Catastrophe bonds are bond issues by risk takers such as insurance companies to offset some of their risk. For example, in 1997 Tokyo Marine & Fire Insurance issued a 10-year bond, the interest on which was tied to whether and to what extent Tokyo was damaged by an earthquake. The bondholders received interest (from the premiums collected by the insurer), which fluctuated at between 400-500 by over LIBOR. The principal was lost in the earthquake occurred.
The diagram below shows a typical catastrophe bond structure including where the capital flows from one party to another.
Catastrophe bonds are used to hedge risks of earthquake, typhoon, thunderstorm, hurricane and even life insurance related risks for example longevity and health insurance claims.