Box 8-3. Capital Market Alternatives for Risk Financing
Alternative catastrophe risk financing mechanisms through weather derivatives
have begun to emerge and are regarded by some observers as playing a role
in the continued viability of the insurance sector. Other authors suggest
that these instruments will continue to be a niche product because of
inability to come up with adequate pricing for these mechanisms as offered
through the capital markets. Such products also raise the awareness and
visibility of natural disasters and climate change issues within the financial
markets (Swiss Re, 1996; Credit Suisse Group, 1998; Lester, 1999; Mahoney,
1999; Punter, 1999).
Contingent Capital Securities. The two types of capital contingency
securities available to investors are contingent surplus notes and catastrophe
equity puts. Investors in these securities becomeat the insurer's
optioncreditors of or equity investors in the insurer. The exercised
"notes" and "puts" are shown as surplus on an insurer's
balances sheet and thus increase assets without an offsetting increase
in the liability portion of the balance sheet. The insurer can draw from
surplus to pay unreserved catastrophe losses and have the funds (surplus)
necessary to take on new exposures.
Catastrophe Risk Securities. Two forms of "cat risk securities"
are available that transfer underwriting risk to investors: catastrophe
bonds and catastrophe insurance options. Primary insurers and reinsurers
can make use of these securities. Both benefit insurers by making monies
available to offset catastrophe losses. In contrast to contingent capital
securities, these instruments do not bolster an insurer's surplus;
they provide funds for the payment of losses. They are reflected as both
an asset and as a liability on the insurer's financial statements.
These approaches are relatively new, and their efficacy and robustness
must be evaluated (see Tol, 1998; Peara, 1999; Swiss Re, 1999b; Bantwal
and Kunreuther, 2000; GAO, 2000a; Nutter, 2000; Jamison, 2000; Mills et
al., 2001). Among the questions to address include:
- In a more competitive environment, would insurers and reinsurers be
inclined to participate in or encourage (subsidize) risk-reduction measures?
- Do derivatives signal a potential means by which self-insurers can
expand their capacity, thereby providing greater competition for primary
insurers and reinsurers?
- Will the occurrence(s) of catastrophic weather-related events turn
away investors after an event?
- Do existing catastrophe and climate modeling techniques yield information
necessary to adequately evaluate financial risks and thus the prices
of these derivatives?
Of 11 major trends in investing, catastrophe bonds were rated by members
of the International Securities Market Association as least likely to
have significant impacts on securities markets in the future (Freeman,
Despite doubts about these new instruments, banks and insurance companies
consider this a growing business. In 1999, the cumulative volume of weather-related
bonds/derivatives reached US$3 billion. It can be assumed that an increasing
number of such instruments will be available to hedge against climate
risks. This, in turn, will allow banks to get the "insurance"
coverage they need for their lending activities (Nicholls, 2000).