Though this newsletter is primarily concerned with accounting best practices, the events of the past month make it worthwhile to be knowledgeable in an emerging risk management best practice, which is the use of catastrophe bonds. This financial instrument, more commonly known as a cat bond, is designed to raise money in the event of a major catastrophe, which is usually defined as an earthquake, hurricane, or windstorm. If the issuer suffers a loss from a pre-defined catastrophe, then its obligation to repay the interest or principal is either deferred or cancelled. Some cat bonds are indemnity-based, which means that they pay out based on actual claims stemming from the catastrophe; these bonds are considered more risky for bond purchasers, since a wide variety of claims may be brought. Another type of cat bond is based on parametric data, so they only pay out if precise physical measurements of the actual event occur, such as wind speed or earthquake magnitude exceeding a threshold level.
Large cat bonds are almost always issued by reinsurance companies, and are typically rated as junk bonds. The only recent exceptions have been the Oriental Land Company (Japanese earthquake), Vivendi Universal (California earthquake), and FIFA (terrorism during the 2006 World Cup). The most recent information about cat bond issuances and risk profiles by country is listed in the excellent World Catastrophe Reinsurance Market report, which is available for free from Guy Carpenter at www.guycarp.com.
Cat bonds are also available in smaller sizes for individual corporations, though these are usually specially-designed private placements to one or two investors. This approach to catastrophe coverage is especially useful when traditional insurance coverage is too expensive, allowing issuers to essentially extract insurance coverage from the securities market.