Catastrophe bonds are a new type of insurance securitization and have become increasingly popular in the insurance industry throughout the 21st century. Unlike traditional reinsurance products, cat bonds are “fixed income instruments issued primarily by insurers and reinsurers as a way of passing on their exposure to potential large financial risks associated with natural catastrophes” (Ip). in the form of an insurance linked security. These securities are designed to protect insurers and reinsurers against “super” catastrophes, or events that are high severity, but low frequency of occurrence, defined as having around a 1% or 1 in 100 years probability. Cat bonds first emerged in the 1990s, after hurricane Andrew and the Northridge Earthquake in California wiped approximately USD 30 billion off balance sheets of insurers and reinsurers. Insurers and reinsurers noticed the industry’s vulnerability to such “super” catastrophes. “The potential cost of a disaster had outgrown the capacity of the insurance industry to protect against it” (Ip). Reinsurers had to increase equity levels in order to protect against a natural disaster which increased the price for catastrophe risk. Although catastrophe bonds have parameters which strictly limit the type and location of a disaster they cover, cat bonds have had a positive impact on the insurance industry because cat bonds add reinsurance capacity through the financial market, cat bonds influence the price of traditional reinsurance, and cat bonds enable regional insurance carriers to expand underwriting.
The insurance industry needed a vehicle to transfer billions of dollars of catastrophe risk to an entity capable enough to manage it. The only entity able to cope with these large risk transfers was the capital market (RMS). The insurance industry’s need for more capacity inspired investment banks like Goldman Sachs and Lehman Brothers Holding Inc. to focus their resources on making insurance an investable asset class. The first insurance linked security was the Super Catastrophe Industry Loss Warranty contract, used by Warren Buffet’s National Indemnity in the mid-to-late 1990’s.
After September 11, the insurance industry’s interest in catastrophe bonds increased drastically. Between 1997 and 2013, the total catastrophe market since its inception has been approximately 20% per annum and, although it was interrupted by the global economic crisis of 2008, this growth pattern is now expected to resume. The following figure shows the growth of the cat bond market in terms of issued and outstanding bonds.
The insurance industry today is highly under-capitalized, meaning there is insufficient capital to fund low probability, high severity catastrophes. Also, the number of insurers and reinsurers willing to underwrite catastrophe risks is diminishing. Alternative risk transfers, such as cat bonds, have enabled insurers to gain access to the capital market, which has significantly added capacity...