The Theory of Catastrophe Risk Financing: A Look at the Instruments that Might Transform the Insurance Industry

Abstract

The current study reviews the risk financing techniques employed in the insurance markets and looks at the changing field of the risk management arena. The overarching view is that apart from the traditional channels of financing risk, alternative routes should be explored. The latter is strengthened with the surfacing of off-balance sheet instruments in modern financial markets. The paper extends the discussion to the layered risk financing approach and reinforces its importance. That is, cash flow engineering instruments are employed to match different segments of the loss distributions. The role of insurance risk capital to assume extreme losses is further discussed, while reinsurance still remains a form of capital restructuring. Taken all together, the intention is that risk financing should be able to release assets committed to liabilities, and should reduce the cost of risk capital in sponsoring all-purpose equity. Finally, risk management platforms are redefined, while the securitisation of insurance risk is explored along with its effectiveness and possible caveats.