The catastrophe bonds, also known as “cat bonds” or simply “CAT” (and catastrophe bond), they are financial instruments that represent an innovative way for insurance and reinsurance companies to manage the risk associated with catastrophic events.
These tools were created to allow these companies to transfer part of the risk linked to catastrophic phenomena (earthquakes, floods, phones etc.).
Practically, insurance companies “sell” risk to investors, who in exchange receive a return on invested capital.
If the catastrophic event occurs, investors may lose part or all of their investment, thus allowing the insurance company to limit its losses.
This risk transfer mechanism is critical to the financial stability of insurance companies, who might otherwise find themselves in difficulty in the event of major catastrophic events.
Origins and Operation
Born in the 90s, Catastrophe bonds were created to transfer part of the risk associated with exceptional events, like hurricanes, earthquakes, floods etc., to other financial operators. This allows insurance companies to reduce their exposure to natural disasters.
Unlike classic bonds, for "cat bonds" the formula for calculating the coupons and repayment of capital is based on the occurrence of a predefined natural event. If the event occurs, the subscriber of the bond may lose part or all of the interest or principal.
Features and Benefits
Catastrophe bonds have a relatively short duration (3 years on average) and have reduced volatility.
Their risk/reward ratio is generally considered attractive, and the fluctuations of these assets are independent of the performance of the economy and very little correlated with that of other assets.
Diffusion
Insurers represent the majority of the total volume of “cat bonds”, but these assets have also attracted other types of issuers, including supranational bodies such as the World Bank, which issues bonds on behalf of countries at risk of natural disasters, and private businesses.
In conclusion, Catastrophe bonds represent an interesting financial instrument that allows you to manage the risk associated with catastrophic events, while offering an attractive risk/return ratio for investors.
