Catastrophe Risk Securitization: Insurer and Investor Perspectives

This paper presents a survey of the various instruments used to securitize catastrophe risk listing their advantages and disadvantages. The paper then focuses on the use of catastrophe options, presenting an example of how catastrophe options work from the investor prospective, and demonstrating a method for analyzing the cost of financing catastrophe insurance with the following instruments: (1) insurer capital; (2) reinsurance; and (3) catastrophe options. The procedure first quantifies the cost of financing in terms of the cost of those instruments. The method then permits searching for a mix of instruments that minimizes the cost. Using a catastrophe model, we create a distribution of simulated losses for each of fifty insurers that report their exposure to ISO. We then create an illustrative catastrophe index based on the combined simulated losses of the fifty insurers. We perform a sample analyses for three insurers. The analyses show that the best mix of capital, reinsurance, and catastrophe options depends on how well an insurer's losses correlate with the index - that is, on the basis risk. Some insurers can significantly reduce their cost of financing catastrophe insurance by using catastrophe options. To illustrate the effect on premiums of the cost of financing catastrophe insurance, we convert those costs into risk loads.