NEW YORK, Jan. 11, 1999 — A new study from Insurance Services Office, Inc., (ISO) provides methodology for determining the optimum mix of risk securitization and traditional financing to pay growing insurer catastrophe losses.
The analytical framework developed in ISO's study, "Financing Catastrophe Risk: Capital Market Solutions," is highly dependent on insurers' unique characteristics.
"The report takes the mystery out of securitizing catastrophe risk by quantifying the uncertainties and clearly demonstrating how certain combinations of cat financing can help an insurers' bottom line," said John J. Kollar, ISO's vice president-actuarial services and research.
"Faced with potential hurricanes and earthquakes that could generate $75 billion to $100 billion and more in losses, the industry needs to consider promising alternatives to traditional catastrophe financing," said Kollar.
Risk securitization enables insurers and reinsurers to share catastrophe risk with investors via the capital markets. The $26 trillion U.S. capital markets are 75 times larger than the property/casualty industry's statutory net worth, ISO estimates. Catastrophe risks can be packaged as securities that can be bought and sold in the capital markets in the form of catastrophe bonds, contingent surplus notes, exchange-traded catastrophe options and catastrophe equity puts.
The study shows how each of three different insurers might minimize its cost of financing catastrophe risk by using the right combination of the insurer's own capital, excess-of-loss catastrophe reinsurance and catastrophe options.
Catastrophe options, such as those traded on the Chicago Board of Trade and the Bermuda Commodities Exchange, give the purchaser the right to a cash payment if a specified index of catastrophe losses for a specific period reaches a specified level. An insurer using this form of securitization buys cat options from investors.
ISO used an illustrative cat index composed of the loss experience of 50 insurers in determining the best risk-financing strategy for each of three insurers. The three insurers were: a medium-sized national insurer with an exposure distribution resembling the 50 companies in the cat index, a large national insurer with an exposure distribution less similar to the distribution in the index, and a regional insurer whose exposure distribution was markedly different than the insurers in the index.
For each of the insurers, the optimal mix and amount of risk financing depends on the relative costs of capital, reinsurance, and catastrophe options, and on each insurer's unique characteristics, such as the amount of business each insurer writes, its geographic distribution, and the insurer's tolerance for risk.
Using computer models, the study shows how the best combination of catastrophe risk financing methods could significantly reduce costs for each of the three insurers. For example, compared with the cost of financing catastrophe risk using just their own capital, the large national insurer could potentially save 9 percent; the medium-sized national insurer could potentially save 16 percent; and the regional insurer, 20 percent.
In particular, the study points out that an insurer's ability to use catastrophe options effectively depends on how its loss experience compares with the catastrophe index used in settling the options. The absence of a high correlation between an insurer's loss experience and the performance of the catastrophe index-frequently termed " Basis risk"-reduces the effectiveness of the options as a hedge against catastrophe losses, according to the study.
Conversely, "the more an insurer's exposure distribution resembles that underlying the index, the more likely it is that the options will provide funds when the insurer needs them to cover catastrophe losses," says the ISO report.
"The report's analysis doesn't imply that using catastrophe options is generally preferable to using reinsurance or vice versa," cautioned Kollar.
"Investors have committed close to $3 billion to forms of catastrophe risk securitization through September 1998, not a large amount against insured catastrophe losses that could exceed $100 billion," said Kollar. "But as investor familiarity with securitization increases, capital markets may one day play a significant role in many insurers' strategies for financing risk."