Will CAT Bonds Take Over Large Reinsurance Risks?

As you may know, catastrophe or "CAT" bonds were developed after Hurricane Andrew in 1992 to spread some large reinsurance risks directly to investors and the broader market.  CAT bonds are securities offered to investors at junk yields (such as 11 percent or higher).  If a given catastrophe, such as a hurricane or terrorist attack, does not happen within the year, the bond pays off to investors.  If the event happens, investors lose all their money and the bond pays out to the reinsurer.

Specifically, the trigger is an insurance loss above a given amount because of a catastrophe.  It appears that the $190 million in Kamp Re CAT bonds will be the first CAT bonds to actually pay out, due to Hurricane Katrina and Rita losses, although this is not confirmed.   For those who just love economic jargon and math (and really, who doesn’t?), here is a scholarly paper in which the authors predict that CAT bonds will increasingly take over large reinsurance risks because they address a problem in reinsurance markets: the larger the risk, the more risk averse insurers become.  This leads to higher premium levels at the upper end of reinsurance that are out of proportion to the actual risk, but instead are based on risk plus fear (my words, not the authors’).  

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