A catastrophe bond transfers specified catastrophe risk from an insurer or other sponsor to capital-market investors.
Catastrophe bonds, often called cat bonds, are typically issued through a special-purpose vehicle. Investors receive interest while the specified event does not occur. If a defined catastrophe, such as a major hurricane or earthquake meeting agreed trigger conditions, occurs, some or all of the principal may be used to help compensate the sponsor.
These instruments can provide insurers, reinsurers, governments, and other organizations with additional risk capacity beyond traditional reinsurance. Their triggers may be based on indemnity losses, modeled losses, industry losses, or physical measurements, and the choice affects both basis risk and investor exposure.
A catastrophe bond is not ordinary corporate debt. Investors accept the possibility of losing principal in exchange for catastrophe-linked returns, while the sponsor obtains protection against severe but infrequent events. The market expanded after major natural catastrophes increased demand for alternative risk transfer.