Hedging the impact of climate change in the catastrophe space

Abstract

Unprecedented increases in climate change-induced extreme loss events have raised major concerns about the inadequacies of catastrophe risk financing in the insurance/reinsurance industry. The US Federal Reserve’s ultra-low interest rate policy following the 2008–2009 financial crisis, however, has transformed the catastrophe space into a new normal. Demand shocks from an influx of third-party capital have prompted capacity expansion, risk capital redistribution and premium reduction, resulting in a convergence and expansion of the traditional reinsurance and the securitised catastrophe bond markets. This research investigates optimal allocation of these two inherently different assets to help achieve ex ante full catastrophe risk sharing and intermediation. By constructing a novel two-agent sequential optimisation framework that mimics the economics of the reinsurance/insurance markets, we demonstrate through simulation how net present value (NPV)-maximising reinsurers and hedging cost-minimising insurers optimally allocate these two assets and mitigate the impact of climate change relative to catastrophe arrival intensity and severity, and other reinsurance and catastrophe bond characteristics.