Catastrophe Bonds: Definition, Benefits, How to Structure

Article Key Points: 

• Catastrophe bonds (CAT bonds) are high-yield, high-risk bonds designed to fund insurance companies during natural disasters, helping them avoid insolvency.
• CAT bonds are part of the Insurance-Linked Securities (ILS) market and are issued by organizations like insurers, reinsurers, and even corporations and governments to manage risk.
• The structure of CAT bonds involves creating a Special Purpose Vehicle (SPV) that acts as an intermediary between investors and the insurer, setting up a trust for the principal, and selecting a structuring agent to assist with bond design and sales.
• There are several types of triggers that can activate a payout to the sponsor, including indemnity, industry loss, parametric, and modeled triggers, each with its own criteria for payout.
• The future of CAT bonds looks promising, with high yields and ongoing growth, despite fluctuations in investor interest and yield stability.

Catastrophe Bonds Explained (CAT) 

Since the mid ‘90s, insurers have used catastrophe bonds in response to cataclysmic events like hundred-year floods, category four and five hurricanes, major wildfires, and even terrorism. 

CAT bonds are the most popular investment instrument carriers use within the burgeoning Insurance-Linked Securities (ILS) market, which consists of products created to help the insurance industry handle enormous financial setbacks that result from the most extreme circumstances. Reinsurance sidecars and life insurance securitization are two other investment vehicles included in the ILS market, but here we’ll just cover CAT bonds as they are currently the most widely used. 

What are CAT bonds and why would an insurance carrier issue them? We’ll cover these questions, discuss how and why these bonds were conceived, and what the future holds for this high-yield, though also high-risk bond. 

What is a catastrophe bond?

A catastrophe bond is designed to fund companies in the insurance industry when natural disasters like hurricanes, tornadoes, or earthquakes occur. Catastrophe bonds can be a last resort for insurers when claims push a carrier toward insolvency. 

Catastrophe bonds are high-yield bonds that are, in large part, non-investment grade bonds. Investment grade ratings are important because they help the investor understand the risks involved. Credit rating agencies like Moody’s and Standard & Poor’s (S&P) rate bonds according to bond risk variables, and catastrophe bonds tend to fall into the riskiest category, making them unsuitable for typical investors. 

CAT bonds are also sometimes labeled “junk” bonds, which is a Wall Street term for a high-risk bond; however, some have crept into investment-grade territory. These investments are also more often variable rate bonds and can mature anywhere from one to five years, with most hitting maturity at the three-year mark.

Understanding catastrophe bonds

To understand the basics of catastrophe bonds, there are a few terms that are helpful to know. In some cases, investment instruments such as these can be multifaceted, and have special nuances that are particular to that bond deal. However, the following should help you gain a solid foundational knowledge.  

Sponsors

The organization that issues a bond to the investor market. This can be a carrier, a reinsurer, a state catastrophe fund, a country, a non-profit, or even a corporation. An example of a state catastrophe fund is the California Earthquake Authority (CAE), which has sponsored numerous CAT bonds over the years to protect insurers in the event of a major earthquake. 

Another example of a sponsor is search engine giant Google, which has issued three CAT bonds since 2020. While Google (and its parent company, Alphabet, Inc.) aren’t insurance companies, they’ve issued CAT bonds to protect corporate operations in California. The technology giant could face substantial losses in the event of a catastrophic earthquake, and it appears they felt the ILS market was their best bet for financial security.

Investors 

Hedge funds and institutional investors are keen on these instruments for a variety of reasons, namely their high yields. In general, this isn’t a “mom and pop” bond as CAT bond complexity requires a good deal of due diligence and sophistication before investing. In fact, a married “mom and pop” filing jointly will need a combined income that exceeds $300,000 for the two most recent tax-filing years or a joint net worth that exceeds $1 million. If it’s just mom or just dad, he or she needs $200,000 in income and still would need a million dollars in net worth. These investors would be considered accredited, as they meet the requirements, and would be able to purchase catastrophe bonds. 

Catastrophe bonds are also separated from the general stock market’s performance, which helps with portfolio diversification. To a CAT bond investor, keeping tabs on major weather events is more relevant than the ups-and-downs of the Dow Jones or S&P 500. The majority of CAT bond investors are located in the United States, but buyers worldwide also participate in this market. 

Specified set of risks

Risks, as they pertain to the CAT bond definition, are the risks bondholders face that could trigger payment to the sponsor. These risks include major natural disasters such as earthquakes, floods, wildfires, windstorms, tornadoes, and hurricanes. 

