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Please help improve th is article by adding reliable references. Unsourced material may be challenged a nd removed. (April 2011) The aftermath of Hurricane Andrew in Lakes by the Bay, Florida. Catastrophe bonds (also known as cat bonds) are risk-linked securities that tran sfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northr idge earthquake. Catastrophe bonds emerged from a need by insurance companies to alleviate some o f the risk they would face if a major catastrophe occurred, which would incur da mages that they could not cover by the premiums, and returns from investments us ing the premiums, that they received.[citation needed] An insurance company issu es bonds through an investment bank, which are then sold to investors. These bon ds are inherently risky, generally BB,[citation needed] and are multi-year deals . If no catastrophe occurred, the insurance company would pay a coupon to the in vestors, who made a healthy return. On the contrary, if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this m oney to pay their claim-holders. Investors include hedge funds, catastrophe-orie nted funds, and asset managers. They are often structured as floating rate bonds whose principal is lost if specified trigger conditions are met. If triggered t he principal is paid to the sponsor. The triggers are linked to major natural ca tastrophes. Catastrophe bonds are typically used by insurers as an alternative t o traditional catastrophe reinsurance. For example, if an insurer has built up a portfolio of risks by insuring propert ies in Florida, then it might wish to pass some of this risk on so that it can r emain solvent after a large hurricane. It could simply purchase traditional cata strophe reinsurance, which would pass the risk on to reinsurers. Or it could spo nsor 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 t he cat bond. Investors would buy the bond, which might pay them a coupon of LIBO R plus a spread, generally (but not always) between 3 and 20%. If no hurricane h it 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 princi pal initially paid by the investors would be forgiven, and instead used by the s ponsor to pay its claims to policyholders.[1] Michael Moriarty, Deputy Superintendent of the New York State Insurance Departme nt, has been at the forefront of state regulatory efforts to have U.S. regulator s encourage the development of insurance securitizations through cat bonds in th e United States instead of off-shore, through encouraging two different methods pr otected cells and special purpose reinsurance vehicles.[2] In August 2007 Michae l Lewis, the author of Liar's Poker and Moneyball, wrote an article about catast rophe bonds that appeared in The New York Times Magazine, entitled "In Nature's Casino."[3] Contents [hide] 1 History 2 Investors 3 Ratings 4 Structure 5 Trigger types 6 Market participants 7 Patents 8 See also 9 References 10 External links [edit]History

The notion of securitizing catastrophe risks became prominent in the aftermath o f Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot, and a group of professors at the Wharton School who were seeking vehicles to bring m ore risk-bearing capacity to the catastrophe reinsurance market. The first exper imental transactions were completed in the mid-1990s by AIG, Hannover Re, St. Pa ul Re, and USAA. The market grew to $1 2 billion of issuance per year for the 1998 2001 period, and o ver $2 billion per year following 9-11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of Reinsurance Sidecars. Issuance contin ued to increase through 2007, despite the passing of the post-Katrina "hard mark et," as a number of insurers sought diversification of coverage through the mark et, including State Farm, Allstate, Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Total issuance exceeded $4 billion in the second qua rter of 2007 alone. It should be possible to adapt these instruments to other contexts. Professor La wrence A. Cunningham of George Washington University suggests adapting cat bonds to the risks that large auditing firms face in cases asserting massive securiti es law damages.[4] Other innovative uses of cat bond structures have been propos ed as well. [edit]Investors Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities , so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments, as long as the y are not triggered. Key categories of investors who participate in this market include hedge funds, specialized catastrophe-oriented funds, and asset managers. Life insurers, reins urers, banks, pension funds, and other investors have also participated in offer ings. The financial changes beginning in 2007 accelerated what had been a gradua l shift away from the fund of funds community toward more direct investment. A number of specialized catastrophe-oriented funds play a significant role in th e sector, including Credit Suisse, Goldman Sachs Asset Management, Juniperus Cap ital, AXA Investment Managers, Fermat Capital Management, Nephila Capital, and C lariden Leu. Several mutual fund managers also invest in catastrophe bonds, amon g them Oppenheimer Funds, Pioneer Investments, and PIMCO. [edit]Ratings Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fi tch Ratings. A typical corporate bond is rated based on its probability of defau lt due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to a qualifying catastrophe triggering loss of p rincipal. This probability is determined with the use of catastrophe models. Mos t catastrophe bonds are rated below investment grade (BB and B category ratings) , and the various rating agencies have recently moved toward a view that securit ies must require multiple events before occurrence of a loss in order to be rate d investment grade. [edit]Structure Most catastrophe bonds are issued by special purpose reinsurance companies domic ilied in the Cayman Islands, Bermuda, or Ireland. These companies typically writ e one or more reinsurance policies to protect buyers (most commonly, insurers or reinsurers) called "cedants." This contract may be structured as a derivative i n cases in which it is "triggered" by one or more indices or event parameters (s ee below), rather than losses of the cedant. Some bonds cover the risk that multiple losses will occur. The first second even t bond (Atlas Re) was issued in 1999. The first third event bond (Atlas II) was

