Cat Bonds are securities created by the securitization of reinsurance contracts (for further information on reinsurance see the section on collateralized reinsurance). They are typically principal-at-risk notes issued under rule 144A of the United States Securities Act. They can only be purchased by QIBs and typically have a minimum investment of USD 250,000, hence investors interested in this asset class often participate through dedicated ILS funds.
The note proceeds are put in a collateral account and then invested in ‘risk-free’ investments (typically US Treasury Money Market Funds). The collateral is used to support the risk assumed via the reinsurance agreement. The premium paid by the reinsured is used to make the quarterly coupon payments to the investors in the cat bond. In the event of a loss the coupon ceases for that proportion of the lost collateral and the equal proportion of the principal will not be returned.
Initial pricing of cat bonds is based upon the modelling results of a third party model from one of the recognised cat modelling firms: RMS, AIR or Corelogic. The offering documentation includes a write-up of the risk and the probabilities associated with a no loss, through partial loss to a full loss of principal.
Many, but not all, cat bonds are also rated by one of the rating agencies.
Cat bonds are typically 3-4 year duration transactions, with a possible extension period of typically 3 years in case a loss event that could cause a loss of principal has occurred, but the final loss quantum has not been ascertained. (It can take years for all losses to be submitted and the total loss suffered by a reinsured to a given event finally calculated).
Cat bonds are traded through the broker-dealer market and many broker-dealers put out weekly / monthly indicative price sheets for cat bonds. Cat bonds trade frequently on the secondary market, however many investors tend to buy and hold cat bonds only rebalancing their portfolio on the secondary market.