Catastrophe Bonds

Definition: Sold by insurers to defray some of their risk. The investors pays a principal sum to the insurance company for a CAT bond. The insurance company will pay the investor a regular yield which is generally a floating rate in excess of Libor. However, if a trigger event(s) occurs such as a hurricane or particular level of damage, then the investor loses his entire principle investment. The insurance company will use the "confiscated" bond proceeds to finance its own insurance payouts. The risks CAT bonds have covered to date have been North Atlantic hurricanes, European windstorms, U.K. river floods, and earthquakes in North America, Japanese and Mexico. In spite of numerous catastrophes over the past few years, the only publicaly disclosed CAT bond loss occured with hurricane Katrina in USA.

High Returns: Investors buy these CAT bonds because

• they pay higher interest rates, usually 2% - 10% floating above Libor i.e rise and fall with corresponding changes in Libor.
• return is uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification.

Pricing : There is a similarity between default bonds prices and CAT bonds prices. In order to price a default bond the partial or complete loss of the principal value should be considered. Default bonds yield high returns, partly due to their potential default ability. CAT bonds yield high returns because of the unpredictable nature of the process of catastrophes. However, a difference between the CAT bonds and the high yield bonds is the information flow and the price processes. In a high yield bond the information about the issuer arrives constantly, while the information about a natural event is available only after it occurs. Whereas defaulting high yield bond prices are affected by business cycles and corporate events, CAT bond prices are based as a function of the expected loss calculation.

Credit Ratings : CAT bonds are often rated by an agency such as Standard & Poor’s (S&P), Moody’s, or Fitch Ratings. Typically, a corporate bond is rated based on its probability of bankruptcy. A CAT bond is rated based on its probability of default due to a natural event like an earthquake or a hurricane, triggering loss of the principal. Most CAT bonds are rated "BB+" by Standard & Poors, which is just below investment grade but better than non-investment grade.