The Bonds of Catastrophe

It is perhaps not widely understood (outside the specialized domains of risk modeling and property insurance) that the last twenty years have seen the relatively rapid growth of a new kind of financial instrument: the catastrophe bond. I aim in what follows to offer the reader a brief introduction to these innovative money-things, which sit at the precarious nexus of mathematical modeling, environmental instability, and vast sums of capital. Techno-legal creations of considerable complexity (and some genuine elegance), “cat bonds“ circulate in the Olympian air of global high finance, where they afford investors an opportunity to place large bets on the occurrence (and non-occurrence) of various mass disasters: earthquakes, hurricanes, plagues, suitcase nukes. The lengthy, turgid, and highly confidential specifications that make up the prospectuses of these investments might be said to represent a special and entirely overlooked subgenre of science fiction: what we discover, turning the pages of such deals, are fanatically extensive metrical descriptions of countless doomsday scenarios, each story told in lovingly legalistic and scientific detail. Unlike most dystopian fantasizing, however, the worst-case scenarios played out in the appendices of cat bond issues come with very real-world prospective paydays, precisely priced and proper to the consideration of an imaginative portfolio manager looking to diversify her investments. 


Put your paranoia aside (at least temporarily). It is quite possible that cat bonds are basically a good thing, creating mechanisms as they do for hedging against the tremendously disruptive costs of low-probability, high-negative-impact natural and/or social events. It is also possible, of course, that they are simply another sophisticated exercise in plutocratic self-dealing. We will bracket that thorny problem for now, and focus here on conveying (1) a general understanding of how these instruments work, and (2) a specific appreciation of the way that they constitute perhaps the most elaborate and powerful social technology currently available for articulating just what we mean when we say “catastrophe.”


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So what’s a cat bond? A cat bond is, first of all, a bond—meaning a kind of debt arrangement. The holder of any bond has conveyed a sum of money to the bond issuer for a fixed term (say, a year or two) in return for the promise of some sort of interest payment: You hold my hundred thousand dollars this year, but you promise that at the end of the year you are going to give me back, not a hundred thousand dollars, but a hundred and ten thousand dollars—netting me a 10% return on my investment. With an ordinary high-quality corporate or municipal bond, my odds of getting my principal back are pretty close to 100%, and my rate of return (given the near-negligible risk of loss) is generally pretty low. US Treasury bonds are about as minimal-risk an investment as the earth seems to afford at present (since they are backed by the American government, which, despite its problems, looks unlikely to evaporate anytime soon), and so whatever they are paying in a given year basically sets the baseline for investors everywhere: it’s a small rate of return but, for all intents and purposes, it’s guaranteed. By contrast, if I am buying a “junk” bond—issued by some business guys with wild eyes and big ideas—I am promised considerably bigger interest payments than I would get on a “T-bill” (a short-term US Treasury bond), but I have to weigh the non-zero probability of a default on the part of my debtors, who may in fact not only not pay me my nice premium, but could even lose some or all of my principal (though this is pretty rare in normal financial climates). That, in a nutshell, is the bond market: lend money to different folks, who have to promise to pay you more or less for the privilege of the loan, depending on how shady they look.


Catastrophe bonds have this basic structure. The holder of such a bond has indeed conveyed a sum of money to the bond issuer for a fixed term, in return for the promise of a downstream percentage premium. What makes a cat bond a cat bond, however, is that—unlike most ordinary bonds, which are issued by people/governments/institutions needing ready-to-hand money to build a building or a bridge or expand a business—a cat bond has been issued by somebody who is worried about some kind of possible disaster, somebody who is looking for protection from the financial effects of a catastrophe.


Think like a gigantic insurance corporation for a moment. If you’ve been writing property insurance for a large number of homeowners in southern Florida, you get pretty nervous every hurricane season. Yes, you’ve socked away everybody’s premiums for years and years, so you are sitting on a mountain of cash, but you still have to reckon with the fear that, in your competitive drive to underbid the other insurance companies writing policies in the Sunshine State, you may have left yourself inadequately capitalized in the event that a massive storm flattens the region. You would do well to hedge against that whopper, by basically buying some insurance yourself. And indeed, the “reinsurance” market—insurance for insurers—has been around for a long time, and amounts to a circa $500 billion business, whereby the financial risks of different large-scale insurable events are carved up and spread out among a sizable (but relatively cozy) community of mutually re-insuring insurers. This is all good old-fashioned insurance. Meaning, basically, contracts with the following form: “If you lose this under these conditions, I will pay you back for it.” It’s a big deal to take on that sort of obligation. You had better be sure you can do what you say you are going to do—or else you go bankrupt (and your clients get screwed). 


by D. Graham Burnett, Cabinet |  Read more:

Image: MultiCat Mexico Ltd