How do catastrophe-linked (cat) bonds work?

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AcadiFi · Accepted Answer

Catastrophe bonds (cat bonds) are insurance-linked securities where investors accept risk of a specified natural catastrophe in exchange for yield. Structure: (1) insurer/reinsurer forms a Special Purpose Vehicle (SPV); (2) SPV issues cat bonds to investors, raising e.g. $250M; (3) proceeds are invested in high-quality short-term collateral (Treasuries or repo); (4) sponsor pays the SPV a premium, combined with collateral yield → coupon to investors (often SOFR + 500-1,000 bps); (5) if the defined catastrophe TRIGGER occurs, principal is written down and used to indemnify the sponsor; (6) otherwise, principal returns at maturity (typically 3-5 years). Trigger types: (a) indemnity — actual insurer losses (most basis-risk-friendly for sponsor); (b) industry loss — total industry losses exceed threshold (PCS estimates); (c) parametric — physical parameters like wind speed or earthquake magnitude at named locations; (d) modeled loss — losses per a predefined model applied to the event. Example: the Coral Reef Re cat bond covers Florida hurricane risk for Gulfshore Property Insurance. $300M principal, 3-year maturity, SOFR+725 bps. Parametric trigger: attachment at Category 4+ hurricane making landfall between Naples and Fort Myers with sustained winds >140 mph per NHC. Investors are 'almost risk-free' for wind under 140 mph but take total loss if the specific parametric event occurs. Appeal: very low correlation with financial markets (hurricanes don't care about stocks), attractive absolute yields. Risks: basis risk (for non-indemnity), model risk, climate-change assumptions.

How do catastrophe-linked (cat) bonds work?

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