Catastrophe bonds: the $100 billion market for investing in disaster

Last year, we explored the lucrative (and controversial) market for investing in ​life insurance contracts​.

Life settlement funds can generate strong returns — but as it turns out, they’re just a small part of the broader Insurance-Linked Securities market (ILS).

Currently, the ILS market is worth ​$100 billion​. And about half of that value is held in one specific type of instrument: Catastrophe Bonds.

If catastrophe does not occur, holders of these bonds can realize ample returns. (The cat bond market returned 17.3% last year.)

But when disaster strikes, investors could lose big — up to 100% of their principal.

And right now is the perfect time to explore this asset class. The world’s first ​Catastrophe Bond ETF​ is due to start trading this month.

Today, I’m going to dive into the cat bond market, trying to determine whether the yields on these bonds justify bearing the risk of catastrophe.

In this deeply researched issue, I’ll show you:

• How this entire asset class was sparked by Hurricane Andrew
• Why cat bonds don’t always trigger — even when catastrophe occurs
• How yields stack up compared to junk bonds and private credit
• The different ways individual investors can access this asset class (which is currently dominated by institutions)

Since you have the All-Access Pass, you get the full issue. ✅

Let’s go 👇

​​Brian Flaherty​ purchased his first mutual fund at 15. After graduating from UVA with a degree in Economics, he began advising institutions and high-net-worth investors as a strategist at a wealth management firm. Today, Brian helps investors uncover the best opportunities and make intelligent use of their capital. You can follow him on ​LinkedIn​.

What are catastrophe bonds?

As the name suggests, catastrophe bonds are debt instruments whose returns are tied to a devastating real-world event.

Typically, ‘cat bonds’ pay investors a floating rate coupon, currently ​around 10% annually​.

If the covered catastrophe occurs, however, investors sacrifice the principal on their bond.

Instead of paying investors back, the bond issuer uses this money to cover their catastrophe-related losses.

What kind of catastrophes are we talking about here? Cat bonds almost universally cover natural disasters, which are ​split​ into two categories:

1. Primary Perils are infrequent disasters with huge loss potential. Think hurricanes, earthquakes, and tsunamis.
2. Secondary Perils are more frequent but tend to generate low-to medium-size losses. These include floods, tornadoes, and wildfires.

In the modern era, however, secondary perils may not be truly ‘secondary.’

Climate change is making secondary perils ​more frequent and more severe​. Just consider this year’s devastating California wildfires, which could be the costliest natural disaster in US history.

Moreover, because secondary perils are highly dependent on local conditions, they are ​much harder to model​. This makes proper risk pricing a challenge.

I spoke about this with ​Steve Evans​, who covers the ILS market at ​Artemis​. He noted that part of the challenge with covering secondary perils is that it opens investors up to too many small-scale risks – which isn’t the point of a ‘catastrophe’ market:

“There are fewer secondary perils in the cat bond market than there have been previously. For me, I’d like to see the market cover more of them in time, but the loss-sharing needs to be fair. Investors don’t want to face losses for every small event. If a catastrophe hits the front page of the newspaper, that’s the event investors should have to worry about.” – Steve Evans

For now, the market remains focused on natural disaster primary perils, although a few cat bonds also cover man-made disasters like ​cyber attacks​ and ​terrorism​.

The origins of the cat bond market, however, lie with one particular type of catastrophe – hurricanes.

The birth of catastrophe bonds

Although the idea of securitizing insurance risk had been around for ​decades​, the cat bond market was kickstarted by one specific storm: the infamous ​Hurricane Andrew​, which pummeled Florida in 1992.

Prior to the storm, insurers thought that a worst-case hurricane would cause about ​$7 billion​ in insured losses. (At the time, that was roughly equivalent to the total economic losses in the US from 1989’s ​Hurricane Hugo​).

But Hurricane Andrew completely upended that assumption. The storm caused an unprecedented ​$15 billion​ in insured losses — twice what insurers anticipated.

Here’s an astonishing fact: In the few hours it took Hurricane Andrew to pass over Florida, the state’s property insurers lost ​every single dollar​ they had earned in premiums for the last 22 years. Plus a few billion dollars more.

