Financial Innovation in the Management of Catastrophe Risk

Like the preceding article, this article argues that the high costs of reinsurance present the opportunity for hedging instruments to be offered to primary insurers that are both competitive with current reinsurance and that offer investors high rates of return. But the combination of high reinsurance premiums and the vast capacity of the capital market for diversification is not sufficient to ensure the success of these new instruments. If new instruments such as catastrophe options and catastrophelinked bonds are to compete successfully with reinsurance, they must provide a cost‐effective means of resolving incentive conflicts between the primary insurer and the ultimate risk bearer that are known as “moral hazard.” Without an effective solution of this moral hazard problem, the use of past insurance loss data to estimate the potential returns for purchasers of catastrophe bonds and other such instruments will be misleading and unreliable. As the author demonstrates, both traditional reinsurance and each of the new catastrophe hedging instruments presents insurance companies and other hedgers with the challenge of managing a different combination of moral hazard, credit risk, and basis risk. For example, traditional catastrophe reinsurance is subject to significant credit risk and moral hazard, but little if any basis risk. By contrast, both catastrophe options and bonds can be designed in ways that reduce moral hazard and credit risk, but at the cost of taking on some basis risk. The risk manager's task in such circumstances is to design an instrument that embodies the optimal, or cost‐minimizing, trade‐off among these three sources of risk.