Sometimes referred to as a CAT bond, the catastrophe bond is a type of security in which the risk associated with the issue is transferred from the sponsor or originator of the security to the investors. Essentially, a catastrophe bond creates a situation where the principal of the security is voided if certain specified conditions should occur during the period that the investor remains the holder of the security. It is not unusual for insurers to employ the approach of a security bond as an alternative to utilizing catastrophic reinsurance coverage to cover the risk.
One of the best examples of how a catastrophe bond works is to think in terms of providing some degree of protection for the issuer in the event of some natural disaster. For example, the owner of a great deal of property in the American Midwest may wish to issue catastrophe bonds that will provide protection from a financial loss in the event that tornadoes or floods render the properties unusable. A business entity that has significant holdings in states bordering the Gulf Coast area might choose to issue a catastrophe bond that would provide some degree of financial protection in the event of a hurricane. By passing on the risk to the investor, the originator stands a good chance of remaining financially solvent, even in the face of a major disaster.
For the investor, the acquisition of a catastrophe bond represents a security with a high level of risk. At the same time, bonds of this type are definitely high-yield opportunities. If no disaster occurs during the life of the bond, then an investor stands to realize a return that may be anywhere from three to twenty percent. Of course, should a covered catastrophe occur, the investor will lose the entire principal investment, which may amount to a substantial amount of resources.
A catastrophe bond is one way to diversify the investment portfolio, and provide at least one investment that has the potential for a high level of return. At the same time, this type of insurance-backed bond does come with significant risk, which may cause the catastrophe bond to not be the right choice for many investors.