By its nature, catastrophe risk is often not diversifiable on a local or even regional scale. Instead, insurers usually look to the global reinsurance markets for catastrophe risk protection. Recently, a third option has risen to prominence as hedge funds, pension funds, and other institutional investors (hereafter “alternative capital”) have sought to “directly” invest in catastrophe risk. Through investments in insurance-linked securities (ILS) and collateralized reinsurance, alternative capital has increased the available supply of property catastrophe risk coverage and driven ILS prices toward all-time lows.
Yet alternative capital may be most remarkable not for its impacts to date, but for its vast untapped potential. ILS is still a niche asset class, and the existing market for catastrophe risk is dwarfed by the pool of available institutional capital. Nevertheless, price competition on existing property catastrophe risk may have already reached the point of diminishing returns. Product innovation is needed to support the growth rate of alternative capital and to produce further improvements in the availability and cost of catastrophe coverage.
In this paper, the use of pooling and tranching techniques similar to those used in collateralized debt obligations (CDOs) is proposed as a tool for expanding the market for catastrophe risk. Given the somewhat infamous legacy of CDOs and inherent complexity of catastrophe risk, the pairing of the two may seem problematic. However, catastrophe risk is a far stronger candidate for inclusion in a CDO-type structure than economic assets such as securitized mortgages. An appropriately designed collateralized risk obligation (CRO) would have significantly less systemic vulnerability than the subprime mortgage-fueled CDOs at the heart of the recent financial crisis.