In the wake of the storm, ​seven insurance companies collapsed​ and dozens more stopped doing business in Florida.

For insurers, this disaster was a wake-up call that they needed to hedge huge amounts of natural disaster risk.

Insurers have always hedged their books by taking out their own insurance policies, in what’s known as ​reinsurance​. (Another fascinating topic we’ll explore in the future)

The problem, however, was the ​reinsurance rates spiked​ in the wake of Hurricane Andrew. Traditional reinsurers simply did not have enough capital to bear all the risks that insurers demanded!

As a result, reinsurers started looking for ways to offer insurance hedging without carrying the risks on their own balance sheets.

Thus, catastrophe bonds were born,.

This allowed reinsurers to pass along the risks to investors (in exchange for yield, of course).

One of the first major catastrophe bonds was an ​$85 million issue​ sponsored by Hannover Re in 1994.

After that, the market grew rapidly. Today, there are about ​$50 billion​ worth of cat bonds outstanding, with ​$17.2 billion​ of new issuance in 2024.

Over the years, primary insurers have grown to be the ​majority issuers​ in the market, rather than reinsurers.

There have even been cat bonds issued directly by major corporations as an alternative to traditional insurance (including ​Google​ and ​Blackstone​).

But in terms of catastrophes covered, the market hasn’t strayed far from its roots — hurricanes still dominate.

In fact, in 2024, ​82% of new issuance​ was exposed to Atlantic hurricane risk, ​roughly in line​ with previous years.

That’s the state of the market – but how do these bonds work in practice? As it turns out, the mechanics aren’t as straightforward as they might appear.

How do catastrophe bonds really work?

On the surface, the concept of a catastrophe bond is fairly intuitive.

If the covered catastrophe happens, investors lose a bunch of money. If it doesn’t happen, they don’t. Simple, right?

Not quite. And the reason it’s more complex is because it’s not always clear what it means for a catastrophe to actually occur…

This isn’t a trivial point. Last year, after ​Hurricane Beryl​ hit Jamaica, a $150 million hurricane cat bond issued by the Jamaican government ​didn’t trigger​ — despite the ​entire island being​ declared a disaster zone !

(Note: Jamaica had multiple natural disaster insurance policies, and some of these ​did pay out​.)

The 3 types of triggers

In industry parlance, cat bonds can be ‘triggered’ based on different criteria.

This market is dominated by three distinct trigger types, which exist on a sliding scale in terms of objectivity and payout speed.

Indemnity Triggers (​71%​ of the market)

These are based on the actual losses experienced by an issuer.

Indemnity triggers are the least objective, leaving room for gamesmanship by insurers. Payouts can also take ​years​.

Industry Loss Triggers (20%)

Industry Loss triggers are similar to indemnity triggers, but with losses estimated across the entire industry (as calculated by an independent third party).

Industry loss triggers are more objective and tend to result in quicker payouts, but third-party firms do have some ​discretion​ in determining losses.

Parametric Triggers (4%)

Parametric Triggers are determined by the value of a specific ‘parameter,’ such as wind speed or rainfall amount.

These are the fastest and most objective – but can also result in some odd and (arguably unfair) outcomes.

In fact, the Jamaica bond had a parametric trigger based on air pressure, which was just ​1% too high​ to trigger a payout!

Okay, so suppose there’s a disaster, and a cat bond is triggered.

How much are investors on the hook for?

Attachment points

Indemnity and industry loss cat bonds come with an attachment point, which is the dollar value at which the bond is triggered (i.e., $1 billion in issuer indemnity losses, or $20 billion in estimated industry losses).

Once this attachment point is reached, what happens next depends on the specific terms of the cat bond:

• Some cat bonds have proportional payouts, meaning that investors lose money on a sliding scale past the attachment point (such as 75¢ per dollar of additional loss).
• Others have binary payouts, which are fixed losses triggered as soon as the attachment point is hit (typically ​100% of principal​).

Parametric cat bonds work similarly. While some of these bonds have a single binary payout triggered when a parameter hits a certain level, others have a menu of possible payouts depending on what value the parameter reaches

For example:

• $50 million payout for a category 4 hurricane
• $100M for a category 5 hurricane
• etc…

Exhaustion points

Cat bonds also come with an exhaustion point at which investors can’t lose any more money (typically the full principal amount.)

