An introduction to catastrophe bonds

Introduction

Catastrophe bonds (cat bonds for short) have received significant interest in recent years, with 2023 breaking the record for total issuance at US$16.45 billion (previously set in 2021).¹ We believe this trend is likely to continue as the first half of 2024 surpassed the prior year’s first-half record. As of the time of this writing, the size of the market (capital outstanding) has grown about 32% since the end of 2021,² while yields are at attractive levels last witnessed in 2012.

Cat bonds cover specific perils, such as natural disasters. Therefore, it is not surprising that the growth in this market is often attributed to two factors:

1. Concerns about climate change—storms of greater magnitude and intensity could cause greater property damage.
2. Recent inflation—reconstruction from storm damage is now more costly.

Investors are compensated if the disaster does not occur or, if it does, monetary losses remain below a predefined threshold. The returns to investors have not gone unnoticed. Investments in cat bonds have underpinned some of the most successful hedge fund sub-strategies of 2023.³

Cat bonds provide investors with the possibility for returns largely independent of market and economic risks that affect traditional equity, fixed income and even most alternative asset classes, potentially making them an appealing diversifier.

Investing in the asset class comes with risks, which we describe in this paper. Nevertheless, we seek to use risk-management techniques to hedge the unpredictability of nature, even while reaping the rewards of the asset class.