What is a Catastrophe Bond?

It's always a gamble when trying to guess if Mother Nature is going to strike via earthquake, hurricane, or some other natural disaster. Some people take that gamble in the form of catastrophe bonds. These special bonds allow investors to benefit if no natural disaster occurs where they purchase the bond, or lose out if one does.

Function

The way a catastrophe bond works is fairly simple. An investor purchases the bond from a reinsurance company. The bond has a 3-20 percent return depending on the specific bond. The investor will get the return back unless the bond is "triggered." This means that some kind of natural disaster has occurred. So, if a hurricane in Florida is the trigger, and one occurs that causes the reinsurance company to have to pay money to customers, the bond fails. If not, the investor will get back a hefty sum of money.

History

Hurricane Andrew devastated southern Florida in 1992, and afterward it was thought that securitizing catastrophe risks should happen. A number of professors at the Wharton School were responsible for the ideas behind catastrophe bonds. The first bonds were experimentally handled in the mid-1900s, and they became more popular in subsequent years. The market for these bonds grew after major catastrophes such as 9/11 and Katrina, but always tapered off afterward.

Benefits

The benefits of a catastrophe bond for an investor are best seen when the bond has more than one trigger, which makes it more likely that an investor will see a return on the bond. For the reinsurer selling the bond, it gives them the money they need to give out in times of a catastrophe. These bonds make insurance safer for all parties involved, and allow investors to diversify their folders.

Types

There are a few different types of catastrophe bonds that are categorized by their particular trigger. This is when a catastrophe occurs, and the investor will not receive a return on his investment. Some are triggered when the issuer loses a certain amount of money in claims, while others run on a predicted loss model instead of actual figures. Still others are triggered simply when a natural catastrophe occurs, such as in the case of hurricane bonds.

Warning

While the return on catastrophe bonds are generally higher than other bonds, they are not a safe bet. In fact, when it comes to ratings, they are generally rated below investment grade. However, those that require multiple triggers to default make the likelihood of a return much higher. Those catastrophe bones are rated higher and are generally purchased more. Still, catastrophe bonds in generally do add to the diversification of any investor's folder.