How do catastrophe bonds work, and what are the different trigger types investors need to understand?

Catastrophe bonds (cat bonds) are insurance-linked securities that transfer catastrophic event risk from an insurer or reinsurer to capital market investors. If a qualifying catastrophe occurs, investors lose some or all of their principal, which goes to the sponsor to cover losses.

Basic Structure

Pelican Re Insurance wants to offload Florida hurricane exposure. It sponsors an SPV called StormShield Ltd, which issues $250 million in 3-year cat bonds. Investors receive SOFR + 750 bps, but risk losing principal if a covered hurricane triggers the bond.

Four Trigger Types

Indemnity triggers pay based on Pelican Re's actual claims, so there is no basis risk — but the sponsor has less incentive to minimize losses (moral hazard), and settlement is slow because actual claims must be tallied.

Parametric triggers use objective physical measurements. If a hurricane's sustained wind speed exceeds 130 mph within a defined coastal grid, the bond triggers regardless of actual losses. This is transparent and fast but creates basis risk: Pelican Re might suffer $200 million in losses from a storm that doesn't technically meet the parametric threshold.

Key investor considerations: Cat bonds have near-zero correlation with equity and credit markets, making them attractive diversifiers. However, investors must understand that trigger complexity affects both pricing and the probability of losing principal.

FRM exam tip: Questions often present a scenario and ask which trigger type best balances basis risk against moral hazard. Remember: indemnity = low basis risk but high moral hazard; parametric = opposite.

Explore our FRM practice questions for more on insurance-linked securities.