Academic journal article Risk Management and Insurance Review

Cat Bonds and Other Risk-Linked Securities: State of the Market and Recent Developments

Academic journal article Risk Management and Insurance Review

Cat Bonds and Other Risk-Linked Securities: State of the Market and Recent Developments

Article excerpt

ABSTRACT

This article reviews the current status of the market for catastrophic risk (CAT) bonds and other risk-linked securities. CAT bonds and other risk-linked securities are innovative financial vehicles that have an important role to play in financing mega-catastrophes and other types of losses. The vehicles are especially important because they access capital markets directly, exponentially expanding risk-bearing capacity beyond the limited capital held by insurers and reinsurers. The CAT bond market has been growing steadily, with record amounts of risk capital raised in 2005, 2006, and 2007. CAT bond premia relative to expected losses covered by the bonds have declined by more than one-third since 2001. CAT bonds now appear to be priced competitively with conventional catastrophe reinsurance and comparably rated corporate bonds. CAT bonds have grown to the extent that they now play a major role in completing the market for catastrophic-risk finance and are spreading to other lines such as automobile insurance, life insurance, and annuities. CAT bonds are not expected to replace reinsurance but to complement the reinsurance market by providing additional risk-bearing capacity. Other innovative financing mechanisms such as risk swaps, industry loss warranties, and sidecars also are expected to continue to play an important role in financing catastrophic risk.

INTRODUCTION

This article analyzes risk-linked securities as sources of risk capital for the insurance and reinsurance industries. Risk-linked securities are innovative financing devices that enable insurance risk to be sold in capital markets, raising funds that insurers and reinsurers can use to pay claims arising from mega-catastrophes and other loss events. The most prominent type of risk-linked security is the catastrophic risk (CAT) bond, which is a fully collateralized instrument that pays off on the occurrence of a defined catastrophic event. CAT bonds and other risk-linked securities are potentially quite important because they have the ability to access the capital markets to provide capacity for insurance and reinsurance markets. The CAT bond market has expanded significantly in recent years and now seems to have reached critical mass. Although the CAT bond market is small in comparison with the overall nonlife reinsurance market, it is of significant size in comparison with the property-catastrophe reinsurance market. Some industry experts observe that nontraditional risk financing instruments, including CAT bonds, industry loss warranties (ILWs), and sidecars, now represent the majority of the property-catastrophe retrocession market.

This article begins by discussing the design of CAT bonds and other risk-linked securities. The discussion then turns to the evolution of the risk-linked securities market and an evaluation of the current state of the market. The scope of the article is limited primarily to securitization of catastrophic property-casualty risks. However, there also are rapidly developing markets in automobile and other types of noncatastrophe insurance securitizations as well as life insurance securitizations, which are discussed in Cowley and Cummins (2005).

THE STRUCTURE OF RISK-LINKED SECURITIES

This section considers the structure of CAT bonds and other risk-linked securities that have been used to raise risk capital for property-casualty risks. The discussion focuses primarily on CAT bonds but also considers other innovative risk financing solutions. Included in the latter category are some investment structures that are not necessarily securities in the sense of being tradable financial instruments but are innovative approaches whereby insurers and reinsurers can either access capital markets to supplement traditional reinsurance.

Risk-Linked Securities: Early Developments

Following Hurricane Andrew in 1992, efforts began to access securities markets directly as a mechanism for financing future catastrophic events. …

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