Insurance-Linked Securities and Cat Bonds

Insurers and reinsurers use these securities to pass the risk of typhoon and earthquake claims to bond investors, as a way to prepare for claim payments.

What is exchanged

In a catastrophe bond (cat bond), the best-known insurance-linked security (ILS), an insurer or reinsurer that wants to pass on disaster losses (the sponsor) sets up a special purpose vehicle (SPV). An SPV is a separate legal structure created only for this transaction. It has no employees or property of its own and raises capital through bonds¹. The SPV issues bonds to investors and invests the proceeds in low-risk securities (collateral)². The collateral is held in a trust account, and the sponsor receives protection from the SPV in the form of a reinsurance contract or a catastrophe swap¹. The general structure of such bonds is covered in What Are Structured Products?.

The coupons to investors are paid from the return on the collateral and from the insurance premiums the sponsor pays to the SPV². If the specified disaster does not occur during the life of the bond, investors receive the coupons and get their principal back from the collateral at maturity. If an event occurs, the collateral goes to the sponsor. Investors lose most or all of their principal and any unpaid coupons. The term is most often 3 years, within a range of 1 to 5 years².

Consider a hypothetical example in which Company Y, a non-life insurer, issues a cat bond on the following terms to prepare for typhoon claims.

Figure description

Investors pay the SPV 10 billion yen to buy the bonds. The SPV invests the proceeds as collateral, pays investors a coupon of 600 million yen a year, and returns the 10 billion yen of principal from the collateral at maturity. Company Y pays the SPV a premium of 500 million yen a year. Only when an event that meets the trigger occurs does the SPV pay Company Y from the collateral, and the investors' principal is written down by the same amount.

Payoff at maturity

If Company Y's claims are 300 billion yen or less, the principal is not written down. Above 300 billion yen, the principal is written down by the excess, and the whole 10 billion yen is gone at 310 billion yen. Besides this type, in which the write-down is proportional to the claims, there is a type that writes down a fixed share of the principal all at once when a condition is met³.

To keep the example simple, assume that the write-down is fixed at the end of year 3 and that investors receive 3 years of coupons. Actual bonds pay different amounts of coupon depending on when the event occurs, so this is a simplification.

The investors' profit and loss is the 1.8 billion yen of coupons over 3 years minus the write-down. Company Y's burden is its claims, minus the amount it receives from the collateral, plus 1.5 billion yen of premiums over 3 years. Without the cat bond, the burden would have been the claims themselves: 280 billion yen, 305 billion yen, and 330 billion yen.

Figure description

The investors receive 1.8 billion yen of coupons over 3 years. If Company Y's claims are 300 billion yen or less, the profit and loss is the coupons alone, 1.8 billion yen, and this is the maximum. Above 300 billion yen, the profit and loss falls by 100 million yen for every 100 million yen of additional claims, and it reaches zero (the break-even point) at 301.8 billion yen. At 310 billion yen and above, the whole principal is written down and the loss is fixed at 8.2 billion yen. The larger the disaster, the larger the investors' loss, while the profit is capped at the coupons. The axis of the figure is in units of 100 million yen.

In this example, if no event occurs, Company Y's burden rises by the amount of the premiums. If an event occurs, the amount Company Y receives from the collateral equals the write-down of the investors' principal. If no event occurs, 500 million yen a year of the investors' coupon is the premium that Company Y pays.

Types of triggers

The trigger decides whether the collateral passes to the sponsor. Triggers divide broadly into the indemnity trigger, which uses the sponsor's actual losses, and index triggers, which are further divided into parametric, industry loss index, modeled loss, and hybrid triggers⁴.

The type changes the speed of settlement and the risks borne by investors and sponsors. A mismatch between the sponsor's losses and what it receives is called basis risk.

An indemnity trigger depends on the sponsor's actual claims, so it works much like reinsurance. On the other hand, losses must be verified and confirmed, so it can take 2 to 3 years from the event to payment, which the OECD contrasts with 3 months for non-indemnity triggers⁵. An index trigger depends only on measurements or an index, so it is fast and the structure is easy for investors to understand. The sponsor, however, bears basis risk, because what it receives can differ from its own losses⁶.

Sources differ on how the trigger relates to yield. FINRA says that indemnity triggers, which protect the sponsor best, have the highest yields, while parametric triggers tend to be lower⁷. In contrast, the studies cited in an OECD report reach different conclusions on how the trigger type affects yield⁸.

In actual issuance, indemnity triggers account for the majority. The OECD report states that about 75% of cat bond and ILS issuance in 2023 used indemnity triggers⁹.

What the coupon pays for

The coupon on a cat bond is the floating-rate return $L$ on the collateral plus a fixed spread $s$ set at issuance¹⁰.

$$c = L + s$$

Here $c$ is the coupon rate investors receive, $L$ is the floating-rate return on the collateral, and $s$ is the risk premium that pays for the insurance risk. In Company Y's example, $L$ is 1% a year, $s$ is 5% a year, and the coupon rate is 6%. The spread $s$ corresponds to what the insurance world calls the rate on line (ROL). The rate on line is the ratio of the premium to the amount of loss that can be recovered. In Company Y's example, it is 5%, the ratio of the 500 million yen premium to 10 billion yen¹¹.

