Page 19 - Insurance Times July 2022

The first CAT Bonds were issued in 1997, giving insurers access Most CAT Bonds are rated below investment grade (BB and
to broader financial markets. Since then, the CAT Bond B category ratings).
market has grown steadily and they have been utilized to
mitigate the expenses of severe natural disasters. Natural disasters and Risk transfer
through CAT Bonds
What are CAT Bonds?
Many countries have insufficient protection against the
CAT Bonds are a type of insurance-linked security (ILS)-an financial impact of natural disasters. Failure to close this
umbrella term for financial securities that are linked to pre- protection gap can divert funds away from other critical areas
specified events or insurance-related risks. of need and drain state and national budgets. One way to
build protection is to transfer the financial risk of natural
They are thus a type of high-yield debt instrument that is catastrophes to third parties such as insurers.
designed to raise money for the insurance industry in the
event of a natural catastrophe or disaster. The term natural This form of risk protection provides governments with the
catastrophe (Nat Cat) refers to a major adverse impact from funds to respond quickly to disasters and helps strengthen
either weather or geological-related events. their financial resilience.

Implementation of a successful risk transfer program requires
Basically, CAT Bonds allow insurance companies to transfer
co-ordinated effort by all stakeholders.Public-private sector
the risk of natural disasters covered by their policies to
cooperation is key in this equation with both parties playing a
investors for a price.
complementary role. The public sector has the breadth of
When CAT Bonds are issued, the proceeds raised from distribution and ability to create a conducive operating
investors go into a secure collateral account, where they environment, whilst the private sector brings products,
technology and expertise.
may be invested in various other low-risk securities. The
money raised with these bonds is set aside to cover potential
A conducive regulatory environment is also required since it
losses. Interest payments to investors come from these
attracts the right public/private participants, facilitates
secure collateral accounts.
prompt distribution of pay-outs and ensures a sustainable
A CAT Bond allows the issuer to receive funding from the program.
bond only if specific conditions, such as an earthquake or
tornado, occur. If triggers spelled out in the contract - insured How CAT Bonds help to mitigate the
losses from a hurricane reaching a specific level, for example costs of extreme weather events
- are met, the insurer gets to use the money to offset what it
Disasters take a huge toll on individuals and larger
has paid out to policyholders.
communities. The financial fallout is generally handled by
insurance and government support through mechanisms such
If an event protected by the bond activates a pay-out to the as disaster response funds. The protection is inadequate
insurance company, the obligation to pay interest and repay because the available options are not good enough to meet
the principal is either deferred or completely forgiven and increased natural risks.
the holders of the bond lose their investment.
Insurance against extreme events works best if insurers are
able to spread the risk among a wide pool of investors. That
CAT Bonds have short maturity dates between three to five
way, neither will insurers be financially overwhelmed by a
years.
disaster, nor will they have to disproportionately raise
premiums to cover increased risk of some events like floods
Individual investors do not usually buy CAT Bonds.The primary
or earthquakes.
investors in these securities are hedge funds, pension funds
and other institutional investors.
It is with this understanding that solutions have emerged
where one avails of a larger global basket of insurance-linked
CAT Bonds are often rated by an agency such as Standard &
securities (ILS), particularly Catastrophe Bonds.
Poor's, Moody's or Fitch Ratings. They are rated based on
their probability of default due to a qualifying catastrophe Foreign governments have sponsored CAT Bonds as a hedge
triggering loss of principal. This probability is determined with against natural disasters and three such case-studies are
the use of catastrophe models. elucidated below.

The Insurance Times, July 2022 19