Financing Catastrophe Risk
Insurance companies can prudently write policies only to the extent that the companies have access to the capital necessary to finance the risk they assume. Regulators — and good business practice — require that insurers have access to enough funds to protect their policyholders under all but the most extreme circumstances.
Traditionally, insurers use their own capital and the premiums they collect to finance their risk. Insurers also traditionally finance some of their risk by purchasing reinsurance.
Demographic projections and modeling indicate that insurers and society as a whole may one day face a catastrophe — a hurricane or earthquake, for example — that causes several times the losses of Hurricane Andrew, the most expensive catastrophe to date.
Aware of the possibility of unprecedented catastrophe losses, insurers and entrepreneurs have been devising ways to take advantage of the vast potential of the capital markets to spread catastrophe risk.
As of December 31, 1999, the property/casualty insurance industry's net worth — or surplus — was $336 billion. Adding up the value of private holdings of various kinds of financial instruments (such as stocks, corporate bonds, government bonds, and others), ISO estimates that, as of December 31, 1999, investors in the U.S. capital markets controlled financial assets totaling $32.0 trillion — more than 95 times the net worth of the property/casualty insurance industry.
To help insurers finance catastrophe risk, entrepreneurs have been developing ways to securitize the risk — that is, ways to package catastrophe risk as securities that insurers and investors can buy and sell. Since 1995, investors have committed about $4.7 billion to various vehicles for securitizing catastrophe risk. Though that figure is small compared with potential losses — and not all of the money was available at any one time — access to the capital markets could one day play a significant role in many insurers' strategies for financing catastrophe risk.
In the long run, securitizing catastrophe risk will provide substantial insurance capacity only if:
- Insurers find that securitization is a cost-effective means of spreading their risk.
- Investors find that securitizing catastrophe risk enhances the performance of their portfolios.
ISO's 1999 study Financing Catastrophe Risk: Capital Market Solutions provides a detailed analysis of the principal forms of securitization and how insurers and investors are using them. Instruments for securitizing catastrophe risk fall into two general categories — customized and standardized. Using the customized approaches to securitizing risk, insurers can tailor individual transactions to meet their specific needs. However, such tailoring increases the cost of using customized securities compared with the cost of using standardized securities.
The following discussion summarizes just two ways of securitizing risk and suggests how securitization can benefit insurers and investors.
Catastrophe Bonds
Catastrophe bonds are corporate bonds with special language that requires the bondholders to forgive or defer some or all payments of principal or interest if actual catastrophe losses exceed a specified amount, or trigger. When that happens, an insurer or reinsurer that issued catastrophe bonds can pay claims with funds that would otherwise have gone to bondholders. To the extent that bondholders must forgive repayment of principal, the insurer or reinsurer can write down its liability for the bonds. That boosts surplus and may prevent insolvency.
Insurers and investors negotiate the terms of each issue of catastrophe bonds, tailoring the deals to meet particular needs. Thus, catastrophe bonds are a customized approach to securitizing risk. The transaction costs associated with issuing catastrophe bonds include fees to investment bankers, lawyers, and others.
Exchange-Traded Catastrophe Options
Options are, in general, securities that give the purchaser the right — but not the obligation — to buy something from or sell something to the seller of the option at a predetermined price and for a specified period of time. Typically, a commodities market or exchange acts as an intermediary, and the buyer and seller are unaware of each other's identity.
Similarly, exchange-traded catastrophe options are standardized contracts bought and sold through an organized market. However, unlike traditional options, catastrophe options give the purchaser the right to a cash payment if a specified index of catastrophe losses reaches a specified level — the strike price. An insurer that wants to use this form of securitization to hedge catastrophe risk can purchase options through an exchange or commodities market. Investors can sell the options in hopes of earning a profit.
Today, one exchange — the Chicago Board of Trade (CBOT) — lists such options. CBOT's PCS Catastrophe Insurance Options use an index of catastrophe losses compiled by ISO's Property Claim Services unit. If catastrophe losses cause the index to equal or exceed the strike price for an option, the investor must pay the insurer an amount based on the terms of the contract. If the index remains below the strike price, the option expires, and the investor keeps what the insurer paid for the option.
As a standardized form of securitization, catastrophe options offer relatively low transaction costs. However, an insurer purchasing such options faces basis risk — the risk that the catastrophe index used in the options will not correlate well with losses on the insurer's own book of business. Because of basis risk, the options may not provide sufficient funds when needed.
The Insurer's Perspective
An insurer can use computer models and information about the policies the insurer has written to determine its potential catastrophe losses and how much capital the insurer would need to finance that risk on its own. The insurer could then compare the cost of using its own capital with the cost of reinsurance and the cost of catastrophe options or other instruments for securitizing risk.
Using an analytical framework like the one described in ISO's 1999 study on financing catastrophe risk, an insurer can determine the optimum combination of capital, reinsurance, and securitization, based on the insurer's own book of business and tolerance for risk. [14]14. See Insurance Services Office, Inc., Financing Catastrophe Risk: Capital Market Solutions (New York: Insurance Services Office), 1999. Insurers that want more information about ISO's analytical framework should contact ISO's Consulting and Research Department.
The Investor's Perspective
Like insurance companies, capital-market investors can also use catastrophe models and exposure data to analyze the benefits of securitizing catastrophe risk. In addition to the profits an investor might earn, securitizing catastrophe risk offers another potential advantage — an opportunity to reduce portfolio risk through diversification.
The results of most investments generally depend on economic and market conditions. Since the same economic and market conditions affect many investments, the results of many investments tend to correlate with one another. That correlation limits investors' ability to reduce risk through diversification.
By contrast, the results of investments securitizing catastrophe risk depend on catastrophe loss experience. Therefore, the results of such investments do not correlate with the results of most other investments, and an investor can diversify a portfolio by adding instruments that securitize catastrophe risk. Such diversification can, with no offsetting reduction in expected returns, reduce the overall investment risk of a portfolio. Or, using catastrophe options and bonds to improve diversification and high-yield investments to increase returns, an investor can, with no increase in risk, improve the expected overall return on a portfolio.
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