The Securitization of Catastrophic Property Risks

Several reasons are suggested for the current slow emergence of a market for the securitization and derivatization of insurance risk. The rincipal focus of the paper is the financial engineering of securities and derivatives instruments that convey insurance risk directly to investors in the capital markets. It is shown how a special purpose reinsurer forms a bridge between conventional reinsurance and catastrophe-linked bonds. An equation is developed for the price of a pure catastrophe bond, which puts both principal and interest at risk, in terms of the probability of occurrence of the insured catastrophic event. It is then shown how to utilize a special purpose reinsurer to manufacture a principal-protected catastrophe bond as a more investor-friendly form of security that is ideal for launching the new insurance risk securitization market. Next, it is demonstrated that over-the-counter catastrophe call spread contracts are economically equivalent to excess of loss reinsurance contracts, and it is argued that such call spreads are likely to be the most efficient vehicle for transferring to investors exposure to low-probability mega- atastrophes. A stochastic simulation quantifies the value added to a portfolio of stocks and bonds from overlaying a modestly diversified portfolio of catastrophe call spreads. Finally, a cursory, qualitative treatment of various tax, accounting, and regulatory matters is presented, as well as a suggestion as to how the US federal government should become involved in the long-term financing of property catastrophe risks.

Keywords: Call spreads, catastrophic risks, excess-of-loss reinsurance, insurance derivatives, insurance risk securitization