Traditional reinsurance capacity can be exhausted after major disasters. A catastrophe bond is a securities instrument that transfers specified natural-catastrophe risk from an insurer or reinsurer to capital-market investors. If a defined event occurs, investors may lose principal; if not, they receive an attractive coupon.

The bond is usually issued through a special-purpose vehicle that holds collateral and pays the sponsor when trigger conditions are met. Triggers may be indemnity-based, industry-loss-based, or parametric. Modeling firms provide the probability analysis that supports pricing.

Catastrophe bonds diversify the sponsor’s risk financing and give investors returns uncorrelated with traditional financial markets. The market has grown substantially since the 1990s and now covers hurricane, earthquake, and other perils. Transparency of the trigger and quality of the modeling are critical to investor confidence.

• Security transferring catastrophe risk to investors
• Pays sponsor if a defined event occurs
• Uses special-purpose vehicle and collateral
• Provides alternative capacity beyond reinsurance