By Force of Nature: Explaining the Yield Spread on Catastrophe Bonds

Abstract

This paper re-examines to which extent catastrophe bond prices can be explained via investor preferences. I show that cat bond spreads equal between two and three times expected losses after controlling for bond-specific characteristics. At the occurrence of Katrina, the model predicts a 15-20% increase in the cost of capital of reinsurance companies and plausible degrees of comovement among different perils. The driving force behind the model is a habit process, in that catastrophes are rare economic shocks that could bring investors closer to their subsistence level. Such preferences may also explain why catastrophe bonds offer higher yield spreads compared to equally-rated corporate bonds.

Keywords: Fixed Income, Insurance-Linked Security, Natural Disasters, Katrina, External Habit

JEL Classification: D51, D53, G12, G22