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Reinsurance or CAT Bond? How to Optimally Combine Both

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  • Denis-Alexandre Trottier
  • Van Son Lai

Abstract

We study how traditional reinsurance and CAT bonds can be combined to build an optimal catastrophe insurance programme. We develop a contingent claims model to investigate the imperfections and imitations of the reinsurance market stemming from financial distress costs and default risk. We find that the pricing markup and credit risk will typically be larger for reinsurance contracts that cover the higher and less probable layers of losses. We show that the optimal hedging strategy is to cover small losses using reinsurance and hedge higher losses by issuing a CAT bond. Our results demonstrate that this strategy significantly lowers the insurer?s cost of protection, expands his underwriting capacity and yields higher shareholder values.

Suggested Citation

  • Denis-Alexandre Trottier & Van Son Lai, 2017. "Reinsurance or CAT Bond? How to Optimally Combine Both," Working Papers 2017-003, Department of Research, Ipag Business School.
    • Handle: RePEc:ipg:wpaper:2017-003
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    References listed on IDEAS

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    Cited by:

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    3. Karl Demers‐Bélanger & Van Son Lai, 2020. "Diversification benefits of cat bonds: An in‐depth examination," Financial Markets, Institutions & Instruments, John Wiley & Sons, vol. 29(5), pages 165-228, December.
    4. Reichel, Lukas & Schmeiser, Hato & Schreiber, Florian, 2022. "On the optimal management of counterparty risk in reinsurance contracts," Journal of Economic Behavior & Organization, Elsevier, vol. 201(C), pages 374-394.
    5. Faias, José Afonso & Guedes, José, 2020. "The diffusion of complex securities: The case of CAT bonds," Insurance: Mathematics and Economics, Elsevier, vol. 90(C), pages 46-57.
    6. Tobias Götze & Marc Gürtler, 2022. "Risk transfer beyond reinsurance: the added value of CAT bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 125-171, January.

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