Special purpose vehicle & special purpose insurer

The SPV/SPI is “bankruptcy remote” (isolates financial risk for the sponsor) and has the legal authorization to act as the insurer. This means it’s actually able to write reinsurance. In many instances, these vehicles are domiciled in Bermuda, Cayman Islands, or Ireland. Malta is on the map as well. The reasons for these exotic locales are tax and accounting purposes – as one source put it, SPVs find a home in Bermuda because of the country’s “adaptive regulatory environment.” Local legislation in these countries offer the CAT bond sponsor favorable benefits they can’t obtain in the U.S. or other countries with tighter regulations.  

How to set up a CAT bond

Let’s say an insurer has a high concentration of risk because its customers are largely Louisiana homeowners who could all be impacted by a Category 5 hurricane at the same time. The insurer may decide that setting up a CAT bond is the best way to protect its solvency in case of a trigger that exceeds its own ability to pay claims. So, how do they begin? 

Creating and issuing a CAT bond requires setting up multiple special entities and hiring various professionals who are important in the creation and sale of the bond. CAT bonds are intricate financial debt instruments, however, the basic elements can be broken down into the following phases:

Create a SPV/SPI

In this example, this hypothetical insurer is looking for help reducing its risk of hurricane-induced losses. It creates an SPV that acts as the intermediary between bond investors and the insurer. This vehicle is the center of the action between investors, the insurer, and trust accounts (which we discuss later on). The insurer pays premiums into the SPV and, if a catastrophic event is triggered, the principal amount (provided by the investors) will flow to the insurer from the SPV.

Set up a trust

When bonds are sold, the principal is collected in the SPV and placed in a trust, which can then be reinvested into low-risk accounts like a money market. Returns from this external trust vehicle flow back to the SPV and on to investors in the form of variable rate payments. To sweeten the pot, investors also receive a premium payment through the SPV from the sponsor for bearing the risk of losing their principle in the event of a catastrophe or triggering event. 

Select a structuring agent

The sponsor selects a structuring agent, typically an investment bank, to assist with bond design and sales. The bond purchasers buy from the structuring agent, who’s licensed to sell bonds. An independent modeling agent is essential to craft models to forecast sponsor event risks, and they work alongside attorneys to ensure securities compliance. As you can see, there are a few “cooks in the kitchen” when structuring and issuing a CAT bond.     

Determine the trigger

The structuring agent and sponsor work together on the sponsor protection dollar amount and select the triggering event that’ll activate a payout to the sponsor from bond investors. In addition, the trigger has to occur within the time frame agreed upon in the contract. Many of these trigger events are tricky to substantiate, and some require independent third parties to confirm the aggregate dollar amounts. There are several companies that provide this third-party verification service.

Catastrophe bond payouts  

A “trigger” precipitates payout from bondholders to the CAT bond sponsor. The most common are indemnity and industry loss triggers, followed by parametric and modeled loss triggers.

Depending on how the bond is constructed, the payout to a sponsor after the trigger occurs is either a portion of the principal of the bond or the whole amount. If a trigger is activated, bond holders could lose their investment, which is why these products are so risky for investors. If a specific triggering event doesn’t occur within the agreed upon time frame, investors then receive their principal back at the bond maturity date. 

Types of CAT bond triggers  

There are several types of triggers in the world of CAT bonds. These include:

• Indemnity triggers
• Industry loss triggers
• Parametric triggers
• Modeled triggers

Indemnity triggers

The indemnity trigger activates a payout to the sponsor based on the sponsor’s actual losses. Indemnity triggers may mean longer payout processes because it can take more time to verify the sponsor’s actual losses. Despite this potential downside, indemnity triggers and industry loss triggers are the most common types of CAT bond triggers.  

Industry loss triggers  

The industry loss trigger activates a payout to the sponsor based on what the insurance industry as a whole loses as a result of a catastrophic event. The losses must exceed an amount, called an attachment point, which the sponsor sets beforehand. Again, data collection on this trigger can take a long time to compile after a serious disaster. State governments and individual insurers release initial assessments, but this number often changes as more facts and data points are collected.

Parametric triggers 

A less common trigger, the parametric trigger, is activated when an event surpasses a certain predetermined threshold. For example, if an earthquake is equal to or greater than 5.0 on the Richter Scale or a hurricane’s wind speeds are more than 120 mph. These measurements are easier to confirm quickly with modern technology, resulting in faster payouts to sponsors.

Modeled triggers 

These triggers are similar to indemnity triggers with one major difference: Rather than being based on actual claims, this trigger relies on computer and/or third-party models. These models are estimations and will render data much faster than the indemnity triggers. Modeled triggers only compose around 1 percent of the current trigger mechanism pie, and were more common in the early years of CAT bond development.

