Business and Personal Finance Dictionary

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• CATASTROPHE BOND
  
  Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region. Catastrophe Bonds may be ABS's (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities. Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas. Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority – any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e., outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization. Pricing: Equilibrium of supply and demand. Risk Management: Traditional hedging is impossible. Diversification is possible. Comments: The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game's odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc.
  
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