Accounting Best Practices, Fifth Edition

11–21. Issue Catastrophe Bonds

A company may issue debt and then be unable to pay it back to creditors, due to the impact of a natural disaster on its facilities. A good way to reduce the impact of a natural disaster on debt repayment is the catastrophe bond. More commonly known as a cat bond, it is designed to raise money in the event of a major catastrophe, which is usually defined as an earthquake, hurricane, or windstorm. If the issuer suffers a loss from a predefined catastrophe, then its obligation to repay the interest or principal is either deferred or canceled. Some cat bonds are indemnity based, which means that they pay out based on actual claims stemming from the catastrophe; these bonds are considered more risky for bond purchasers, since a wide variety of claims may be brought. Another type of cat bond is based on parametric data, so they pay out only if precise physical measurements of the actual event occur, such as wind speed or earthquake magnitude exceeding a threshold level.

Large cat bonds are almost always issued by reinsurance companies, and are typically rated as junk bonds. The only recent exceptions have been the Oriental Land Company (Japanese earthquake), Vivendi Universal (California earthquake), and FIFA (terrorism during the 2006 World Cup). The most recent information about cat bond issuances and risk profiles by country is listed in the excellent World Catastrophe Reinsurance Market report, which is available for free from Guy Carpenter at www.guycarp.com ...