Imagine an insurer of coastal properties concerned about the next hurricane season. A severe storm happens once every few decades; if the severe storm hits this year, she’ll have to pay out most of her money in claims. To help remain solvent, she could buy reinsurance. Alternatively, she could issue a catastrophe (cat) bond, which would pass the risk on to an investor. An investor could buy the bond valued at, say, $100,000; over time, the insurer would repay the bond with, say, 15% interest. If no hurricane hits during the year, the investor makes 15% on his investment. The insurer also turns a proﬁt because she continues to collect premiums. But if this low-probability severe hurricane does hit, then the investor loses his $100,000, which is used by the insurer to pay claims.
A cat bond triggers payments based on the occurrence of a specified catastrophic event. Most cat bonds to date have been linked to hurricanes and earthquakes, but some have been issued to respond to mortality events. Capital raised by issuing a cat bond is invested in a safe security like a treasury bill, which is held by a special-purpose vehicle (SPV). A SPV is often a company created to execute specific financial transactions. The bond issuer holds a call option on the bond principal (option to buy all or part of the principal) in the SPV with triggers that are specified in the bond contract.
The triggers can be defined in terms of the insurance company's total losses from the catastrophe or some hazard event characteristic. If the defined catastrophic event occurs, the bond issuer can withdraw bond funds from the SPV to pay claims, and part or all of the interest and principal payments are forgiven. If the catastrophe does not occur the investor receives the principal plus interest equal to the risk-free rate (e.g., London Inter-Bank Offered Rate--LIBOR), plus a spread above LIBOR. Cat bond maturity is typically on the order of 1 to 5 years.