The last element of cat bond mechanics we need to discuss is their relatively unique legal structure.

Cat bonds collateralized legal structure

Cat bonds are rarely ever issued by an insurer or reinsurer directly.

Rather, they flow through a special purpose vehicle (SPV). This is similar to how ​aviation asset-backed securities​ work. SPVs are also what we use to create investments through ​Altea​).

There’s a really important reason for this — every dollar of investor principal is parked in a collateral account attached to the SPV, typically invested in short-term Treasury bonds (the universal ‘risk-free’ investment).

It’s the SPV, not the issuer, that issues the actual bonds (typically in tranches of varying levels of risk-reward).

This means that cat bonds are 100% collateralized on both sides of the transaction.

If an issuer goes bust because of some unrelated catastrophe, investors can still get their money back (SPVs are ​‘bankruptcy-remote’​).

Similarly, issuers don’t have to haggle investors to make their required payments – the money is already sitting there, ready to go.

Understanding this structure is also helpful to start analyzing the yields on catastrophe bonds.

Analyzing catastrophe bond yields

Compared to the broader market, cat bond yields can be generous.

Currently, average nominal yields in the cat bond market are ​around 10.34% annually​. That’s roughly in line with ​private credit yields​ and about 3 points higher than ​junk bonds​.

But how can we understand whether that yield justifies bearing the risk of catastrophe?

The best way to think about cat bond yields is as the sum of three separate components:

• The risk-free rate, which investor funds will earn while sitting idle in the SPV.
• The expected loss, which reflects the annual probability of catastrophe times the anticipated loss if catastrophe occurs.
• And the spread, which is the ‘premium’ not explained by the two factors above.

Now, the ‘expected loss’ component here is a really fuzzy variable.

It’s not possible to know exactly what the probability of catastrophe is. But you can build a predictive model based on historical data and some assumptions about the future.

Cat bonds typically come with an initial expected loss (IEL) in their offering documents, calculated by a third-party modeling firm.

For example, the ​East Lane Re VII Ltd. 2024-1 A bonds ​(sponsored by ​Chubb​ and covering cybersecurity risk) came with an IEL of 1.39%.

Expected losses will clearly evolve over a bond’s life, so relying on IELs from past issuances isn’t perfect. But right now, the average expected loss (based on IELs) ​is around 2.22%​.

We also know that the risk-free rate is ​roughly 4.20%​. By subtracting these two figures from the yield of 10.34%, we find a net spread of 3.92%.

How does that stack up to other fixed-income instruments?

• High-yield bonds have a ​nominal spread​ above the risk-free rate of 2.81% and an ​average annual loss​ of around 1.5%, leaving a comparable net spread of 0.31%.
• For investment-grade bonds, those figures are ​0.85%​, ​0.1%​, and 0.75%.
• And for ​private credit​, they are ​5.25%​, ​1%​, and 4.25%.

Note that the figures above come from many different sources and shouldn’t be considered absolutely authoritative (especially private credit, where data collection can be tricky).

But these numbers do give us some idea of the relative attractiveness of cat bond yields – which appear to be in the range of private credit.

The main point is that while nominal yields on cat bonds are high, those yields need to be understood in the context of annual expected losses, which are also high (relative to ordinary fixed-income).

Finally, it’s worth noting two additional points on cat bond yields:

• Cat bonds are usually floating rate, so nominal returns will rise and fall with a risk-free benchmark rate (typically ​SOFR​).
• The cat bond market goes through periods of hard and soft pricing, so the spread can vary substantially. In 2017, for instance, the net spread was as low as 1.5%, only to rise to an eye-popping 9.0% in 2023 – meaning returns can depend on the state of the market.

According to Steve (of ​Artemis​), hard markets can also come with significant non-price adjustments:

“In hard markets, reinsurers are not just charging more, they’re also increasing the robustness of their terms. Reinsurers may demand a higher attachment point on policies, so price is only one component that investors need to consider.”

That completes the hard work of analyzing how cat bonds are structured and priced in practice.

Now let’s turn to the performance data to understand the risks & rewards of the asset class.

