A Cat Bond Premium Puzzle?

Catastrophe bonds, the payouts of which are tied to the occurrence of natural disasters, offer insurers and corporate entities the ability to hedge events that could otherwise impair their operations to the point of insolvency. At the same time, cat bonds offer investors a unique opportunity to enhance their portfolios with an asset that provides a high-yielding return that is uncorrelated with the market. Despite the attractive nature of these investments, spreads in this market remain considerably higher than the spreads for comparable speculative-grade debt. This article uses behavioral economics to explain the reluctance of investment managers to invest in these products. Finally, we use simulations to illustrate the attractiveness of cat bonds under a wide range of outcomes, including the possible effects of model uncertainty on investor appetite for these securities.