The risk implications of insurance securitization: The case of catastrophe bonds

Abstract

Catastrophe (Cat) bonds are insurance securitization vehicles which are supposed to transfer catastrophe-related underwriting risk from issuers to capital markets. This paper addresses key, unanswered questions concerning Cat bonds and offers the following results. First, our findings show firms that issue Cat bonds exhibit less risky underwriting portfolios with less exposure to catastrophe risks and overall less need to hedge catastrophe risk. These results show that the access to the market for insurance securitization is easiest for firms with less risky portfolios. Second, firms that issue Cat bonds are found to experience a reduction in their default risk relative to non-issuing firms and our results, therefore, demonstrate that Cat bonds provide effective catastrophe hedging for issuing firms. Third, firms with less catastrophe exposure, increase their catastrophe exposure following an issue. Therefore, our paper cautions that the ability to hedge catastrophe risk causes some firms to seek additional catastrophe risk.

Reinsurance or securitization: The case of natural catastrophe risk

“…Such dominance is generally compounded by the presence of many liquidity traders and by large uncertainty about losses: the greater the presence of liquidity traders and loss uncertainty, the greater informed traders' profit opportunities, the greater these traders' incentive to produce information for the purpose of taking advantage of these opportunities; this exacerbates the problem of excess information production in financial markets. Result (iv) is consistent with the finding that insurers with less risky portfolios are more likely to issue catastrophe bonds (Hagendorff et al, 2014), to which the stock market responds more positively (Hagendorff et al, 2013). Result (iii) is consistent with the aforementioned success of catastrophe bonds and relative failure of exchange-traded catastrophe futures and options: there are few, if any liquidity traders in OTC markets, unlike in exchanges.…”

“…The dominance of financial markets for low loss uncertainty is consistent with the finding that insurers with less risky portfolios are more likely to issue catastrophe bonds (Hagendorff et al, 2014), to which the stock market responds more positively (Hagendorff et al, 2013). It may provide a tentative explanation for the relative success of the catastrophe contracts traded on the Chicago Mercantile Exchange: recall from the Introduction that the contracts once trading on other exchanges since have been delisted.…”

“…However, whereas these authors consider adverse selection between insurers and financial market investors to conclude that securitization should be more attractive to insurers with more risky portfolios who suffer less from adverse selection, we consider adverse selection among financial market investors to draw the opposite conclusion (recall Result (iv) in the Introduction). While both types of adverse selection no doubt exist, the aforementioned results of Hagendorff et al (2013Hagendorff et al ( , 2014 suggest an important role for adverse selection among financial market investors, between informed traders and liquidity traders.…”

Size is everything: Explaining SIFI designations

“…The hypotheses behind these suspected causal relations are similar to arguments brought forward in banking. Insurer size, for example, could have an increasing effect on systemic risk in the insurance sector, because larger insurance companies have a wider range of different risks covered and thus are less prone to suffer from cumulative losses (see Hagendorff, Hagendorff, Keasey, & Gonzalez, 2014). Yet, larger insurance companies could become too‐interconnected‐to‐fail and thus systemically relevant (see Acharya et al, 2009).…”

Influence of Flow Velocity on Tsunami Loss Estimation

“…Catastrophe risk assessment is essential for achieving effective risk management to deal with the low-probability high-consequence catastrophes in the global insurance-reinsurance system by transferring financial risks among stakeholders [1][2][3]. Tsunamis are one of the low-probability high-consequence natural disasters, and thus the improved accuracy of tsunami loss estimation can help insurance/re-insurance underwriters to better understand their exposure to catastrophe risks and is beneficial for profitable design of risk transfer instruments [4][5][6].…”