Product Code Database
Catastrophe bonds (also known as cat bonds) are a subset of insurance-linked securities (ILS) that transfer a specified set of risks from a sponsor to . They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.
Catastrophe bonds emerged from a need by (re)insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damage that they could not cover with the invested premiums. An insurance company issues bonds through an investment bank, which are then sold to investors. Catastrophe bonds are High-yield debt (roughly equivalent to B or BB) with floating interest rates, and have an average maturity of 3 years with some up to 5 years but are uncommon. If no catastrophe occurred, the insurance company would pay a coupon to the investors. But if a catastrophe did occur, then the Principal sum would be forgiven and the insurance company would use this money to pay their claim-holders. Investors include , ILS-dedicated funds, pension plans, (re)insurance companies, and . They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered, the principal is paid by the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by as an alternative to traditional catastrophe reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of SOFR plus a spread. If no hurricane hits Florida, then the investors will make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors.
Michael Moriarty, Deputy Superintendent of the New York State Insurance Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance through cat bonds in the United States instead of off-shore, through encouraging two different methods—protected cells and special purpose reinsurance vehicles. In August 2007 Michael Lewis, the author of Liar's Poker and , wrote an article about catastrophe bonds that appeared in The New York Times Magazine, titled "In Nature's Casino."
The market grew to $1–2 billion of issuance per year for the 1998–2001 period, and over $2 billion per year following 9/11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of reinsurance sidecars. Issuance continued to increase through 2007, despite the passing of the post-Katrina "hard market", as a number of insurers sought diversification of coverage through the market, including State Farm, Allstate, Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Following the Tohoku Earthquake and April 27, 2011 Super Outbreak, issuance hovered around $6-8 billion per year from 2012 - 2016. In 2017, Hurricanes Hurricane Harvey, Hurricane Irma, and Hurricane Maria all impacted the market. This spurred yet another increase in issuance, now to the $10 billion per year mark. At year end 2023, Swiss Re estimates the market size is $43.1 billion with a record $15.4 billion issued in 2023 alone.
The cat bond market has withstood a multitude of catastrophes, both natural and manmade. These include September 11 attacks, Hurricane Katrina, the 2008 financial crisis, 2011 Tōhoku earthquake and tsunami, Hurricanes Hurricane Harvey, Hurricane Irma, and Hurricane Maria, the COVID-19 pandemic, Hurricane Ida, and Hurricane Ian. Following each of these events, the market has increased the volume of primary issuance. Moreover, it is estimated that the market suffers from a historical loss rate between 2.69% and 3.00%. This loss rate is generally quite close to the estimated loss rate given by the catastrophe models broadly used in the market (2.00% - 3.00%).
Key categories of investors who participate in this market include , ILS-dedicated funds, and asset managers. , reinsurers, banks, , and other investors have also participated in offerings.
A number of specialized fund managers play a significant role in the sector, including Fermat Capital Management, K2 Advisors, Leadenhall Capital Partners, Nephila Capital, Aeolus Capital Management, Elementum Advisors, Schroders, Neuberger Berman, Twelve Capital, AXA Investment Managers, Plenum Investments, and Tangency Capital. Several mutual fund and hedge fund managers also invest in catastrophe bonds, among them Stone Ridge Asset Management, Amundi US, and PIMCO.
For all cat bonds regardless of rating, a third-party modeling agent is hired as part of the transaction. This agent will generate a risk analysis of the bond taking into account the underlying structure of the notes using a catastrophe model. This risk analysis will generate an attachment probability (probability of first-dollar loss to the notes), an expected loss probability, and an exhaustion probability (probability of complete loss of principal). The two most commonly utilized modeling firms are Verisk Analytics, and Moody's RMS.
Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance.
Modeled loss: instead of dealing with the company's actual claims, an exposure portfolio is constructed for use with catastrophe modeling software, and then when there is a large event, the event parameters are run against the exposure database in the cat model.
Industry Loss: instead of adding up the insurer's claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS or PERILS. "Modified index" linked securities customize the index to a company's own book of business by weighting the index results for various territories and lines of business. Common "modified index" structures are the State-Weighted Industry Loss (SWIL - pronounced swill) and the County-Weighted Industry Loss (CWIL - pronounced quill).
Parametric: instead of being based on any claims (the insurer's actual claims, the modeled claims, or the industry's claims), the trigger is indexed to the natural hazard caused by nature. So the parameter would be the windspeed (for a hurricane bond), the ground acceleration (for an earthquake bond), or whatever is appropriate for the peril. Data for this parameter is collected at multiple reporting stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered.
