Financial Innovation in the Management of Catastrophe Risk

Catastrophic events such as hurricane and earthquakes are the dominant source of risk for many property casualty insurers. Primary insurers usually limit the scale and geographic scope of their operations in order to focus on core competencies such as marketing, underwriting and loss control. But his often leaves them without sufficient geographic spread to diversify catastrophe risk. The traditional hedge for the primary insurer is reinsurance. Specialist reinsurers achieve a spacial spread of risk and can therefore bear catastrophe risk that is undiversifiable to the primary. But the transaction costs associated with reinsurance, and therefore premiums, are high. High premiums, coupled with the fact that catastrophe losses exhibit little correlation with capital market indices, has attracted considerable activity in Wall Street in searching for new instruments that securitize catastrophe risk. Indeed many players are now talking of catastrophe risk being a new “asset class” and new instruments such as catastrophe options and catastrophe bonds are starting to appear. The rationale for these new instruments is usually developed as follows. Recent catastrophe events such as Hurricane Andrew and the Northridge earthquake have imposed costs on the insurance industry of an order of magnitude not thought possible only a decade ago. More sophisticated modeling now presents potential losses to the industry of $50 billion or more. Examples would be Andrew hitting Miami, a major quake on the New Madrid Fault and a repeat of the 1906 San Francisco earthquake. These events could wipe out 25% or more of the entire industry’s net worth which currently is in the order of $200 billion. Two such events, or one such event combined with continued mass tort claims (e.g. successful plaintiff claims in tobacco litigation) could cripple the whole industry. However, losses of this size would hardly cause a ripple in capital markets. The U.S. capital market currently currently consists of securities representing some $13 trillion of investor wealth and the loss scenarios cited above amount to less than one standard deviation of daily trading volume. Presentations by merchant bankers, reinsurance brokers and others have echoed this potential for diversifying catastrophe risk within the capital market. The high transactions costs of reinsurance offers potential for hedging instruments to be offered to primary insurers that are both competitive with current reinsurance and which offer investors high rates of return. Moreover, since catastrophe risk is uncorrelated with market indices, the benchmark for such investments is just the risk free rate. Pricing new instruments requires that the expected loss be estimated with some. Until recently, insurers and reinsurers had a comparative advantage in information on catastrophic events. But in the past decade a number of modeling firms have developed models that combine seismic and meteorological information with data on the construction, siting, and value of individual buildings. These models can be used to simulate the economic effects of many thousands of storms and earthquakes. Although such models are used by the insurance firms and reinsurers, mainly for loss estimation and re-balancing their exposure, the same models are now available to other companies and investors. The arrival of the modelers and their models is eroding the comparative information advantage of insurers and reinsurers and opening the door to new players. Insurers will retain their comparative advantage over, say, merchant banks in related insurance services such as marketing, underwriting and loss settlement facilities. But the stage has been set for an unbundling of insurance products with insurers retaining marketing underwriting and settlement services and risk bearing by-passing the reinsurance industry and being provided more directly from the capital market. But the combination of high transaction costs for reinsurance and the vast capacity of the capital market for diversification, is not sufficient to ensure the success of these new instruments. The costs associated with reinsurance do not necessarily reflect monopoly rent. Relationships between primary insurers and reinsurers involve moral hazard; the relationship relaxes the incentive for the insurer to underwrite carefully or to settle claims efficiently. Consequently, the reinsurer will monitor the primary. Moreover, long term relationships are often formed to counter such expropriation. The apparently high transaction costs of reinsurance may simply reflect the resolution of moral hazard. If new instruments such as catastrophe options and bonds are to compete successfully with reinsurance, they must be able resolve incentive conflicts between the primary insurer and the ultimate risk bearer. Indeed, if moral hazard is not resolved, using past insurance loss data to estimate the potential returns for purchasers of catastrophe bonds, etc, is spurious. The purpose of this paper is to examine and categorize new catastrophe hedging instruments. These instruments will then be compared with traditional risk management strategies adopted by primary insurers in order to compare their relative efficiency at resolving incentive conflicts. Each instrument offers a different combination of credit risk, basis risk and moral hazard. For example, catastrophe reinsurance is subject to significant credit risk and moral hazard, but does not encounter significant basis risk. I will argue that the differential performance of the traditional and new instruments offers primary insurers with a richer portfolio of risk management strategies, though no strategy is dominant in its performance on all three criteria.