Content area
Full Text
ABSTRACT
This article considers 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 cédants 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.
INTRODUCTION
Insurance-linked securities (known as ILS) is a general term that covers different instruments designed to pass life and non-life insurance risks on to the financial markets. They range from ILS in the strict sense of the term to contingent capital, cat bonds, cat swaps, cat options, sidecars, collateralized quota shares, and industry loss warranties. Some observers would probably also include under the ILS barmer specialist hedge funds and certain derivatives, such as weather or climate derivatives. For reviews of these contracts see Cummins (2005, 2008), Cummins and Weiss (2009), and Albertini and Barrieu (2009).
Insurance risk securitization remains marginal compared with the businesses of insurance and reinsurance. However, it has undergone rapid growth in response to major loss events such as Hurricane Andrew in 1992, World Trade Center terrorist attacks in 2001, and Hurricanes Katrina, Rita, and Wilma in 2005. After each of these disasters, the capital of reinsurers was seriously weakened and the usual means of rebuilding capacity - i.e., new company formation through initial public offerings, seasoned equity issues, and capital increases - were not sufficient to enable the market to rebuild to previous levels of capacity. In fact, ILS provided much of the additional risk capital that was unavailable through the usual channels. In 2007 and the first half of 2008, insurance and reinsurance companies continued to issue ILS even though the loss ratio for these years was moderate. Initially conceived as a supplement for rebuilding capacity exhausted by exceptional disasters, ILS seem to have gradually carved out a place for themselves in the insurance and reinsurance landscape (see also GC Securities, 2008).
This article provides an...