Cat bonds are an increasingly popular alternative investment (a member of the “Insurance Linked Securities” or ILS family) that offers investors exceptional returns, or catastrophic losses, depending which way the wind blows. Here’s a layman’s terms explanation.

Let’s say the State of Iowa wants to take a policy that pays out US$50m if damage from natural disasters in 2012 is greater than US$100m. They could go to a broker in the regular commercial insurance market who would go round the houses of insurance companies trying to accumulate the necessary coverage. Let’s say the premium was US$5m.

Or, they could go the cat bond route. An investment bank would find investors willing to put up US$50m in capital in return for US$4m in premium. A Cat bond normally has a “digital” outcome. Either the insured event occurs or it does not. If it does, the investors lose their shirt (and at $50m that’s some fine cloth). If it doesn’t, they’ve made a market-beating 8% return.

One of the most appealing aspects of cat bonds is that they are what is known as a “non-correlated” investment, which essentially means that, unlike regular corporate equities and bonds to varying degrees, they are not exposed to the general economy. It doesn’t matter if a recession causes demand to slump. That doesn’t make tornadoes any more or less likely to strike.

Cat bonds are generally created as a Special Purpose Vehicle (SPV) in the Cayman Islands or Bermuda as a) onshore they would be regulated as insurance companies incurring weighty and rather pointless compliance costs, and b) much like hedge funds they simply wouldn’t work if they were subject to corporation tax (note that, again like hedge funds, the returns WILL effectively be subject to tax in the hands of the investor (which, incidentally, may be a hedge fund).

Because cat bonds are a high value all-or-nothing bet, they are not for the feint hearted or the light of wallet.

For further reading on cat bonds, see this fascinating, if rather lengthy, article from Michael Lewis (author of such tomes as Liar’s Poker and The Big Short), entitled “Nature’s Casino”.