Description

CAT bonds are specific bonds issued as insurance for different climate-related risks in projects. The key difference to green bonds is that these bonds protect against the risk of a catastrophic event. If it doesn’t happen, the investment is returned with interest. The level of risk is high for the investor, and therefore the rates of return on investments are necessarily high as well to attract the necessary investment. On average, the interest rate in 2013 was nine percent. Catastrophe bonds typically have a lifespan of one to three years.

Instrument category

Debt financing

Implementation status

Moderate - tried and tested

Enabling conditions and success factors

• A strong institutional investor base is needed.
• Sophisticated modelling and quality underlying required.

Instrument benefits

• CAT bonds can offer investors stable, high-yield interest payments over the bond's life.
• CAT bonds can help hedge a portfolio against certain types of risk, as natural disasters don't correlate to stock market moves.
• CAT bonds have short maturities of one-to-five years, which reduces the likelihood of a payout to the insurance company, including loss of principal.

Challenges and risks to implementation

• CAT bonds can risk losing the principal amount invested if payment to the insurance company occurs.
• Natural disasters can occur during stock market declines and recessions, which could negate the diversification benefit of CAT bonds.
• The short-term maturities of CAT bonds might not lessen the probability of a triggering event if the frequency and costs of natural disasters increase.

References