Understanding Disaster Insurance by Carolyn Kousky

Author:Carolyn Kousky [Kousky, Carolyn]
Language: eng
Format: epub
ISBN: 9781642832266
Publisher: Island Press

Catastrophe Bonds

Catastrophe bonds (often shortened to cat bonds) are a bit of a hybrid between insurance and a more traditional bond. Investors put up capital in exchange for premium payments, but if a certain disaster occurs, their capital is transferred to the entity seeking the financial protection. If the term of the bond passes without a disaster, the investors get their money back. Catastrophe bonds have been used by insurance companies to manage losses, by other private sector firms when they prove more cost-effective than traditional reinsurance, and also by the public sector—a few examples of which we discuss later in this chapter. First, let’s look in a bit more detail at how cat bonds work.

Figure 8.1 provides an overview of the basic structure of a catastrophe bond. The firm (or government entity) that is seeking the financial protection, which we will call the sponsor, first must establish an entity called a special purpose vehicle (SPV). The SPV is needed because it has the legal authority to act as an insurer. The SPV then collects insurance premiums from the sponsor and issues the catastrophe bond to investors. The principal paid by investors is placed in a safe and liquid asset, such as US Treasury bills. The investors get the returns from that investment plus the premiums paid by the sponsor. The extra premiums paid are what make catastrophe bonds an attractive financial investment. If the predefined disaster occurs, some or all of the principal is transferred to the sponsor. If the term of the bond ends (bonds are typically around three years) and no disaster has occurred, the principal is given back to the investors. The pricing of catastrophe bonds is driven by the underlying risk, just like insurance, and typically requires the use of catastrophe models, discussed in chapter 7, to evaluate the risk of the bond.

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