Catastrophe Bonds (Cat Bonds)

Catastrophe Bonds Author Name Institution Affiliation Catastrophe bonds are also called cat bonds. These are a collection of risk-linked securities that transfers certain risks from the sponsor to the investor. Catastrophe bonds have been around since the 1990s, and they were first used in the aftermath of Hurricane Andrew and the Northridge earthquake. With time, these bonds emerged from a requirement of insurance companies to alleviating risks these companies might have to face in case of a catastrophe. In addition, incur damages may also take place that can be difficult to cover by invested premiums. Insurance companies issue bonds via the investment bank, and these bonds are then sold to investors. Most often, their maturity is not more than three years. During these three years, if no catastrophe occurs, then the insurance company is responsible for paying a coupon or two to the investors. With the arrival of catastrophe bonds, the market developed significantly as insurance companies were allowed to pay some money to their claim-holders. Investors who have had benefited from these bonds are asset managers, hedge funds and catastrophe-oriented funds. These bonds are structured as a floating-rate bond whose principal gets lost if particular trigger conditions are not met properly or efficiently. And if these are triggered, then the principal has to be paid to the sponsor. It’s safe to say that catastrophe bonds have transformed the way investors invest their money in the market. These are primarily used by insurers as alternatives to typical catastrophe reinsurance. The market has been growing to $1 billion of insurance every year for years. Systematic risk, also known as aggregate risk, arises when the market structure is considered uncertain or due to the dynamics that produce shocks in the market; these shocks are felt and tolerated by all agents working or serving the same market. It should be noticed that such shocks are the result of government policies, international economic forces, or the act of nature. Catastrophe bonds can be the reason of various systematic risks. For instance, because of the idiosyncratic nature of unsystematic risk, this can be eliminated or reduced even when the risk has been the result of a catastrophe. In some situations, the aggregate risk may exist because of institutions or some special constraints on market completeness. On the other hand, catastrophe bonds may cause idiosyncratic risk which can be defined as the risk that affects a diminutive number of assets. It can be eradicated via diversification and is quite similar to that of unsystematic risk. One example is the unexpected strikes by workers. The value of a company may fluctuate depending on the level of profitability and expected growth. Similarly, the interest rate risk may be caused due to catastrophe bonds. This risk can be defined as a chance of investment in bonds, and if this investment is done in catastrophe bonds, then the risk automatically gets associated. The investor may have to suffer from unexpected interest rate ...