Through the end of the first quarter of 2014, issuance of catastrophe bonds, or CAT bonds, totaled a reported $4.75 billion. These fixed income bond instruments have generally been structured to pay coupons at relatively attractive levels, compared to many other fixed income securities with similar credit ratings.
CAT bonds were initially designed and issued following several significant natural disasters in the mid-1990s. As various insurance companies recognized the need to decrease their potential exposure to specific catastrophic events, CAT bonds were devised as an alternative method for these insurance companies to seek their own insurance.
As the payoff structure of most CAT bonds is tied to a specific natural disaster or group of potential disasters over a defined period of time and often in a specified geographic area, purchasers of CAT bonds are providing disaster insurance to these insurance companies. Following an event insured through the coverage of a specific CAT bond, the coupon or principal can be decreased or eliminated altogether on this specific bond. As specified for each CAT bond, these diminished repayment requirements allow the issuing insurance company to use these funds to meet the property and casualty claims resulting from the insured risk event.
The investment profile of a CAT bond is very different from buying the shares of an insurance company. Because the performance profile of CAT bonds is tied to specific events, a specific hurricane, tornado or flood could result in the investment return to the purchaser of a CAT bond being significantly decreased or eliminated altogether. The owner of shares of an insurance company has exposure to the broad range of risks insured by the specific insurance company. In addition, the equity owner has the potential strength of the insurance company’s balance sheet and operating earnings to provide additional financial strength to withstand significant catastrophic natural disasters.
In the investment world, there is never a “free lunch.” The fact that these CAT bonds are paying a relatively attractive coupon, as compared to other similarly rated bonds, is the market acknowledging there are risks of some sort imbedded in these bonds that underpin a higher level of coupon payment. Whether the credit ratings being assigned to these CAT bonds are not fully reflecting the risks inherent in the bonds or the market is demanding some incremental yield to compensate for the risks of owning these bonds, the relatively higher coupon should be an indicator of higher risk.
Investors should only enter this segment of the fixed income market with appropriate knowledge and understanding of the risks of these CAT bonds. Whether purchased directly or through a mutual fund or some other investment vehicle, providing catastrophe insurance to insurance companies should be undertaken with appropriate analysis and return expectations.