Because the collateral is high-quality securities that pay a floating rate, investors' interest rate risk and credit risk are small, and the main remaining risk is losing principal when the trigger event occurs¹⁰. The spread $s$ depends on the trigger type, the rating, the term, and the number of perils covered. A bond covering several perils often incurs no write-down on the first event and a loss only from the second or later event¹².

What moves the price after issuance

After issuance, the price falls sharply when an event may have occurred¹³. The maturity can be extended to verify the trigger or to assess claims, and the extension ranges from 3 months to more than 2 years depending on the bond¹³.

Ease of selling also affects the price. Secondary market trades are negotiated directly between two parties and prices are often not published, and cat bonds are said to be less liquid than corporate bonds¹⁴¹⁵. One study estimates the liquidity premium in secondary market cat bond yields at 98bp, or 21% of the total risk premium¹⁶.

Who uses them and the size of the market

Sponsors include insurers and reinsurers, and there are also cases in which foreign governments and private companies have acted as sponsors to prepare for natural disasters². For a sponsor, a cat bond replaces or complements reinsurance. Because the collateral is fully funded, a cat bond is less exposed than reinsurance to the other party's inability to pay. Many have terms of 3 to 4 years, so they provide multiyear protection, unlike reinsurance, which must be renewed every year¹⁷. On the other hand, the sponsor keeps paying the premium in years when no event occurs, which is a cost.

Investors cite a higher coupon rate than corporate bonds with the same rating, and returns that tend not to move with other assets. The effect of disasters on financial markets is not well studied, however, and diversification can be limited if several bonds are tied to the same event. Cat bonds are not often sold directly to individual investors and are mostly held by funds such as mutual funds¹⁸.

The size of the market can be seen from the following figures in the OECD report. Cat bonds began in 1996 with a single transaction, and cumulative issuance exceeded 560 deals in 2022¹⁹. New issuance was USD 12.8 billion in 2021 and USD 8 billion in the first half of 2022²⁰. In the report's 2022 data, the perils covered are mainly those in Europe, Japan, and the United States²¹.

Two Japanese examples follow. The first is the first cat bond in Japan, a transaction from the mid-to-late 1990s. Tokio Marine and Fire transferred USD 100 million of earthquake risk over a term of 10 years. Parametric Re, a special purpose reinsurer in the Cayman Islands, provided the earthquake reinsurance contract. It had a parametric design: when an earthquake in a specified area around Tokyo measured magnitude 7.1, 7.2, or 7.3, 25%, 40%, or 55% of the principal, respectively, became subject to loss, and above 7.6 the entire principal did²².

In the second, Zenkyoren, the national organization of the mutual aid system of agricultural cooperatives, issued a parametric cat bond in 2008 through a special purpose company in the Cayman Islands. After the 2011 earthquake in the Tohoku region it paid out in full, and the proceeds were used for payments to farmers insured under the mutual aid system²³.

Risks

The investors' largest risk is the sudden loss of most or all of the principal when an event occurs. The high yield does not make up for the loss when an event occurs. FINRA calls this sudden loss of value triggered by an event the credit cliff¹⁴.

Investors also bear the following risks.

• Prices, yields, and ratings depend heavily on the models that estimate disaster losses. Data quality varies by peril and region. A modeled loss trigger also depends on how far the model differs from actual losses¹⁴²⁴.
• Limited liquidity and extension of maturity are risks investors bear, as described in "What moves the price after issuance" above.
• Whether an event qualifies can be disputed, and a court's decision may be needed. The trigger terms are written in the offering documents, which may be visible only to buyers²⁵.
• In the United States, many cat bonds are offered under Rule 144A and are for institutional investors. They are not registered with the Securities and Exchange Commission (SEC) and carry no obligation of periodic disclosure, so information for evaluating the price or structure can be hard to get²⁶.

With a parametric or index trigger, the sponsor bears basis risk, because what it receives can differ from its own losses. With an indemnity trigger, the sponsor has no such gap. Investors, in turn, worry about moral hazard. Moral hazard here means that, because of differences in information, an insurer may act in ways such as not paying losses properly. Some theoretical studies conclude that, for this reason, indemnity triggers have higher yields⁵⁸.

Differences from similar products

There are other kinds of insurance-linked securities besides cat bonds. The four main types of ILS are collateralized reinsurance, cat bonds, industry loss warranties, and sidecars, and collateralized reinsurance accounts for the largest share of the market²⁹. A sidecar is a structure that lets institutional investors take part directly in the profits and losses of a specific set of an insurer's policies, much like a small insurer or reinsurer. It resembles a cat bond SPV, but it is often negotiated individually and issues both equity and debt³⁰. There are also securities that pool the ILS of several sponsors into one (collateralized risk obligations, or CROs). They can lower the chance that investors lose everything, and they can also increase losses if diversification is insufficient³¹.