In addition to the above types of triggers, CAT bonds can be structured per event or can provide coverage for multiple catastrophes over a specified period of time. For example, a trigger could be set off when a third hurricane strikes in a certain region within a specific time frame, or by combined losses from three named storms in a season. The sophistication level and creativity of triggers continues to evolve as much as the world’s weather does.

Even “catastrophic” disasters may not trigger CAT bond payouts

As of this writing, the California wildfires of 2025 have caused an estimated $275 billion in damage. They are by all definitions, “catastrophic.” But does this mean they’ll trigger CAT bond payouts to the bonds’ sponsors? Not necessarily. The Insurance Journal reports that CAT bond fund managers expect to get through this round of wildfires largely unscathed, with most of the losses hitting primary insurers and their reinsurers. 

Because CAT bonds are intended for the most catastrophic of catastrophes, the thresholds for paying out are very, very high. It’s also uncommon for CAT bonds to be written for wildfire risks alone. Rather, the bonds are set up so that a fire is only one portion of what’s necessary to trigger payout. On top of that, CAT bonds are often based on aggregate or cumulative risk over the course of a year, so an extreme event like January, 2025’s California wildfires may be too early in the year to reach that aggregate dollar amount. 

History of CAT Bonds  

CAT bonds were created, in part, as a response to insurers’ staggering losses during Hurricane Andrew in 1992. At the time, it was the costliest natural disaster to ever strike the United States. Clocking in at over $25 billion in damages, Andrew and its ensuing wrath resulted in the failure of numerous insurance carriers. Further disasters such as the 1994 California Northridge Earthquake reinforced a sense of urgency within the insurance industry to find a solution for the largest and costliest situations. 

Since then, the CAT bond market has bounced along steadily and somewhat quietly until Hurricane Katrina roared ashore in 2005. Katrina caused over $65 billion in insured losses, triggering an explosion in bond growth, resulting in a 136% increase in issued bonds in 2006. The financial crisis of 2008 to 2009 resulted in a slowdown, especially in wake of the Lehman Brothers collapse, but bonds stormed back by 2010.

As the world grows even more dangerous, risks are expanding into other areas such as terrorism and pandemics. In fact, PoolRe, a U.K. terrorism reinsurer, issued the first bond to cover insurance carrier losses suffered as a result of terrorist acts. A pandemic, in the wake of Covid-19, is now a real risk, and the appetite for pandemic CAT bonds is growing as well.

Taking full advantage of the high yields they so covet, institutional investors continue to place money into CAT bonds. Additionally, the insurance industry continues to use bonds to buffer themselves as losses pile up from unabated disasters.

Benefits of catastrophe bonds  

As losses mounted in the early ‘90s insurance industry, Wall Street came to the rescue after other financial safety plans became inadequate. Reinsurance was just not enough anymore; the industry needed new options. 

Obviously, the biggest CAT bond benefit is capital to keep a carrier solvent, but there are other advantages as well. The overall cost of capital can be lower for a sponsor if a carrier decides to explore this special bond market. A bond helps an insurance carrier obtain money from a variety of different sources. For example, hedge funds will naturally compete with reinsurers, driving down reinsurance costs. As the pool of capital increases for a carrier to choose from, it creates more flexibility and options for bond sponsors

Catastrophe bond structuring  

Catastrophe bond deals are typically structured as multi-year agreements, whereas most reinsurance contracts are for 12 months. The extended time afforded by a bond allows the issuing sponsor to enjoy set prices for a longer period. Insurers are also required to have a minimum reserve account on standby, and these bonds assist in reducing that amount.   

What does the future look like for CAT bonds?  

The overall future looks good for CAT bonds, considering even some of the worst and most costly hurricanes of 2024 didn’t reach the payout thresholds. This might have made investors more interested in buying CAT bonds in late 2024, particularly considering that high interest rates brought high CAT bond yields that far exceeded previous predictions of hitting eight or nine percent in 2023. 

At the same time, thanks to early and large disasters like the California wildfires in January, 2025, investors have good reason to be concerned that more large-scale disasters later in the year could trigger bonds to pay. This concern has caused CAT bond prices to drop, as they’re seen as more risky and less appealing at this particular moment in time.  

Still, current yields are fairly stable, though down from extreme highs in 2023 and 2024 when high interest rates drove CAT bond yields even higher. 

Manage catastrophic risk in your distribution channel with AgentSync

We’re not in the CAT bond business, but we do help insurance agencies, carriers, MGAs/MGUs, and others reduce their compliance risk and take charge of their distribution channel management strategies. 

Contact us today, or watch a demo to learn how AgentSync can transform the way your organization manages its distribution channels from start to finish.