CAT bonds, or catastrophe bonds, are instruments issued by insurance companies in order to alleviate some of the catastrophe-related risk they bear. Such bonds issue regular coupons unless a specified catastrophe occurs.
Q. So, these are very unusual high yield bonds, right? What are they, exactly?
A. You can think of CAT bonds as, essentially, reverse insurance policies. They are ways for a property and casualty insurance company to lay off risk of a big catastrophe. For example, just last month a Louisiana insurance company issued a $100 mm bond to help protect it from the risk of a hurricane.
Q. So, how does that work, exactly?
A. The insurance company issues the bond at a significant premium to LIBOR—maybe 500 or 700 bps. Investors buy the bond, and collect the coupon; if nothing happens, they get paid back in, say, 3 years. But, if that disaster strikes in between, say that Louisiana hurricane, then the payments either are reduced or stop altogether.
Q. So, it’s binary? If there’s a hurricane, you don’t get your principle back, otherwise you do?
A. No, there are all sorts of ways of calibrating the amounts deducted from the bond principle. For example, it might be actual losses (above a certain amount, like a deductible); or it could be based on a mathematical model, to protect the investors from questionable claims adjustments by the insurance company.
Q. And so, obviously, these bonds can be attractive because of their high yields. And hedge funds are pretty big buyers of these instruments as a result.
A. Yes, high yield and, very importantly, they provide uncorrelated performance. It’s not just about higher returns. Btw, they also account for the big fees some hedge funds pay for the most advanced weather forecasting software you can imagine.
Q. I bet! And are they used to protect against things other than natural disasters?
A. Hurricanes and earthquakes are the big ones, but there are other uses. CAT bonds have been issues to cover excessive workman’s comp claims; excessive mortality by a life insurance company, and the flip side, excessive longevity. But definitely my favorite one, was issued to cover excessive lottery payouts. They are a fascinating way of spreading risk, and its pretty clear you’ll see the kinds of risks they are used for expand over the next few years.