bonds is derived. The following is the formula: (EL)(1/) (EL)(1/) (EL)(1/) (EL)(1/) (EL) EL is the Expected Loss expressed as a percentage, and 1 is the Risk Aversion Level (RAL).
What is the purpose of catastrophe bonds?
Insurance and reinsurance businesses can use catastrophe bonds to transfer catastrophic risks by issuing securities. These securities pay an investor a premium; if the event occurs, the insurance provider will reclaim the principal to cover the event’s costs.
How are cat bonds bought and sold?
Through severe financial market dislocations, such as the dot-com bust and the credit crisis, CAT bonds have traded continually at non-distressed prices. Prior to the credit crisis, however, there was little visibility into the volume and pricing of CAT bond secondary market transactions.
Is it possible to purchase cat bonds?
Some mutual funds track an underlying index, such as the Swiss Re Cat Bond Performance Index, while investing in cat bonds. Individual investors interested in cat bonds should try investing in those mutual funds. Rather than buying a handful of separate cat bonds, the investor can hold a basket of them. Through diversity, this approach of mutual fund investment decreases risk.
What causes a bond to form?
In its most basic form, a rate trigger is a type of trade trigger that, when activated, causes an action to be taken. Dropping interest rates could be the rate trigger in the event of a bond. When interest rates drop, an issuer of a callable bond decides to call the bond. Interest rate fluctuations have ramifications throughout the economy, but they are particularly significant in the bond market.
Who is eligible to purchase cat bonds?
Cat bonds are typically purchased by institutions rather than individuals, such as hedge funds, mutual funds, and pension funds. Indeed, a retail investor who invests in only one or even a few cat bonds may be underserved.
Which bond is the best?
Government, corporate, municipal, and mortgage bonds are among the several types of bonds available. Government bonds are generally the safest, although some corporate bonds are the riskiest of the basic bond categories. Credit risk and interest rate risk are the two most significant concerns for investors.