Catastrophe bond risks & rewards

Cat bonds are coming off a banner year. Actually, a banner two years.

The ​Swiss Re Cat Bond Index​ is the most popular industry benchmark. In 2023, the index posted a 19.7% return, followed by a 17.3% return last year.

To understand these returns, remember a point I made earlier: the cat bond market is dominated by Atlantic hurricane risk.

• While the 2024 Atlantic hurricane season was active, storms ​largely missed​ major populated areas.
• Cat bond investors only faced ​small losses​ after Tampa was spared from a direct hit by ​Hurricane Milton​.
• Similarly, the 2023 hurricane season left the US ​relatively unscathed​.

In 2022, however, the index posted a 2.2% loss, largely due to anticipation of losses stemming from ​Hurricane Ian​.

Overall, the asset class has posted 6.2% 10-year annualized returns and 8.8% 5-year returns (rising global rates in recent years have been a tailwind).

These returns highlight how resilient the cat bond market has been. A -2.2% return in 2022 compares to double-digit losses in traditional equities and fixed-income that year.

Even years with several catastrophes haven’t derailed the market. As Steve noted, “2017 came with multiple catastrophes at a time of soft reinsurance pricing, but cat bond market indices still showed a small positive performance.”

What also makes these returns so compelling is that they’re uncorrelated.

Natural disasters have basically no relationship with broader economic trends or corporate earnings. This can make cat bonds very compelling as a diversification tool.

Of course, this asset class is not risk free.

It’s not just the risk of catastrophe that investors should worry about – model errors pose a challenge too.

When you’re dealing with such remote possibilities, small forecasting adjustments can make a huge difference to expected returns.

After all, can we truly differentiate between a once-a-century storm and a twice-a-century storm based on historical data, especially when climate change is making weather ​far less predictable​?

Perhaps not, but that’s enough to double expected investor losses!

The magnitude of a catastrophe can also take investors by surprise. Recall how shocking losses from Hurricane Andrew were – and then realize that ​Hurricane Katrina​ absolutely dwarfed those figures.

Still, historical performance shows that cat bonds could be a diversifying, high-yield component of a fixed-income portfolio – and the compelling spread could make these risks worth bearing.

If you’re interested in investing in cat bonds, there are a few options worth considering….

How to invest in cat bonds

Unfortunately, cat bonds are an institutionally dominated asset class. Retail investors don’t have many options.

Essentially all cat bonds are ​144A securities​, meaning they’re only sold to very large institutions. So direct investment is off the table.

If you’re in the US, your best bet for accessing cat bonds is likely to be the ETF due to start trading in March: the Brookmont Catastrophic Bond ETF with ticker ILS.

The fund is set to be actively managed by a ​former PIMCO executive​ and charge a 1.58% expense ratio.

(Note that although the fund’s mandate is to hold at least 80% of its assets in cat bonds, the prospectus defines ‘cat bonds’ to include other forms of ILS including collateralized reinsurance and reinsurance sidecars.)

US investors have few other options. Although asset managers like ​Stone Ridge​, ​Amundi​, and ​City National Rochdale​ all offer their own ​interval funds​, these all come with $1m+ minimums – not very accessible.

International investors have a few more options under the UCITS structure (which is generally not accessible to US investors without clearing a few regulatory hurdles).

UCITS cat bond funds currently hold around ​$14 billion AUM​ and include:

• ​Franklin K2 Cat Bond UCITS Fund​ – $142m AUM, $10K minimum.
• ​Securis Catastrophe Bond Fund​ – $328m AUM, $100K minimum.
• ​Leadenhall Capital Partners UCITS ILS Fund​ – ~$900m AUM, $250K minimum.

Note that this isn’t an exhaustive list — and while I’ve tried to gather accurate information, always do your own research before investing in any of these funds.

That’s it for today!

You can ​chat with me​ in the Alts community.

See you there,
Brian

Disclosures

• This issue was written and researched by ​Brian Flaherty​ and edited by Stefan von Imhof.
• This issue was sponsored by Vintage Acquisitions
• This issue contains no affiliate links.
• Neither Alts nor Altea has any current holdings in any companies mentioned in this issue
• This is a paid issue. To read the full thing you need the ​​​​All-Access Pass​.