Catastrophe bonds

Catastrophe bonds (cat bonds) are a form of insurance securitisation. They are an alternative to insurance that transfers risk to investors rather than insurers. They are legally not insurance, which has some important consequences.

The most important of these differences are that they are not uberrimae fides and that they can be bought by any investor (not just a insurer). See credit default swaps for a more detailed discussion of the differences between insurance and non-insurance contracts.

Catastrophe bonds may be issued by an insurer to spread risk, in order to protect their own balance sheets in the event of large scale payouts such as those caused by natural disasters. They therefore also reassure policy holders.

They may also be issued an entity that requires insurance against a single large risk. In this case they can be regarded as a form of insurance disintermediation. A good example of was FIFA's issue of $260m worth of catastrophe bonds against cancellation of the 2002 football world cup.

Catastrophe bonds are usually issued by an SPV. The SPV will keep bondholders' money and pay them interest. It will also usually receive a premium from the insured. In the event of the "catastrophe" occurring the bondholders lose their money and it is used to pay the insured.

In return for a low risk of losing all their money cat bond holders get a better yield and an otherwise reasonably safe investment. The risk is also usually an easily diversifiable one.

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