A catastrophe bond or CAT Bond is a bond which nominal and / or its coupon will depend on the occurrence (or not) of catastrophic events such as storms, earthquakes, pandemics, etc.
This type of bond is issued by insurance or reinsurance companies to securitize the risk of occurrence of "disastrous" events.
The issuer covers some of his reimbursement cost in case of events such as a major earthquake in California, typhoons in Asia, storms in Europe or hurricanes in the Gulf of Mexico for instance. “Wind" and "earthquake" risks in the U.S. and Japan currently account for the largest part of catastrophic events covered by CAT bonds.
The damage caused by such events can indeed be huge in terms of human and financial costs. The damage caused by Hurricane Katrina in 2005 for example was estimated at more than $ 80 billion by the U.S. government. Therefore, insurers live in constant fear since hurricanes occur annually from June to October in the Gulf of Mexico. They are also forecasting new major earthquakes in California and Japan: recall that in 1906, 3 000 persons died in San Francisco, and more than 140 000 in Tokyo in 1923!
The first catastrophe bond was issued after Hurricane Andrew in the Gulf of Mexico, in 1992, which caused a very large amount of damage (30 billion dollars at that time) and made insurance companies looking for new funding.
This market however, dominated today by the reinsurer Swiss Re, has remained rather discreet with annual issues of about 10 billion dollars a year. With a relatively short duration (usually 2 / 3 years), those bonds do not seem to attract investors, probably because of their randomness. Yet the benefits are many: first, the rates are as attractive as those offered by sovereign or corporate bonds, yet being “rated” equally by the rating agencies, but most of all, they exhibit a low correlation to other asset classes.
But with current concerns about H1N1 flu, it is important to note that some of these bonds also cover the risk of excess death rate, upon the occurrence of a pandemic, for instance. Current flu related risks, however, could be very costly for insurers, since only a portion is covered with "CAT bonds".
