A catastrophe bond(CAT Bond) is a financial instrument which insures the insurer in cases of natural disasters. These events include tsunamis or earthquakes. The loss is transferred to the investors of the bond. In layman terms, these bonds insure an insurance or re-insurance company who is subject to loss in case of specified insurance risks. Pay-out to the insurance company is approved only if there is a series of natural events. For instance, the five hurricanes that hit Texas. The Insurance and re-insurance companies who issue Catastrophe bonds, are majorly involved in real estate or casualty insurance. If a disaster is witnessed, the pay-out and the interest due is either forgiven, or is postponed for the future. These bonds, yield higher returns than any fixed income instruments, as the investor is undertaking a higher degree of risk.
Economic catastrophe bonds are the bonds which trigger payment only when the economy experiences adverse situations. They possess lower risk of default being subject to severe economic conditions. This security is created by pooling different financial security. They have different risk factors to hedge against the risk of an economic situation.
Triggers that simulate a pay-out :
- Indemnity : The sponsor or investor is indemnity against the losses of the insured in absence of actual losses. For instance the loss margin has been set at above Rs 500 million. Then the pay-out is obligatory only if the losses cross the threshold of Rs 500 million.
- Modeled Loss : The deciding factor as to whether pay-out is eligible or not a model is adapted. The model is known as exposure model. In case of loss making specified event the database is run against the model. The outcome is final and accepted.
- Indexed to Industry Loss : Here the underlying parameter is the industry loss. The index is determined by a recognized agency. If the loss crosses the specified limit a pay-out is inevitable.