How do catastrophe bonds work as insurance-linked securities?

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AcadiFi · Accepted Answer

A cat bond transfers catastrophe risk from a sponsor (insurer, reinsurer, or corporate) to capital market investors through a special purpose vehicle (SPV). Structure: the sponsor pays premium to the SPV; investors buy notes and deposit principal in a collateral trust (usually Treasury money market funds); the SPV pays investors coupon equal to risk spread plus collateral yield. If a defined catastrophe trigger fires, principal pays out to the sponsor; otherwise investors receive principal at maturity. ```mermaid flowchart LR S[Sponsor
Insurer] -->|Premium| SPV[SPV
Issues Notes] I[Investors] -->|Principal| SPV SPV -->|Collateral| T[Trust
T-Bills] SPV -->|Coupon| I SPV -->|Recovery on Trigger| S ``` Trigger types trade off basis risk vs. moral hazard. Indemnity triggers pay based on sponsor's actual losses (low basis risk, high moral hazard, slow settlement). Industry loss triggers use market-wide losses reported by PCS or Verisk (moderate basis risk). Parametric triggers use physical measurements like wind speed at defined grid points (zero moral hazard, higher basis risk, fast settlement). Modeled loss triggers use vendor models on captured event parameters. A typical 3-year, $250M Florida wind bond might price at T + 500bps, with expected loss of 1.5% per year. Investors diversify portfolios with catastrophe risk uncorrelated to equities or credit (though some correlation exists in extreme tail scenarios). Settlement can take months as loss development matures. Post-loss collateral release provisions and extension spreads protect both sides during loss emergence.

How do catastrophe bonds work as insurance-linked securities?

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