Introduction to the SCOR-JRI Special Issue on New Forms of Risk Financing and Risk Engineering

Article excerpt

The world's insurance markets face growing exposure to catastrophic risk as well as rising loss exposure from legal liability, marine, aircraft, and other risk exposures. In response, global reinsurers have raised significant amounts of new capital, and the financial markets have responded with the development of innovative alternative financing techniques. The special issue examines many relevant aspects of these dynamic changes in risk financing and risk engineering.

The articles in the special issue fall into two primary categories. The first category of articles focuses on risk financing by insurers and reinsurers and the relative importance of various sources of new risk capital. This group of articles analyzes the financing of catastrophic risk and the relationship between reinsurance and capital market solutions. The discussion considers innovative sources of risk capital including industry loss warranties, multiperil and multitrigger contracts, sidecars, and risk-linked securities, such as catastrophe bonds, options, and swaps. Theoretical articles consider alternative securitization designs that may be able to expand the market for insurance-linked securities, and a comparative analysis is provided of alternative regulatory approaches to catastrophe risk finance in the United States and the European Union. The second category of articles in the special issue focuses on risk engineering and modeling, with particular emphasis on methodologies that can be utilized in solvency measurement and risk management. Articles in this category consider the theory and application of copulas as well as the impact of linear and nonlinear dependencies among risks. Also considered are optimal reinsurance strategies under regulatory constraints, the modeling of mortality risk and securitization with stochastic jumps, and the economic relationship between insurance premiums and financial markets. The remainder of this introduction provides a brief overview of the articles published in the special issue.

RISK FINANCING BY INSURERS AND REINSURERS

J. David Cummins and Philippe Trainar consider strengths and weaknesses of reinsurance and securitization in managing insurable risks. Traditional reinsurance operates efficiently in managing relatively small, uncorrelated risks and in facilitating efficient information sharing between cedants and reinsurers. However, when the magnitude of potential losses and the correlation of risks increase, the efficiency of the reinsurance model breaks down, and the cost of capital may become uneconomical. At this juncture, securitization has a role to play by passing the risks along to broader capital markets. Securitization also serves as a complement for reinsurance in other ways such as facilitating regulatory arbitrage and collateralizing low-frequency risks.

J. David Cummins and Mary A. Weiss conduct a broad analysis of the convergence of insurance and financial markets in transferring risk. Convergence has been driven by the increase in the frequency and severity of catastrophic risk, market inefficiencies created by (re)insurance underwriting cycles, advances in computing and communications technologies, and the emergence of enterprise risk management, among other factors. These developments have led to the creation of hybrid insurance-financial instruments that blend elements of financial contracts with traditional reinsurance as well as new financial instruments patterned on asset-backed securities, futures, and options that provide direct access to capital markets. Cummins and Weiss also provide new information on the pricing and returns on contracts such as industry loss warranties and catastrophe (cat) bonds. The results show that cat bond returns have low correlations with returns on alternative investments such as stocks and bonds.

Pauline Barrieu and Henri Louberge analyze diversification issues related to cat bonds. Insurance-linked securities, such as cat bonds, have been issued to complete the international risk transfer process, but so far they account for only a small proportion of the overall market for insurance risk transfer. …