Parametric Index: Many firms are uncomfortable with pure parametric bonds due to the lack of correlation with actual loss. For instance, a bond may pay out based on the wind speed at 50 of the 150 stations mentioned above, but the insurer loses very little money because a majority of their exposure is concentrated in other locations. Models can give an approximation of loss as a function of the speed at differing locations, which are then used to give a payout function for the bond. These function as hybrid Parametric / Modeled loss bonds, and have lowered basis risk as well as more transparency.
Aggregate: the sum of losses over a time period (commonly one year, a so-called Annual Aggregate) breach a threshold (the attachment level) to trigger the bond payout.
Per Occurrence: the loss from a single event must breach a threshold (the attachment level) to trigger the bond payout.
Industry Loss Aggregate: the sum of losses to the insurance industry (as reported by PCS or PERILS) over a given time frame must breach the attachment level. Say for example, 3 hurricanes and 1 earthquake all affect the covered area for a catastrophe bond. Each hurricane does $20 billion in damage and the earthquake does $40 billion. In this case, if the attachment of the note was set to $90 billion, the bond would pay out as the sum of the insured losses are $100 billion = 20 + 20 + 20 + 40.
Indemnity Per Occurrence: the loss from a single event to a specific insurer must breach the attachment level. For example, an insurance company suffers a $500 million loss from an earthquake and a $400 million loss from a hurricane. If the attachment level was set to $550 million, then the bond would not pay out as neither the earthquake or hurricane caused enough damage to the insurer for the attachment level to be exceeded.
Parametric Per Occurrence: the parameter for a single event exceeds the preset threshold. For example, the wind speed in a certain location exceeded 150mph.
Life & Health Risk: Issued in April of 1998, the L1 Securitization for Hannover Re covered Life insurance risk. This was a pseudo-quota share coverage. More comparable to the cat bonds of today, the Vita Re transaction of 2003 on behalf of Swiss Re is claimed to be the "pioneer of life ILS globally".
The International Bank for Reconstruction and Development (IBRD or World Bank) has sponsored a cat bond issuance to provide funding for the Pandemic Emergency Financing Facility (PEF). The IBRD CAR 111 and IBRD CAR 112 transaction raised $320 million of subscription in July of 2017. These notes did end up suffering a loss due to COVID-19.
Lottery Winnings: In September of 2011, the Hoplon Re transaction provided $101 million of coverage to the MyLotto24 lottery. The covered risk was "the risk of exceptional jackpot wins" which could potentially cause the lottery to fail.
Stock Market Crashes & Hedge Fund Collapses: Citigroup developed the Stability Note in 2003, which protects the issuer against catastrophic stock market crashes; it was later adapted to protect against hedge fund collapses. Professor Lawrence A. Cunningham of George Washington University suggests adapting cat bonds to the risks that large auditing firms face in cases asserting massive securities law damages.Lawrence A. Cunningham, Securitizing Audit Failure Risk: An Alternative to Damages Caps, William & Mary Law Review (2007)
Cyberattack: Beazley successfully sponsored the first Cyber cat bond in January 2023, dubbed "Cairney". This was a $45 million Section 4(2) private cat bond that triggers on an Indemnity Per Occurrence basis. The first public rule 144A cat bond was the Long Walk Re transaction in November of 2023, providing AXIS Capital with $75 million of Indemnity Per Occurrence coverage. These notes cover so-called "systemic cyber events".
Terrorism: Pool Re (Pool Re), the UK government-backed mutual terrorism reinsurance facility, sponsored the issuance of Baltic PCC Limited (Series 2019) notes. This was an Indemnity Annual Aggregate transaction issued in February of 2019. It raised $97 million of support.
Event Cancellation: Ahead of the 2006 FIFA World Cup, FIFA sponsored the Golden Goal Re transaction. The transaction was issued in September of 2003 and raised $262 million. If the 2006 FIFA tournament was canceled because of terrorism risk, the bond would pay out, resulting in a loss of 75% of the money invested in the bonds. As a result of the attacks in the USA on 11 September 2001 and the subsequent withdrawal by insurers from the 2002 FIFA World Cup cancellation insurance policy, FIFA requires any future protection to be immune from such risk, thus resulting in the issuance of Golden Goal Re.
Other: The first actively managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut was issued in 2007, with Nephila as the asset manager.
To date, all direct catastrophe bond investors have been institutional investors, since all broadly distributed transactions have been distributed in that form. These have included specialized catastrophe , , investment advisors (money managers), , reinsurers, , and others. Individual investors have generally purchased such securities through specialized funds.
There are 5 main investment banks that are active in the issuance of cat bonds. These include Aon Corporation Securities Inc., Swiss Re Capital Markets, GC Securities (a division of MMC Securities Corp. and an affiliate of Guy Carpenter), Howden Capital Markets and Advisory, and Gallagher Securities. There are also 5 main secondary market makers in the space. These are RBC, Beech Hill Securities, Gallagher Securities, Swiss Re, and TP ICAP.
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