What is a Catastrophe Bond(CAT)?
A financial instrument to help governments finance disaster relief and post-disaster reconstruction without over-stressing their fiscal budgets. OR A catastrophe bond is a high-yield debt instrument designed to raise money for companies in the insurance industry in the event of a devastating natural disaster.
The economic cost of disasters averages $250 billion to $300 billion annually, according to the 2015 United Nations Global Assessment Report on Disaster Risk Reduction .
Considering that only about 30% of the damage from natural disasters are insured, such losses can impose severe financial burden on governments. In developing countries like India, governments may have to divert state funds, including those earmarked for development projects, to disaster relief and rebuilding efforts.
One way to bridge this financial gap is through the issuance of catastrophe bonds, a debt instrument that allows governments to tap the capital market and raise money from investors willing to bet against the likelihood of a disaster occurring in a particular place during a particular time period.
Features of Catastrophe Bond
1.CAT bonds have short maturities not exceeding three to five years.
2.The primary investors in these securities are hedge funds, pension funds, and other institutional investors.
3.Catastrophe bonds are used by property and casualty insurers as well as reinsurance companies to transfer risk to investors.
4.These bonds provide insurance and reinsurance companies with another method to defer risk associated with underwriting policies.
5.In return, institutional investors receive a higher interest rate than most fixed-income securities over the life of the bond, which could have a maturity of up to five years.
6.CAT bonds are only paid to the insurance company if a triggering event happens.
Pay Outs From CAT Bonds
When the bonds are issued, the proceeds raised from investors go into a secure collateral account. The secured funds might be invested in other, various low-risk securities. Interest payments to investors—usually at a higher rate than other fixed-income products—come from the secure collateral account.
A CAT bond might be structured so that the payout only occurs if total natural disaster costs exceed a specific amount over the specified coverage period. Bonds may also be pegged to the strength of a cyclone or earthquake or the number of events . If a series of natural disasters happen the payout to the insurance company is triggered. The insurance company receives bond proceeds from the secure collateral account.
Investors lose their principal if the costs of the covered natural disasters exceed the total dollar amount raised from the bond issuance, and stored in the secured account. However, if the costs to cover the disaster do not exceed the specified amount during the bond’s lifetime, investors get the return of their principal at the bond’s maturity. The investor also benefits from receiving the regular interest payments in return for holding the bond.
Catastrophe Bond Benefits
I.Benefits for investors
The interest rates paid by CAT bonds are not usually linked to the financial markets or economic conditions. In this way, CAT bonds offer investors stable interest payments even in times when interest rates are low and traditional bonds are offering lower yields.
CAT bonds offer a competitive yield compared to other fixed-income bonds and dividend-paying stocks. Investors in CAT bonds receive fixed interest payments over the life of the bond. Also, the maturities of the bonds are typically short-term decreasing the likelihood of a triggering event.
II.Benefits for insurance industry
CAT bonds benefit the insurance industry since the capital raised lowers their out-of-pocket costs for natural disaster coverage. CAT bonds also provide insurance companies with much-needed cash when they need it the most preventing them from going into bankruptcy due to a natural disaster. As a result, insurance companies have more cash on their balance sheets that could be used to issue additional insurance policies.
Disadvantages of Catastrophe Bond
CAT bonds have risk of losing the principal amount invested if a payment is triggered to the insurance company.
The short-term maturities of CAT bonds might not reduce the probability of a triggering event if the frequency and costs of natural disasters increases