Diversification benefits of cat bonds: An in‐depth examination

AbstractReinsurance and CAT bonds are two alternative risk management instruments used by insurance companies. Insurers should be indifferent between the two instruments in a perfect capital market. However, the theoretical literature suggests that insured risk characteristics and market imperfections may influence the effectiveness and efficiency of reinsurance relative to CAT bonds. CAT bonds may add value to insurers’ risk management strategies and may therefore substitute for reinsurance. Our study is the first to empirically analyse if and under what circumstances CAT bonds can substitute for traditional reinsurance. Our analysis of a comprehensive data set comprising U.S. P&C insurers’ financial statements and CAT bond use shows that insurance companies’ choice of risk management instruments is not arbitrary. We find that the added value of CAT bonds mainly stems from non-indemnity bonds and reveal that (non-indemnity) CAT bonds are valuable under high reinsurer default risk, low basis risk and in high-risk layers.

Download Full-text

Understanding Cat Bonds

The Journal of Alternative Investments ◽

10.3905/jai.2016.19.1.027 ◽

2016 ◽

Vol 19 (1) ◽

pp. 27-40 ◽

Cited By ~ 2

Author(s):

Andrew J. Sterge ◽

Bernard van der Stichele

Keyword(s):

Cat Bonds

Download Full-text

The diffusion of complex securities: The case of CAT bonds

Insurance Mathematics and Economics ◽

10.1016/j.insmatheco.2019.10.011 ◽

2020 ◽

Vol 90 ◽

pp. 46-57

Author(s):

José Afonso Faias ◽

José Guedes

Keyword(s):

Cat Bonds

Download Full-text

A New Class of Probability Distortion Operators with an Application to CAT Bonds

SSRN Electronic Journal ◽

10.2139/ssrn.3020384 ◽

2017 ◽

Author(s):

Denis-Alexandre Trottier ◽

Van Son Lai

Keyword(s):

New Class ◽

Cat Bonds

Download Full-text

Catastrophe risks, cat bonds and innovation resistance

Qualitative Research in Financial Markets ◽

10.1108/qrfm-06-2012-0020 ◽

2014 ◽

Vol 6 (1) ◽

pp. 75-92 ◽

Cited By ~ 1

Author(s):

Tristan Nguyen ◽

Joerg Lindenmeier

Keyword(s):

Capital Markets ◽

Extreme Events ◽

Free Market ◽

Diffusion Mechanism ◽

Persuasive Communication ◽

Content Type ◽

Consumer Resistance ◽

Catastrophe Bonds ◽

Cat Bonds ◽

Private Investors

Purpose – It is essential for the welfare and growth of a society that it is able to share risk efficiently in the economy. However, extreme events have increased enormously during the last decades, so that catastrophe risks seem to become uninsurable in a free-market economy. With insurance-linked securities (ILS) or catastrophe bonds (cat bonds), the limits of insurability can be ex-tended by using the resources of capital markets worldwide. Interestingly, to date the issuers of cat bonds must guarantee excessively high returns in order to attract investors from the financial markets. Therefore, the authors aim to discuss in this paper the hypothesis that at least parts of these excessively high returns can be explained by an individual innovation resistance to cat bonds. Design/methodology/approach – In the first step, the authors examine the criteria for insurability of catastrophe risks and explore the potential reasons for lack of insurance, specifically for extreme events such as catastrophic environmental risks. The authors especially focus on the criteria which are considered to be problematic for the insurance of catastrophic events. In the next step, the authors discuss the new financial products “ILS” or “cat bonds” and analyze to what extent ILS represent an innovative opportunity to increase the insurability of catastrophe risks. Starting from the model of the consumer resistance by RAM, the authors consider different factors that can prevent the acceptance of ILS by private investors. Findings – The authors found out that catastrophe risks do not really fulfil important actuarial criteria in order to be insurable. Thus, insurance exists only if risk can be transferred, not only to reinsurance companies but also to capital markets (through securitization or catastrophe options). In line with Ram's seminal model of consumer resistance, the authors assume that product-related, diffusion mechanism-related and psychographic factors influence individuals' resistance to cat bonds. In particular, the authors expect that perceptions of immorality influence private investors' decision-making. Within this context, Robin and Reidenbach's “Multi-dimensional ethics”-scale represents a possibility to assess perceptions of immorality. Originality/value – In this paper, the authors provide a new approach to explain the excess spreads on cat bonds versus comparable corporate bonds. These abnormal high turns from cat bonds have been subject of intensive research in the last decade. To date, the insurance literature has identified “novelty premium”, “market size” and “cliff risk” as the reasons for the excess spreads. The authors assume that at least parts of these excessively high returns can be explained by an individual innovation resistance against ILS. In the authors' opinion, persuasive communication can be used to alleviate individual resistance towards ILS. The paper provides implications for management and suggestions for further research.

Download Full-text