What are Cat Bonds?
Catastrophe Bonds (“Cat Bonds”) are sold by insurance companies like Allstate, State Farm, and USAA as a way to offload some of the risk that a major weather event like a hurricane or earthquake will force the insurance company to pay out an extremely high amount of claims to their policy holders.
The investor buys the bond hoping to earn a relatively high rate of interest and receive their entire principal back at the conclusion of some time period (usually 1 to 3 years). However, if there is a catastrophic event that does occur, the investor stops receiving interest payments and forfeits all or most of their original principal.
The insurance company gets to keep that money and can use it to offset the cost of paying claims. There are different ways the triggering event can be called out in the bond offering, for instance, one method would say that the event is triggered when a particular agency reports that industrywide losses from a hurricane exceed $50 billion.
Cat bonds have only been around since about 1997 so there hasn’t been a long track record with them; however, the cat bonds issued since 1997 have mostly paid out interest and principal without the triggering event ever happening.
Between 1997 and 2013, investors have only lost out about 4% of the time (~2% due to the weather event triggering, ~2% due to the Great Recession causing impairment to the issuer or collateral). This type of investment is obviously a major gamble, but it is a gamble that has been paying off of late.
Diversification and Income
There are two major reasons for investing in cat bonds. The first is that the income that the cat bonds pay is high relative to other bonds.
It is almost like buying a junk bond; high risk, high return. This WSJ chart shows that cat bond yields from 2006 to about mid-2013 always stayed above 6% and went as high as 12% on a couple of occasions. Like junk bonds, cat bonds are rated below investment grade.
Buying corporate bonds from Allstate, you are betting on the credit quality of Allstate, which is rated highly. Buying cat bonds from Allstate, you are betting on the hurricane season, which is very difficult to analyze and somewhat random.
The second major reason is diversification. Investors are always looking for an investment that might do well when others are doing poorly. The thought is that hurricanes and the stock market aren’t strongly correlated. There haven’t been a lot of academic studies to prove or disprove that theory, but at a high level it seems to make sense to many cat bond investors.
For the individual investor, cat bonds aren’t something you can just login to your Schwab account or got to Allstate.com and buy. The buyers are institutional investors like hedge funds and investment sizes are in the millions.
The only route for an individual investor to invest in cat bonds would probably be through mutual funds. You can Google the words “cat bonds” or “insurance-linked securities” followed by “mutual funds” in front of them to find a few. You should probably be able to find a mutual fund with a manageable minimum investment size of perhaps $5000 to $10,000.