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Catastrophe bonds (also known as cat bonds) are
risk-linked securities that transfer a specified set of risks from a sponsor
to investors. They are often structured as floating rate corporate bonds
whose principal is forgiven if specified trigger conditions are met. They
are typically used by insurers as an alternative to traditional catastrophe
reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring
properties in Florida, then it might wish to pass some of this risk on so
that it can remain solvent after a large hurricane. It could simply purchase
traditional catastrophe reinsurance, which would pass the risk on to
reinsurers. Or it could sponsor a cat bond, which would pass the risk on to
investors. In consultation with an investment bank, it would create a
special purpose entity that would issue the cat bond.
Investors would buy the bond, which might pay
them a coupon of LIBOR plus a spread, generally (but not always) between 3
and 20%. If no hurricane hit Florida, then the investors would make a
healthy return on their investment. But if a hurricane were to hit Florida
and trigger the cat bond, then the principal initially paid by the investors
would be forgiven, and instead used by the sponsor to pay its claims to
policyholders.
Michael Moriarty, Deputy Superintendant of the New York State Insurance
Department, has been at the forefront of state regulatory efforts to have
U.S. regulators encourage the development of insurance securitizations
through cat bonds in the United States instead of off-shore, through
encouraging two different methods ? protected cells and special purpose
reinsurance vehicles.
In August 2007 Michael Lewis, the author of Liar's Poker and Moneyball,
wrote an article about catastrophe bonds that appeared in The New York Times
Magazine, entitled "In Nature's Casino."
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