INVESTING EXPLAINED: What you need to know about cat bonds

In this series, we break down the jargon and explain a popular investing term or topic. Here are the cat bonuses.

Something to do with pets?

No. There’s nothing cuddly here: ‘cat bonds’ is the short name for catastrophe bonds, one of this year’s fastest-growing sectors.

These securities are sold by insurers seeking to transfer some of the risk of catastrophes, natural disasters, terrorism and, increasingly, cyber threats. Governments or government agencies may also be behind a tranche of cat bonds.

The bonds, which have a typical maturity of three years, help the issuer meet its obligations in the event of an earthquake, hurricane, tsunami or ransomware attack.

Insurers used to turn to reinsurers to offset such risks, but they can no longer rely solely on this source.

How do bonuses really work?

Bonds are sold, usually through a special purpose vehicle, to investors seeking a high interest rate. Bonds issued by the California Earthquake Authority this year pay 12 or 15 percent, depending on the extent of damage investors are happy to cover.

These investors are also looking to diversify. They are attracted to the idea that catastrophe bonds are “uncorrelated” with other assets. The value of a cat bond is not subject to economic or stock market fluctuations, and should only fall if the covered catastrophe occurs. If not, investors recover their capital at maturity.

What if the worst really happens?

Investors may lose some or all of their interest and principal under certain strictly defined circumstances, such as the number and amount of claims arising. For example, under the terms of a bond covering flooding of the New York subway system, flooding up to a level of 8.5 feet would be required to force payment.

Who are the investors?

Hedge funds, pension plans and the super-rich are pouring money into the sector. The other buyers are fund management groups Amundi, Franklin, GAM and Schroders, which are among the biggest buyers. Schroders offers the GAIA catastrophe bond fund, which targets a return of 6 percent annually.

Cat bond funds have performed well this year, compared to other bond funds. There may have been many terrible disasters in recent months, but the specific catastrophes covered by some funds have not occurred.

So it’s not something for private investors?

US asset managers believe that only people worth at least $100 million should be direct investors in cat bond funds, as they can afford the level of losses that may arise.

How big is the cat bond market?

It is worth about $41 billion and has doubled in the last decade, largely in response to the increased incidence of climate-related catastrophes. The speed of issuance has accelerated this year as disasters increase.

When were cat bonds created?

The trigger for the creation of catastrophe bonds was Hurricane Andrew, which hit Florida in 1992 and caused about $27 billion in damage, of which only about $15.5 billion was covered by insurance. Eight insurance companies went bankrupt and others were on the verge of insolvency. The need to improve provisions led to the issuance of the first catastrophe bonds in 1997.