For optimal protection, mix cat bonds & reinsurance

A recent academic research paper has highlighted the benefits of utilising catastrophe bonds alongside traditional reinsurance to optimise firms’ catastrophe insurance programmes, creating efficient protection that expands underwriting capacity and provides greater value to shareholders.

The insurance-linked securities (ILS) space, underlined by the recent and rapid rise of the catastrophe bond market, has become an influential force in the overall reinsurance landscape, with its size now estimated to be roughly $70 billion.

Following the realisation that the wealth of capacity from third-party investors is most likely to be a permanent feature of the global insurance and reinsurance industry moving forward, primary insurers and traditional reinsurers have increasingly sought to partner with ILS and incorporate it into their business mix.

Seeking to utilise its efficient capital and structures to supplement existing catastrophe re/insurance contracts and to reduce transactional costs at times of persistent market pressures and ongoing competition.

Depending on where and how a re/insurer is situated in the marketplace will likely influence its use of ILS, and in particular catastrophe bonds, as either a stand-alone asset class, or as part of protection within a broader catastrophe re/insurance programme.

But the majority of noise from the industry does suggest that most players in the insurance and reinsurance marketplace now utilise alternative reinsurance capital in some capacity.

With this in mind, a new academic research paper titled ‘Reinsurance or CAT Bond? How to Optimally Combine Both,’ explores different approaches to using a cat bond alongside traditional reinsurance to create an optimal catastrophe insurance programme.

The paper compares four hedging strategies. One that using just reinsurance protection, one that uses just cat bond protection, another that uses cat bond protection for small losses and reinsurance for larger losses, and then a final strategy that uses reinsurance for smaller losses and a cat bond for larger loss protection.

“Our results indicate that the fourth strategy is optimal with respect to the minimization of the hedging cost and also with respect to the maximization of shareholder value. Our results demonstrate that this combination of a CAT bond with a traditional reinsurance contract provides the desired coverage for a lower cost,” explains the paper.

The paper explains that typically reinsurers will charge more for protection that has a higher severity and lower occurrence probability, supporting its stance of using reinsurance for the lower layer of losses, and using a cat bond and the efficient capacity of the capital markets investors for the larger, less frequent catastrophe loss layers.

“Moreover, in our framework, the risk from moral hazard is reduced when the attachment of the contract is high, and CAT bond’ investors thus demand smaller loadings for such contracts,” says the paper.

Explaining that it’s “therefore optimal to hedge smaller losses with reinsurance and higher losses through the issuing of a CAT bond.”

Despite the reinsurance market being highly suited to smaller, weakly correlated events, the effectiveness and efficiency of traditional reinsurance diminishes as the magnitude of potential losses rises, and the correlation of risks grows also, notes the paper.

Stressing that in circumstances like this a cat bond would be far better suited than traditional reinsurance protection, in order to achieve the most efficient, but comprehensive catastrophe insurance programme.

Interestingly, the paper explains that utilising the fourth hedging strategy, which uses reinsurance for smaller losses and a cat bond for the larger, less frequent events, adds greater value to shareholders and also improves underwriting capacity.

“This is because hedging is cheaper under this strategy, which allows the insurer to purchase more protection so as to increase its risk-bearing capacity,” explains the paper.

“Summing up, our results demonstrate that a combination of a CAT bond with a reinsurance contract can be optimal in the sense that it provides the desired coverage for a significantly lower cost,” concludes the paper.