A bond whose repayment of principal is conditioned on a predefined catastrophe not occurring.
The catastrophe bond, or cat bond, is the most emblematic Insurance-Linked Security. It is a bond issued through a dedicated vehicle, by which a cedant transfers a catastrophe risk to investors. The latter put up capital that is held as collateral and receive in return a coupon comprising the risk-free rate and a catastrophe risk premium. If no triggering event occurs during the contract's term, investors recover their capital at maturity. If, however, the predefined event materializes, all or part of the capital is paid to the cedant to fund its losses, and investors suffer a corresponding loss. The trigger may be indemnity-based, founded on the cedant's actual losses, or parametric, founded on objective physical parameters such as an earthquake's magnitude. The cat bond offers the cedant multi-year capacity, near-zero counterparty risk thanks to the collateral, and diversification of capacity sources. Its limitation lies in the need for a well-modeled risk and a clear trigger, which explains its slower development in cyber, where modeling uncertainty and basis risk remain high.
A parametric cat bond triggers automatically if an earthquake above magnitude 7.5 strikes a defined zone, releasing the capital to the cedant without prior loss adjustment.
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