Catastrophe bond (cat bond)

August 1992: Hurricane Andrew costs insurers billions of dollars and pushes the market to look for capital outside reinsurance. In 1997 USAA places Residential Re, $477 million of notes, one of the first issues of its kind. The catastrophe bond, or cat bond, is the best-known insurance-linked security. A special purpose vehicle issues the bond, usually in 144A format and for about three years, and the cedant transfers a catastrophe risk to it. Investors put up capital held as collateral in a trust and earn a coupon made up of the risk-free rate and a catastrophe risk premium, the spread, which the market reads as a multiple of expected loss. If no triggering event occurs during the term, they get their capital back at maturity. If the predefined event happens, all or part of the capital is paid to the cedant to fund its losses, and investors lose accordingly. The trigger may be indemnity, tied to the cedant's actual losses, or parametric, tied to objective physical parameters, for instance an earthquake above magnitude 7.5 in a defined zone, which releases the capital without loss adjustment. Industry loss indices and modeled loss sit in between. Compared with a cat treaty, cat bonds give the cedant multi-year capacity, near-zero counterparty risk thanks to the collateral, and more varied sources of capacity, at the cost of basis risk once you move away from indemnity. They need a well-modeled risk and a clear trigger, which explains their slower development in cyber, where modeling uncertainty and basis risk remain high.