Reinsurance or Cat Bond? How to Optimally Combine Both

Risk transfer beyond reinsurance: the added value of CAT bonds

“…The authors also find that CAT bonds are more likely to be employed by low-risk type insurers. Trottier and Lai (2017) use a contingent claims model to study the joint use of indemnity CAT bonds and reinsurance. In their model, reinsurance and CAT bonds differ in terms of their exposure to moral hazard, which is greater for CAT bond investors than reinsurers, and reinsurer default risk, which is not present for CAT bonds.…”

“…Prior to examining the substitution of reinsurance by CAT bonds, this section explains the structural differences between reinsurance and CAT bonds that possibly lead to different patterns of use. The theoretical literature suggests that due to the differences between reinsurance and CAT bonds, the advantageousness of one or the other instrument will depend on the insurer and the insured risk (Doherty and Richter 2002;Nell and Richter 2004;Cummins and Trainar 2009;Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Trottier and Lai 2017;Subramanian and Wang 2018). Consequently, CAT bonds may sometimes add value to insurers' risk management and may therefore be used as a substitute for reinsurance.…”

“…CAT bonds are issued in the capital market, which has a significantly larger capacity to cope with extreme catastrophes than the reinsurance market and enables the diversification of risks that are not diversifiable through the reinsurance market (Froot 2001;Doherty and Richter 2002;Nell and Richter 2004;Cummins and Trainar 2009;Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Subramanian and Wang 2018). Additionally, CAT bonds are fully collateralised and their capital is managed by a trustee, so that their sponsors are not exposed to the counterparty default risk a reinsurance contract carries (Froot 2001;Doherty and Richter 2002;Nell and Richter 2004;Cummins and Trainar 2009;Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Trottier and Lai 2017). These characteristics both make CAT bonds preferable to reinsurance as a way to cover high layers of risk (Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Trottier and Lai 2017;Subramanian and Wang 2018).…”

“…Additionally, CAT bonds are fully collateralised and their capital is managed by a trustee, so that their sponsors are not exposed to the counterparty default risk a reinsurance contract carries (Froot 2001;Doherty and Richter 2002;Nell and Richter 2004;Cummins and Trainar 2009;Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Trottier and Lai 2017). These characteristics both make CAT bonds preferable to reinsurance as a way to cover high layers of risk (Cummins and Weiss 2009;Lakdawalla and Zanjani 2012;Trottier and Lai 2017;Subramanian and Wang 2018). The payout of CAT bonds may be defined either on an indemnity or non-indemnity basis, whereas reinsurance contracts are typically defined on an indemnity basis (Doherty and Richter 2002;Nell and Richter 2004;Cummins and Weiss 2009;Finken and Laux 2009).…”

“…However, non-indemnity CAT bonds exhibit basis risk, which arises because the payout structure may not be perfectly correlated with the insurer's actual losses (Doherty and Richter 2002;Cummins et al 2004;Nell and Richter 2004;Cummins and Weiss 2009;Finken and Laux 2009;Braun 2016;Gürtler et al 2016). Reinsurance is based on long-term contract relationships, and reinsurers exhibit underwriting resources superior to those of CAT bond investors, which mitigates moral hazard and adverse selection issues (Doherty and Richter 2002;Cummins and Trainar 2009;Finken and Laux 2009;Trottier and Lai 2017;Subramanian and Wang 2018). Furthermore, through reinsurance, collateral is provided more efficiently through the use of diversification (Lakdawalla and Zanjani 2012).…”