Abstract
Reinsurance and CAT bonds are two alternative risk management instruments used by insurance companies. Insurers should be indifferent between the two instruments in a perfect capital market. However, the theoretical literature suggests that insured risk characteristics and market imperfections may influence the effectiveness and efficiency of reinsurance relative to CAT bonds. CAT bonds may add value to insurers’ risk management strategies and may therefore substitute for reinsurance. Our study is the first to empirically analyse if and under what circumstances CAT bonds can substitute for traditional reinsurance. Our analysis of a comprehensive data set comprising U.S. P&C insurers’ financial statements and CAT bond use shows that insurance companies’ choice of risk management instruments is not arbitrary. We find that the added value of CAT bonds mainly stems from non-indemnity bonds and reveal that (non-indemnity) CAT bonds are valuable under high reinsurer default risk, low basis risk and in high-risk layers.
Highlights
Reinsurance and CAT bonds are two alternative instruments used for risk management by insurance companies
The theoretical work shows that the value CAT bonds add to insurers’ risk management strategies seems to consist of (1) eliminating reinsurer default risk, (2) providing a better risk diversification in high-risk layers, where the diversification benefits of reinsurance deteriorate, (3) introducing non-indemnity-based contracts that include basis risk and that may be attractive for insurers with a relatively low exposure to basis risk, and (4) reducing information asymmetry between insurers and reinsurers through non-indemnity-based contracts (Doherty and Richter 2002; Nell and Richter 2004; Cummins and Trainar 2009; Finken and Laux 2009; Lakdawalla and Zanjani 2012; Trottier and Lai 2017; Subramanian and Wang 2018)
This study examines the use of reinsurance and CAT bonds in insurers’ corporate risk management strategies and empirically investigates if and under which circumstances CAT bonds add value to them
Summary
Reinsurance and CAT bonds are two alternative instruments used for risk management by insurance companies. Based on the evidence presented by Froot et al (1993) and Froot (2001), insurers purchase relatively few reinsurance against extreme catastrophic events at prices considerably above the fair price Such protection should theoretically have a very high value for corporate risk management strategies, anecdotal evidence shows that the most severe natural catastrophes observed throughout the past years exhibit a considerable share of uninsured damages (Bevere et al 2019), indicating that reinsurance markets may be subject to a shortage of supply of catastrophe risk transfer.
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