A weather derivative is a transaction close to a parametric cat bond in that it does not assess losses and pays a set amount if an observation meets the condition. The difference from insurance, which is whether losses are assessed, is covered in Weather Derivatives. A cat bond differs in that investors pay the price in advance and it is held as collateral.

Notes

1. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific" (2024), pages 27–28 (Figure 2.2 and text: the nature of the SPV, collateral in a trust account, protection through reinsurance or a catastrophe swap). ↩ ↩²

2. Financial Industry Regulatory Authority (FINRA), "Insurance-Linked Securities" (July 9, 2021), "What Are Insurance-Linked Securities?". The party that pays the premium is shown in OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 and Figure 2.2. ↩ ↩² ↩³ ↩⁴

3. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 ("The payout function can be binary or proportional to an underlying trigger metric"). ↩

4. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 ("CAT bond trigger mechanisms and choice of trigger"). ↩

5. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 ("Indemnity triggers." The contrast between 2 to 3 years and 3 months is cited in the report as Polacek (2018). The operational risk and stress tests are in the same place). ↩ ↩² ↩³

6. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 15 and pages 28–29 ("Parametric triggers," "Industry-loss index triggers," "Modelled-loss trigger mechanisms"). ↩

7. FINRA, "Insurance-Linked Securities," the "Trigger Happy" table (yield and speed of verification for parametric, modeled loss, industry loss index, indemnity, and hybrid triggers). ↩

8. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 32 (Cummins and Weiss (2009), who find higher yields for indemnity triggers, and the study by Gürtler and others, who find no effect) and page 30 (theoretical studies find that indemnity triggers have higher yields because of moral hazard). ↩ ↩²

9. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 30 ("approximately 75% of total CAT bond and ILS issuance in 2023," Figure 2.3. Data from Artemis Deal Directory). ↩

10. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 ("CAT bonds offer a coupon stream consisting of the floating interest rate [...] and a fixed spread." The small interest rate risk and credit risk). ↩ ↩²

11. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 28 ("Rate on Line (ROL)") and page 48 ("the ratio of premium paid to loss recoverable"). ↩

12. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 32 (the factors that determine yield: rating, number of perils, time to maturity, and trigger type. The description of "multi-peril CAT bonds"). ↩

13. FINRA, "Insurance-Linked Securities," "What Are Insurance-Linked Securities?" ("the SPV might also have the right to extend the maturity." From 3 months to more than 2 years) and Liquidity Risk under "Know When to Walk Away." ↩ ↩²

14. FINRA, "Insurance-Linked Securities," "Know When to Walk Away" (The Credit Cliff, Modeling Risk, Liquidity Risk). ↩ ↩² ↩³

15. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 51 ("CAT bonds are less liquid than corporate bonds"). ↩

16. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 54 (estimate by Herrmann and Hibbeln (2022): 98bp, 21%). ↩

17. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 9 (Executive summary: full collateralization removes counterparty default risk) and page 48 ("typically exhibit a term of three to four years," reinsurance renewed annually). ↩

18. FINRA, "Insurance-Linked Securities," the opening ("generally not offered directly to individual retail investors") and "Reasons Given for Holding Them" (FINRA's caution on the limited study of disaster effects and on diversification is in the same place). ↩

19. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 33 ("From a single transaction recorded in 1996, cumulative issuance of CAT bonds amounted to more than 560 deals in 2022"). ↩

20. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 35 (USD 8 billion in the first half of 2022, USD 12.8 billion in 2021. Data from Swiss Re). ↩

21. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 36 ("CAT bonds have mainly been issued to cover certain named perils in Europe, Japan and the United States"). ↩

22. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 110 ("Japan." The loss share by earthquake magnitude in the Tokio Marine and Fire transaction) and page 21 (mid-to-late 1990s). ↩

23. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 111 ("Zenkyoren," the 2008 parametric transaction, the full payout in 2011). ↩

24. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 29 ("Modelled-loss trigger mechanisms." "model risk"). ↩

25. FINRA, "Insurance-Linked Securities," the opening of "Trigger Happy" (the trigger is written in the offering documents, which may be visible only to buyers. Interpretation can lead to litigation). ↩

26. FINRA, "Insurance-Linked Securities," "Know When to Walk Away," Unregistered Investments ("Rule 144A offerings"). ↩

27. FINRA, "Insurance-Linked Securities," "What Are Insurance-Linked Securities?" (rating agencies, sponsors, and underwriters rely on a small number of modeling firms) and Modeling Risk. ↩

28. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 29 ("Industry-loss index triggers." PCS is a US example). ↩

29. OECD, "Fostering Catastrophe Bond Markets in Asia and the Pacific," page 27 ("There are four main types of ILS"). ↩

30. FINRA, "Insurance-Linked Securities," "Other Insurance-Linked Securities" ("sidecars"). ↩

31. FINRA, "Insurance-Linked Securities," "Other Insurance-Linked Securities" ("collateralized risk obligations (CROs)"). ↩