Cat Bond – a bond that purrs loudly when things are good and scratches like hell when they aren’t
Definition: A “cat” bond is an extremely risky, high-interest, long-term bond that is paid back only if a pre-specified catastrophe does not occur
Explanation:
Normally insurance companies (and their insurers, who are called “reinsurers”) assume all the risk for calamities that befall their clients. In the case of cat bonds however, the insurance company (or an investment bank) sells bonds that pay off investors only if a catastrophe doesn’t happen.
If a pre-designated disaster doesn’t happen, the bondholder (usually a hedge fund or other type of large investor) cleans up from payments of high yields and repayment of their total principle by the insurance company that created the cat bond.
If a catastrophe does happen, the principle on the cat bond is not paid back; it is used by the insurance company to pay its clients’ claims from the disaster.
This is literally a bond that lets you “bet your shirt on the weather”.
Broader terms: securitization; diversification; cat models
Copyright © 2011 Nancy K. Humphreys