In 1992, Hurricane Andrew struck Florida and inflicted 27 billion dollars worth in damage. As a result of the destruction, numerous insurance companies dissolved and went bankrupt after having to pay out an unanticipated amount of money to policyholders. As a result of the losses suffered during Hurricane Andrew, insurers and reinsurers reevaluated their risk exposure to hurricane zones across the country.
Many other insurance companies left the market to avoid suffering a similar fate. They thought it would be too expensive and risky to offer insurance in Florida and other coastal towns. Subsequently, insurance prices in coastal communities rose remarkably to account for the possibility of significant and unexpected losses. Something similar may be said with regards to COVID-19 and its implications in the insurance environment.
To aid insurance companies in demand for additional capital to cover natural-disaster related incidents, the insurance industry created a new financial instrument called a catastrophe bond, or CAT bond for short. The idea behind a CAT bond is to transfer the financial risk of a catastrophe from the insurance companies to the much larger financial market instead by issuing CAT bonds. This type of insurance-linked security would allow investors to earn financial rewards (interest payments) as long as a catastrophe didn’t occur. If a catastrophe does occur, the investor would lose their principal amount.
Example of a Catastrophe Bond
Suppose that XYZ Insurance, a large insurance company issues a CAT bond. The bond might have a $3000 face value that matures in 3 years and pays out an annual interest rate of 7%. When an investor purchases this bond, he/she will receive $210 (3000 x 0.07) each year until maturity, at which the principal amount of $3000 will be paid out to the investor.
Following the issuance of the CAT bonds, company XYZ raised $100 million and has invested the funds in a special account that consists of other low-risk securities. The interest rate over the 3 years is usually greater than most fixed-income securities.
The bond contract is structured as follows: A payout to XYZ occurs only if the costs of a natural disaster exceeds $200 million during the three years. Any remaining funds would be returned to investors at the bond’s maturity.
Let’s say that during the third year, a dreadful hurricane arrives and leaves damages worth a total cost of $250 million. Since this total cost is greater than the $200 million stipulated in the bond contract, the contract is activated and $100 million gets transferred to XYZ insurance from the special account. As a result of the unfortunate event, the investors lost their principal amount in the third and final year, however, the insurance company drastically reduced their risk and expenses.
Benefits for investors
- CAT bonds are uncorrelated with other financial instruments (i.e stock prices). Good for portfolio diversification
- CAT bonds have short maturities, which minimizes the risk of a natural disaster insurance payout and the loss of your principal
- Historically, CAT bonds provide strong returns
Negative for investors
- Natural disasters are unpredictable and there is a risk of losing your principal amount if a disaster occurs
- CAT bond losses might happen at the same time as a downturn in the broader economy (so much for diversification)
- CAT bonds are only available for large investment funds and not the average investor