What is a Catastrophe Bond?

A catastrophe bond, usually abbreviated as a ‘cat bond’ is a mechanism for transferring insurance risk to the capital markets. The cat bond is issued by a Special Purpose Vehicle (SPV) established to support the transaction; the sponsor transfers risk to the SPV through a reinsurance arrangement. The SPV funds itself by issuing a cat bond to the market.

Cat bonds are structured so that principal repayment is reduced if certain trigger conditions, usually related to events that would cause significant loss to the sponsor, are met. Sponsors of cat bonds effectively receive a capital injection when it is needed most -immediately following a loss. Cat bonds are typically priced as a spread over the London Interbank Offered Rate (LIBOR) where the spread is determined by market pricing for the risk. The premiums paid by the ceding insurer fully fund the spread plus any other expenses associated with the structure. The proceeds from the issu-ance are placed in a collateral account and invest-ed in low-risk assets and the returns are swapped to LIBOR. Together the ceding insurer’s premium payments and the swapped investment returns generate the required cashflow to meet the bond’s coupon payments.

In the event that the bond is triggered, the SPV can draw on the assets in the collateral account to meet its reinsurance obligations to the sponsoring company.