Handbook of Finance: Financial Markets and Instruments

Chapter 37. Catastrophe Bonds

WILLIAM L. MESSMORE

Vice President, Lehman Brothers

BETH STARR

Managing Director, Lehman Brothers

SUNITA GANAPATI

MARK RETIK

PAUL PULEO

Abstract: Catastrophe bonds represent a growing class of structured insurance risk products that offer returns that are linked to the occurrence of catastrophic events such as earthquakes and hurricanes. These securities can provide investors with diversification from corporate and asset-backed securities at comparable or wider spreads. Issued through special purpose vehicles, these bondlike securities are usually rated and offer an opportunity to participate directly in catastrophe risk with the benefit of an active secondary market. Investing in catastrophe risk can also improve the risk-return profile of a diversified portfolio of assets because this risk is generally uncorrelated with general credit and interest rate risk present in other securities markets.

Keywords: catastrophe bonds (cat bonds), sidecars, attachment point, trigger, extreme mortality securities, collateralized debt obligation (CDO), synthetics, industry loss warranties (ILWs), shelf issuance programs

The need for additional reinsurance capacity following Hurricane Andrew (1992) and the Northridge earthquake (1994), which in combination produced $27 billion in industry-wide insured losses, encouraged insurers to seek a new form of reinsurance protection. Driven by a particularly catastrophic 2005 U.S. wind season with Hurricanes Katrina, Rita, and Wilma, ...