What are these bonds?
Catastrophe bonds (or “cat bonds” for short) are a way for insurance companies to protect their bottom lines in the event of a major disaster, like a hurricane or an earthquake, by transferring some or all of the financial risk to investors. When an insurance company issues a cat bond, investors fork over money in exchange for interest payments (called coupons, just like with any bond). More specifically, they get paid a floating coupon – that is, one that moves in line with the overall level of interest rates in the economy – and a premium for taking on the catastrophe risk to boot.
Each security will detail a specific potential disaster – right down to its severity – in the terms of its contract. If it happens and causes losses that exceed a certain amount, the insurance company can use the money investors paid to help cover the cost of the claims. In that case, investors might lose some or all of the money they paid for the cat bond, but they’ll still keep all the interest payments they received until the catastrophe hit. If the specified disaster doesn’t happen during the bond’s term, the insurer has to return the principal (i.e. the borrowed amount) to the investors.
In essence, cat bond investors are betting that a major natural disaster won’t happen. If it does, they stand to lose some or all of their money. If it doesn’t, they earn an interest rate that’s typically higher than most other types of debt. Some of the biggest bets focus on high-speed wind storms (especially in Florida) and earthquakes, but there’s growing demand for cat bonds that cover wildfires and flash floods, which have been happening more frequently because of climate change.
And, yeah, they’re popular: in recent years, as bond markets around the world got hammered by rising interest rates, these debt instruments kept on shining. The Swiss Re Global Cat Bond Index is up 46% since the start of 2020, outperforming the SPDR Bloomberg Global Aggregate (made up of investment-grade government and corporate bonds) by more than 50 percentage points.
