INVESTING EXPLAINED: What you need to know about cat bonds

In this series, we debunk the jargon and explain a popular investment term or theme. Here they are cat bonds.

Something about pets?

No. Nothing cuddly here – ‘cat bonds’ is the shorthand for catastrophe bonds, one of the fastest growing sectors this year.

These securities are sold by insurers seeking to transfer some of the risk of catastrophes, natural disasters, terrorism and, increasingly, cyber threats. Governments or government agencies can also be behind a tranche of cat bonds.

The bonds – which typically have a term of three years until maturity – help the issuer meet its obligations in the event of an earthquake, hurricane, tidal wave or ransomware attack.

Insurers used to turn to reinsurers to offset such risks, but they can no longer rely solely on this source.

How do the bonds actually work?

The bonds are sold, usually through a specialty vehicle company, to investors looking for high interest rates. Bonds issued by the Californian Earthquake Authority will pay 12 percent or 15 percent this year, depending on the extent of the damage investors would like to cover.

These investors also want to diversify. They are attracted to the idea that cat bonds are ‘uncorrelated’ with other assets. The value of a catastrophe is not subject to economic or stock market fluctuations, and should only decline if the covered catastrophe materializes. If not, investors will receive their capital back at maturity.

What if the worst actually happens?

Investors may lose all or part of their interest and capital under certain precisely defined circumstances, such as the number and amount of claims arising. Under the terms of a bond covering flooding of the New York subway system, flooding up to a height of 8 feet would be required to force a payout.

Who are the investors?

Hedge funds, pension plans and the super-rich are pouring money into the sector. The other buyers are fund management groups Amundi, Franklin, GAM and Schroders are among the biggest buyers. Schroders offers the GAIA cat bond fund, which targets a return of 6 percent per year.

Cat bond funds have performed well this year compared to other bond funds. There may have been many terrible disasters in recent months, but the specific catastrophes covered by some funds have not occurred.

So not something for private investors?

US asset managers believe that only individuals worth at least $100 million should be direct investors in cat bond funds because they can afford the level losses that could arise.

How big is the cat bond market?

It is worth about $41 billion, doubling in the past decade, largely in response to the increased number of weather-related catastrophes. The issuance rate has increased this year as disasters pile up.

When did cat bonds arise?

The impetus for the creation of cat bonds was Hurricane Andrew, which hit Florida in 1992, causing approximately $27 billion in damage, of which only about $15.5 billion was covered by insurance. Eight insurance companies went bankrupt and others were close to bankruptcy. The need for better arrangements led to the first cat bonds being issued in 1997.