issued in 2001. Subsequently, bonds triggered by fourth through ninth losses hav e been issued, including Avalon, Bay Haven, and Fremantle, each of which apply t ranching technology to baskets of underlying events. The first actively managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut was issued in 2007, with Nephila as the asset manager. [edit]Trigger types The sponsor and investment bank who structure the cat bond must choose how the p rincipal impairment is triggered. Cat bonds can be categorized into four basic t rigger types.[5] The trigger types listed first are more correlated to the actua l losses of the insurer sponsoring the cat bond. The trigger types listed farthe r down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investo rs would not have to worry about the insurer's claims adjustment practices. Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnifie d, as if they had purchased traditional catastrophe reinsurance. If the layer sp ecified in the cat bond is $100 million excess of $500 million, and the total cl aims add up to more than $500 million, then the bond is triggered. Modeled loss: instead of dealing with the company's actual claims, an exposure p ortfolio is constructed for use with catastrophe modeling software, and then whe n there is a large event, the event parameters are run against the exposure data base in the cat model. If the modeled losses are above a specified threshold, th e bond is triggered. Indexed to industry loss: instead of adding up the insurer's claims, the cat bon d is triggered when the insurance industry loss from a certain peril reaches a s pecified threshold, say $30 billion. The cat bond will specify who determines th e industry loss; typically it is a recognized agency like PCS. "Modified index" linked securities customize the index to a company's own book of business by wei ghting the index results for various territories and lines of business. Parametric: instead of being based on any claims (the insurer's actual claims, t he modeled claims, or the industry's claims), the trigger is indexed to the natu ral hazard caused by nature. So the parameter would be the windspeed (for a hurr icane bond), the ground acceleration (for an earthquake bond), or whatever is ap propriate for the peril. Data for this parameter is collected at multiple report ing stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is trig gered. Parametric Index: Many firms are uncomfortable with pure parametric bonds due to the lack of correlation with actual loss. For instance, a bond may pay out base d on the wind speed at 50 of the 150 stations mentioned above, but the insurer l oses very little money because a majority of their exposure is concentrated in o ther locations. Models can give an approximation of loss as a function of the sp eed at differing locations, which are then used to give a payout function for th e bond. These function as hybrid Parametric / Modeled loss bonds, and have lower ed basis risk as well as more transparency.[6] [edit]Market participants Examples of cat bond sponsors include insurers, reinsurers, corporations, and go vernment agencies. Over time, frequent issuers have included USAA, Swiss Re, Mun ich Re, Liberty Mutual, Hannover Re, Allianz, and Tokio Marine Nichido. Mexico i s the only national sovereign to have issued cat bonds (in 2006, for hedging ear thquake risk and in 2009, a multistructure instrument that covered earthquake an d hurricane risk)[7]. To date, all direct catastrophe bond investors have been institutional investors , since all broadly distributed transactions have been distributed in that form. [8] These have included specialized catastrophe bond funds, hedge funds, investm ent advisors (money managers), life insurers, reinsurers, pension funds, and oth ers. Individual investors have generally purchased such securities through speci alized funds.

Investment banks and other dealers that are active in the issuance of catastroph e bonds include Aon Benfield Securities, Inc., Swiss Re Capital Markets, Munich Re Capital Markets, Barclays Capital, Deutsche Bank, BNP Paribas, Goldman Sachs, Merrill Lynch, JP Morgan, and Willis Capital Markets. Some of these groups also make secondary markets in these bonds. Experts in the field include Professor Lawrence A. Cunningham of George Washingt on University and Professor Ken Froot of Harvard University. [edit]Patents There are a number of issued US patents and pending US patent applications relat ed to catastrophe bonds.[9