How Do Insurance Catastrophe Bonds Work?
By Lauren Golick, Supervisor, Assurance Services
Fall is here, which means several things:
- It is now socially acceptable to drink Pumpkin Spice Lattes from Starbucks
- The Halloween candy you already bought will probably not make it until the end of October
- Hurricane season is here
Obviously, the first two items are jokes, but the hurricane part is true. Hurricanes and other natural disasters can devastate affected areas, especially at this time of year. Having insurance is important to ensure that assets are protected; in the case of such an occurrence, the insurance company will usually pay its customers for any lost or damaged items. But what happens if the insurance company has abnormally large payouts? How can it afford to stay in business? That’s why there is another element that we need to consider: catastrophe bonds (CAT bonds).
CAT bonds are high-yield debt instruments that seek to raise funds for insurance companies if a natural disaster occurs and warrants a large payout from an insurance company. They have short maturities, usually only 3-5 years, and are used by insurers and even reinsurance companies to transfer risk to their investors. Essentially, they allow investors to purchase bonds and receive higher interest rates than most fixed-income securities, plus the principal amount at the end of the bond’s life. However, if a natural disaster occurs over the dollar amount raised from the bond issuance and payout from this special CAT bond fund is triggered, investors can lose their principal amount and future interest payments. This can be a large disadvantage, since the risk does not fall on the insurance company but the investors. There are different stipulations that trigger the payment of funds out of this collateral account; sometimes payout only occurs if total natural disaster costs exceed a threshold over a certain time period, or payout could be dependent on the strength or quantities of the natural disasters.
So what are some other benefits to CAT bonds, other than higher than average interest rates? Since natural disasters are not linked to the performance of the stock market, they serve as a diversifying factor in portfolios.
As we weather this hurricane season (yes, pun intended), consider the role that catastrophe bonds play in the insurance industry and the effect they could have on your investment portfolio. The advisors at Marcum are happy to answer any questions that you have on this subject.