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Natural and man-made catastrophes have a low probability of occurrence, but when they do occur the consequences can be of high severity, affecting a large number of persons as well as their property. For many individuals and enterprises, insurance is the most practical and effective way of handling a major risk such as a catastrophe. After all, by obtaining insurance, individuals and enterprises spread risks so that no single entity receives a financial burden it can not cope with. But catastrophic loss presents special problems for insurers because large numbers of those insured incur losses at the same time. Reinsurance supports insurance companies to underwrite large risks, limit liability on specific risks, increase capacity, and share liability when claims overwhelm the primary insurer’s resources. In reinsurance transactions, one or more insurers (i.e. the reinsurers) agree, for a premium, to indemnify a primary insurer against all or part of the loss that that primary insurer may sustain under its policies. The contractual and business relationships between insurers and reinsurers facilitate relatively low transaction costs. However, in the case of extremely large or multiple catastrophic events, insurers might not have purchased sufficient reinsurance, or reinsurance providers might not have sufficient capital to meet their existing obligations.

In any event, after a catastrophic loss, reinsurance capacity may be diminished and reinsurers might limit availability of future catastrophic reinsurance coverage, while, on the other hand, the demand of potential victims increases. This simultaneous occurrence of shrinking supply and rising demand naturally leads to a sharp increase in reinsurance pricing. High reinsurance prices induce investors to invest capital in the reinsurance business (e.g. new reinsurance companies may be formed, investors may be willing to purchase new tranches of equity issued by existing reinsurers). This, in turn, ends in an increase in the supply of catastrophe cover and causes prices to stabilize once again. Finally, in case no major catastrophe happens shortly after the first one, reinsurers offer premiums at prices below expected loss and costs, while primary insurers have excess supply of capital and are therefore capable of supporting new risk exposures. In order to win or retain market share, reinsurers would lower their underwriting criteria and may accept marginal risks or liberalize policy conditions. This ushers in a period of low premium rates. Reinsurance is thus clearly influenced by price cycles, which are particularly pronounced in catastrophe insurance. Given this cyclic nature of the reinsurance market, investors have incentives to look for alternative capital sources.

Of course, the most direct means for (re)insurance companies to raise capital in the capital market is issuing company stock. However, holding extra capital by insurers includes both benefits and costs. The benefits of additional capital comprehend higher premium prices by making their promise to pay claims credible to policyholders, avoidance of loss of franchise value that could occur if the insurer is financially threatened from a catastrophe, and a reduction in foregone investment opportunities. However, the additional agency and tax costs associated with holding more capital limit the amount of capital held by insurers and can have a large effect on the price of catastrophe coverage. Moreover, any investor in an insurance company’s stock is subject to the risks of the entire company. Therefore, an investor’s decision to purchase stock will depend on an assessment of the insurance company’s management, quality of operations, and overall risk exposures from all perils. In contrast, an investor in a specific capital market instrument can face risk associated with the insurance company’s underwriting standards but does not take on the risk of the overall insurance company’s operations.

Therefore, the present paper will give an introduction on the concept of capital markets, as a division of Alternative Risk Transfer, and its products, followed by a more detailed overview of existing literature on the most important capital market instruments available to the insurance industry to transfer and/or hedge catastrophe risks. Emphasis will be laid upon natural catastrophes, since the existing capital market instruments are especially developed to protect against the loss from natural catastrophes. However, the present paper will also touch shortly upon the potential of these instruments for terrorism risk.

After briefly explaining in section 2 the concept of Alternative Risk Transfer (ART), and in section 3 the broad categories of capital market instruments, section 4 will emphasize the concept, the benefits and the costs of insurance linked securities and will develop in more detail the advantages and disadvantages, and the future prospects, of catastrophe bonds. Section 5 will provide an insight into the concept of contingent capital. The next section will highlight (the benefits and costs of) catastrophe derivatives, which are only in a nascent state of development and which yet have to make significant penetration in the risk management sector. Exchange-traded catastrophe derivatives, such as catastrophe futures and call-spread options, and OTC catastrophe derivatives, such as catastrophe swaps, pure catastrophe swaps and weather derivatives, will be challenged as useful capital market instruments to provide catastrophe insurance capacity. Section 7 will try to compare the financial instruments on different grounds, thereby giving more insight in their advantages and disadvantages for catastrophe risk financing. Section 8 will touch shortly upon the potential of these capital market instruments for terrorism risk. The present paper will then conclude with a few concluding remarks.

Contents

Capital Market Instruments for Catastrophe Risk Financing
Table of Contents
I. Introduction
II. Alternative Risk Transfer
III. Capital Market Instruments
III.1. Securitization and Insurance-linked Securities
III.2. Contingent Capital
III.3. (Insurance) Derivatives
IV. Insurance-linked Securities
IV.1. Standard Structure
IV.2. Benefits and Costs of Insurance-Linked Securities
IV.3. Triggers
IV.4. Catastrophe Bonds

IV.4.a. Standard Structure
IV.4.b. Catastrophes Covered
IV.4.c. Advantages and Disadvantages of Catastrophe Bonds

V. Contingent Capital
V.1. Standard Structure
V.2. Benefits and Costs of Contingent Capital
VI. Catastrophe Derivatives
VI.1. Standard Structure
VI.2. Benefits and Costs of (Catastrophe) Derivatives
VI.3. Exchange-traded Catastrophe Derivatives

VI.3.a. CBOT
VI.3.b. CATEX
VI.3.c. BCE

VI.4. OTC Catastrophe Derivatives

VI.4.a. Catastrophe Swap
VI.4.b. Pure Catastrophe Swap
VI.4.c. Weather Derivatives

VI.5. Challenges for Catastrophe Derivatives
VII. An Attempt at Comparing Capital Market Instruments
VII.1. Liquidity Risk, Basis Risk, Moral Hazard and Adverse Selection, and Credit Risk
VII.2. (Indexed) Catastrophe Bonds versus Catastrophe Reinsurance
VIII. Capital Markets and Terrorism Risk
IX. Conclusions on Capital Markets as an Instrument to Manage Catastrophe Risks
X. Bibliography

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