Catastrophe Bond

catastrophes

Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake. These bonds are inherently risky, generally BB, and are multiyear deals. If no catastrophe occurred, the insurance company would pay a coupon to the investors, who made a healthy return.

If a catastrophe did occur, then the principle would be forgiven and the insurance company would use this money to pay their claimholders. 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.

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