A catastrophe bond (CAT bond) is a high-yield debt instrument that was initially designed for insurance/reinsurance companies but is increasingly used by government bodies and other businesses to protect themselves against catastrophe-linked losses. A CAT bond mitigates the impacts of large payouts in the event of a natural disaster by allowing the issuer (such as the insurance company) to receive funding from the bond only if a specific predefined catastrophic event occurs, such as a hurricane causing USD 500 million in losses.
If the event occurs, the insurance company retains the bond proceeds to cover the cost of the catastrophe damages, and its obligation to pay interest and repay the principal to the buyer of the bond is either deferred or completely forgiven. If the event does not occur, the investor (buyer of the bond) receives interest and full principal repayments.
CAT bonds tend to cover short time periods (3 to 5 years). Buyers of CAT bonds tend to be hedge funds, pension funds, and other institutional investors. These investors usually seek diversification in their investment portfolios and are willing to accept the default risk in return for higher interest payments.
Parametric CAT bonds can also be issued by multilateral development banks and sovereign governments. For example, the World Bank has issued CAT bonds that provide insurance for protection against natural disasters and weather events in countries such as Mexico, the Philippines, and Jamaica. Some countries, such as the Philippines, have both catastrophe bonds that are triggered by established parameters (such as modelled loss, wind speeds, and precipitation) and Deferred Drawdown Options for Catastrophe Risks financing that is designed to be accessible before the CAT bond.
Current or potential adaptation-relevant sector applications:
- disaster risk reduction.
Additional insights:
- This is a mature instrument, introduced in the 1990s when the American insurance industry was coping with a series of costly catastrophes resulting mainly from devastating hurricanes.
- Mexico was the first country to utilize CAT bonds, in 2006.
Considerations for issuing a CAT bond:
- Many developing countries have received support from multilateral development banks and bilateral donors to structure and issue CAT bonds.
- CAT bonds require long structuring periods, legal expertise, and the definition of strict terms and conditions.
- Generally, CAT bonds are complex investment vehicles and have relatively higher transaction costs than other financial instruments.
Adapted from the following sources:
Henry, P. (2021). Explainer: How catastrophe bonds help manage the risk of climate change. World Economic Forum. https://www.weforum.org/agenda/2021/11/catastrophe-bond-finance-insurance-climate-change-natural-disaster/
Rabener, N. (2021, June 21). Avoiding disaster with catastrophe bonds? CFA Institute. https://blogs.cfainstitute.org/investor/2021/06/21/avoiding-disaster-with-catastrophe-bonds/
White, S. A., Blake, D, Koch A. C., Goring, K., Tumuluru, K., Radki, A., & Pal, R. (2022, August 16). The G7 takes on climate change: Are catastrophe bonds an answer? Millliman. https://www.milliman.com/en/insight/meeting-the-g7-commitment-to-disaster-financing-with-catastrophe-bonds
World Bank. (2021, July 19). World Bank catastrophe bond provides Jamaica $185 million in storm protection [Press release]. https://www.worldbank.org/en/news/press-release/2021/07/19/world-bank-catastrophe-bond-provides-jamaica-185-million-in-storm-protection