INVESTING EXPLAINED: What you need to know about cat bonds

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s cat bonds. 

Something to do with pets?

No. Nothing cuddly here – ‘cat bonds’ is the short name for catastrophe bonds, one of this year’s most rapidly growing sectors.

These securities are sold by insurers seeking to transfer some of the risk of catastrophes, natural disasters, terrorism and, increasingly, cyber threats. Governments or government agencies may also be behind a tranche of cat bonds.

The bonds – which have a typical term of three years to maturity – help the issuer meet their liabilities in the event of an earthquake, a hurricane, a tidal wave or a ransomware attack.

Insurers used to turn to reinsurers to offset such risks, but they can no longer rely solely on this source.

Risky business: The bonds help the issuer meet their liabilities in the event of an earthquake, a hurricane, a tidal wave or a ransomware attack

How do the bonds actually work?

The bonds are sold, usually through a special purpose vehicle company, to investors looking for a high rate of interest. Bonds issued by the Californian Earthquake Authority this year pay either 12 per cent or 15 per cent, depending on the extent of the damages that investors are happy to cover.

These investors are also looking to diversify. They are drawn by the idea that cat bonds are ‘uncorrelated’ to other assets. The value of a cat bond is not subject to economic or stock market fluctuations, and should only fall if the catastrophe covered comes to pass. If it doesn’t, investors receive back their capital at maturity.

What if the worst actually happens?

Investors can lose some or all of their interest and their capital in certain tightly defined circumstances, such as the number and amount of claims that arise. For example, under the terms of a bond covering flooding of the New York subway system, flooding up to a level of 8.5ft would be required to force a pay out.

Who are the investors?

Hedge funds, pension schemes and the super rich are sinking cash into the sector. The other buyers are the fund management groups Amundi, Franklin, GAM and Schroders are some of the biggest buyers. Schroders offers the GAIA cat bond fund which targets a 6 per cent a year return.

Cat bond funds have performed well this year, relative to other bond funds. There may have been many terrible disasters in past months, but the particular catastrophes covered by some funds have not happened.

Not something for private investors, then?

US asset managers consider that only individuals worth at least $100m should be direct investors in cat bond funds, as they can afford the level losses that can arise.

How big is the cat bond market?

It is worth about $41billion, having doubled over the past decade, largely in response to the increased incidence of weather-related catastrophes. The speed of issuance has picked up this year, as disasters mount.

When were cat bonds created?

The trigger for the creation of cat bonds was Hurricane Andrew which hit Florida in 1992, causing about $27billion in damage, of which only about $15.5billion was covered by insurance. Eight insurance companies failed and others came close to insolvency. The need for better arrangements led to the first cat bonds being issued in 1997.

This post first appeared on Dailymail.co.uk