Catastrophe risk financing

Abstract

Given the increasing number of catastrophes and scale of loss as a result of these catastrophes, Catastrophe Insurance has gained significance in the last two decades. The traditional catastrophe risk transfer market, comprising reinsurance firms, was not effective as the premiums were several multiples larger than the actuarially fair values. This was a result of the strong bargaining power that the reinsurers had in the capital starved market. The high premiums were also a result of structural factors related to the industry like the issue of moral hazard and information asymmetry. As a result, primary insurers started looking at the capital markets as a source of contingent capital. To tap into the capital markets, several innovative products were developed the most popular ones being CAT Bonds, Industry linked warranties, Collateralized Reinsurance (CRI) and Reinsurance Sidecars. CAT Bonds drove most of the initial growth in this segment. However CRIs have replaced CAT Bonds as the fastest growing type of alternate risk capital. Studying trends in the CAT Bond market with respect to factors like issuance size, trigger type, coupon-to-expected-loss multiple and risk adjusted returns, show that alternate capital is gaining acceptance very fast among both insurers and investors. Analysis of the impact of the default of 2 CAT Bonds – Kamp Re. and Muteki Ltd presents further evidence on the acceptance of alternate risk capital The emergence of the alternate risk capital market has had a very favourable impact on primary insurers as it reduced the bargaining power of traditional reinsurers. While reinsurers have found their profits going down, they are presented with an opportunity to manage third party capital by leveraging their expertise and add a new revenue stream.