As Andrew Lo said at a major hedge fund conference in Boston last week, humans have a bad habit of confusing "very low probability" with "no probability". While this heuristic might help us from becoming a bunch of paranoid freaks, it can clearly be dangerous if the "low probability" event is catastrophic. Enter catastrophe bonds.

In our series featuring the thoughts of the CAIA Association members, Robert Koller-Vernot discusses the growth of the catastrophe bond ("cat-bond") industry.

Cat-Bonds are financial markets instruments that include an extra feature - an insurance element.  The main idea behind a cat-bond, as initially conceived, is to transfer risk of a natural catastrophe.

The issuer of a cat-bond issues securities that pay regular interest and return their principal at the end of their lifetime.  The normal maturity of a cat-bond is around three years.

However, the principal re-payments are conditional on certain pre-defined "triggers" (see below).  For example, in an earthquake-linked cat-bond, the trigger might be defined as a specific level of seismic activity.

If that activity occurs, then, generally, the principal will not be paid back or will be reduced at the end of the lifetime of the bond.

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