Innovations in Managing Catastrophe Risk

Abstract

The 1980s and 1990s have ushered in impressive changes in the property-liability insurance market. Among these have been a withdrawal of commercial business into alternative risk management vehicles and strategies; crises and coverage changes in liability insurance; the integration of insurer asset and liability management; the emergence of innovative reinsurance instruments such as financial reinsurance; experiments with radical regulation; and various forms of corporate reorganization and reassembly, the most recent being the merger activity among brokers leading to increased concentration. Perhaps the most dramatic changes lie in the securitization of catastrophe risk. Experiments have occurred with new instruments such as catastrophe (CAT) bonds, exchange traded catastrophe options, insurer issued catastrophe put options, as well as bartered risk exchanges. Although the volume of business yet traded is small, interest is growing both among insurers and investors. PRECONDITIONS FOR SECURITIZATION The emergence of these new instruments at this time is not accidental; the preconditions are well defined (see Santomero and Babbel, 1997). On an intellectual level, corporate risk managers, treasurers, and CFOs of both insurance and noninsurance firms have questioned why risk is important when shareholders can diversify their investment holdings. Out of this climate, a more focused rationale for risk management has emerged that combines hedging strategy with corporate financial management. Hedging can add value because of tax nonlinearities. Moreover, since much of the cost of risk arises from perverse interplays between risk and leverage, leverage management now stands alongside hedging as an appropriate strategy for offsetting the costs of risk. This new intellectual climate stresses the financial economic benefits of managing risk, and its proponents being familiar with financial institutions and financial instruments - have naturally looked to the financial markets to address risk management problems. Moreover, this process has diminished (though perhaps not removed) distinctions between insurable and noninsurable risk; risk management has become more holistic. The second and closely related precondition is that there has been an explosive growth in derivatives markets. In part, the evolution of this market has been fueled by speculative demand; but it has partly been stimulated by the need for new hedging instruments. This market has provided instruments to hedge positions in particular firms and industries, to hedge interest rate and foreign exchange risk, and to hedge positions in commodities. In this climate, it is not surprising that risk managers and CFOs have come to view insurance as another type of option. CFOs of industrial firms, used to hedging commodity risk and foreign exchange risk with options, are now starting to see the firm's liability policy as an option. Similarly, insurance companies' CFOs who currently use options as part of the asset liability management program will start to think of reinsurance as an option. Other preconditions for catastrophe risk securitization are internal to the insurance market. The traditional instrument for insurers to hedge catastrophe risk is reinsurance. Recent evidence has shown catastrophe risk to be unusually expensive compared with other forms of hedges. Evidence of catastrophe reinsurance contracts presented by Froot and O'Connell (1996) suggests that, over the past decade, the ratio of price minus expected losses to expected losses has been in the order of 60 to 70 percent and can be much higher on high level coverages. These costs seem to reflect inefficiencies inherent in traditional reinsurance contracts. The presence of a hedge clearly creates moral hazard costs. Ex ante, the hedge will tend to relax incentives for prudent underwriting. Ex post, reinsurance will tend to make insurers sloppy in their claim settlement practices; an especially serious issue for catastrophe losses, where the loss itself is of sufficient scale that it overwhelms the insurers' capacity to settle claims in an orderly fashion. …