Catastrophe Bond (Cat Bond)

Concept

A catastrophe bond is an insurance-linked security through which an insurer or reinsurer transfers a defined catastrophe risk — such as earthquake, hurricane, or flood — to capital market investors in exchange for a risk premium, with investors receiving a coupon above the market interest rate in return.

Mechanism

If the trigger event defined in the cat bond occurs during its term, the capital invested is used to cover the loss and is wholly or partly forfeited by investors; if the event does not occur, investors receive their capital back in full at maturity.

Trigger Mechanisms

Cat bonds can be based on different trigger types: indemnity-based triggers are linked to the sponsor’s actual loss, parametric triggers to physical measurements such as wind speed or earthquake magnitude, and index-based triggers to industry-wide loss indices; each trigger type carries a different degree of basis risk.

Relevance for Reinsurance Capacity

Cat bonds supplement traditional reinsurance capacity with additional capital from the capital market that is largely independent of the classic reinsurance cycle, and have developed since the 1990s into an established instrument of alternative risk transfer (ART).