Catastrophe bond, an alternative to the traditional risk mitigation mechanisms
Transport & Insurance Focus
Countries are increasingly exposed to natural catastrophes that claim human lives and cause substantial economic losses.
Law Update: Issue 376 – Transport & Insurance
Anand SinghSenior Counsel, Transport & Insurance
Melody HuangAssociate,Transport & Insurance, China Group
Countries are increasingly exposed to natural catastrophes that claim human lives and cause substantial economic losses. Over the past 12 months alone, we’ve witnessed many natural catastrophes including flooding and cyclones in several East African countries, record rainfall and flooding in southern Brazil from El Niño, unprecedented torrential rains in Dubai, UAE on 16th April 2024, and many more.
The heavy rain in Dubai especially is a reminder of the need for robust risk mitigation measures, as certain catastrophic events can occur in areas of the world that had traditionally not been exposed to such threats. Studies indicate that the Arabian Peninsula is expected to experience a 30 percent rise in annual precipitation over the course of this century, suggesting that heavy rainfall events may unfortunately become more frequent.
Faced with increasing exposure to natural catastrophes, governments and the insurance industry have over the years developed instruments to deal with such disaster risks. One being catastrophe bonds or “CAT” bonds, as a useful disaster risk financing tool. In this article, we will look at what a catastrophe bond is, how it works and how it is being utilised.
Studies indicate that the Arabian Peninsula is expected to experience a 30 percent rise in annual precipitation over the course of this century, suggesting that heavy rainfall events may unfortunately become more frequent.
A catastrophe bond (CAT bond) is a type of insurance-linked security — an umbrella term for financial securities that are linked to pre-specified events or insurance-related risks. In essence, a CAT bond is a debt instrument which allows the issuer, such as an insurance company, to receive quick access to funds from the bond if a low frequency and high severity catastrophe, such as an earthquake or tornado, occurs. In time of large natural disasters, the funds from the bond will be used to cover insured losses and offer financial protection.
First marketed in the 1990s in the USA, CAT bond was introduced to help strengthen reinsurance companies’ balance sheets in the aftermath of Hurricane Andrew in the US in 1992. Hurricane Andrew caused over USD15.5 billion in insured losses at the time and ultimately led to the insolvency of at least 16 insurance companies. This brought to light the significant shortfall of resilience in the insurance industry to infrequent, but severe natural catastrophe. Since then, CAT bonds have played a pivotal role in offering property and casualty insurers as well as reinsurance companies another way of offsetting the risk associated with underwriting policies by transferring risk to bond investors. This has been utilised as an alternative to traditional reinsurance and retrocession contracts.
CAT bonds allow for financing to be sourced directly from capital markets. The primary investors are hedge funds, pension funds, and other institutional investors. Once CAT bonds are issued by an insurance company, the funds raised from these investors go into a secure collateral account, where they may be invested in various other low-risk securities. Investors benefit from receiving regular interest payments in return for holding the bond, at an interest rate which often is greater than that of most fixed-income securities. CAT bonds typically have short maturity dates of between three-to-five years. The short-term nature of CAT bonds is attractive to the investors as there is less probability that an event triggering payout would occur.
A CAT bond might be structured so that the payout occurs only if the total natural disaster costs exceed a pre-determined dollar amount over a specified coverage period set forth in the bond terms. It can also be linked to the criteria for location and severity, such as a pre-defined hurricane wind speed or earthquake intensity, or to the number of events. If a trigger is activated, bond investors could lose their principal. If a specific triggering event does not occur within the agreed time frame, investors then receive their principal back at the bond maturity date.
Protection gaps in natural catastrophe insurance are a major concern for both OECD and emerging economies. These gaps are defined as the difference between economic losses and insured losses from natural disasters. The worldwide protection gap has reached USD 368 billion, with approximately 76% of natural catastrophe exposure remaining uninsured. Another way to look at this issue is to consider a country’s insurance penetration, which reflects the development of the national insurance sector, and relates the aggregate volume of insurance premium in an economy to its gross domestic product. GCC countries, for example, typically have low insurance penetration and high protection gap.
In the absence of sufficiently developed private insurance markets, disaster losses ultimately remain either with households and businesses, or absorbed by the public sector. In many developing countries or climate vulnerable countries, governments often will have to shoulder the financial burden by diverting state funds, including those earmarked for infrastructure projects, to disaster relief and rebuilding efforts. Therefore, while insurance and reinsurance companies dominate the CAT bonds market, more and more sovereign CAT bonds have been issued by governments seeking ways to transfer risks amid increasing frequency of natural disasters. CAT bond becomes a useful financial instrument to help governments to finance disaster relief and post-disaster reconstruction without over stressing their fiscal budgets.
Government will need to set up a special purpose vehicle (“SPV”) to facilitate the transaction and raise capital through the issuance of CAT bonds from investors who are willing to bet against the likelihood of a disaster occurring in a particular place during a particular time. The SPV invests the money from investors and pays interest payment to them during the life of the bond. When the bond matures, the SPV will return the investors’ funds if the disaster does not occur. However, a payout is necessary to the issuer as soon as pre-defined trigger events occur. CAT bonds provide multi-year coverage to the issuing governments as they typically have maturity dates of between three to five years.
While the global market for CAT bonds has grown steadily over the last three decades, they have mainly been issued in countries that are highly exposed to disasters such as the United States, Europe, Japan, Canada and Australia. In recent years, countries from the Caribbean and Africa have shown a growing appreciation for this financial instrument. It is also a growing area for Asia and the Pacific. In 2021, Jamaica became the first Small Island Developing State in the Caribbean region to sponsor a CAT bond independently. In 2023, the state-owned Earthquake Commission of New Zealand issued its first CAT bond in a move to diversify funding sources beyond the traditional reinsurance.
Moreover, on several occasions, the World Bank have issued CAT bonds on behalf of countries under its MultiCat Program which was set up in 2009 to facilitate access of member countries and public entities to the CAT bond market. The World Bank helps to arrange the bond issuance, provides advice and support for the transaction, and works with other parties involved in the deal, including the underwriters, legal counsel, modeling agencies, and other service providers. For example, in 2019 the World Bank issued two tranches of CAT bonds on behalf of the Philippines to provide the Philippines with a total of USD 225 million in financial coverage against earthquakes and tropical cyclones for three years.
As climate change increases exposure to natural disasters worldwide, CAT bonds can be an effective, market-based financing tool for insurance and reinsurance companies as well as governments to mitigate the risks of rising claims or disaster relief and rebuilding costs. Traditional methods such as reinsurance and retrocession may no longer be sufficient. The future of the CAT bond market, as an alternative to the traditional risk mitigation mechanisms, appears to be strong.
For further information,please contact Anand Singh andMelody Huang.
Published in April 2025
