Catastrophe Bonds, Reinsurance, and the Optimal Collateralization of Risk Transfer ¤

ABSTRACT Catastrophe bonds feature full collateralization of the underlying risk transfer and thus abandon the reinsurance principle of economizing on collateral through diversification of risk transfer. Our analysis demonstrates that this feature places limits on catastrophe bond penetration, even if the structure possesses frictional cost advantages over reinsurance. However, we also show that catastrophe bonds have important uses when buyers and reinsurers cannot contract over the division of assets in the event of insolvency and, more generally, cannot write contracts with a full menu of state-contingent payments. In this environment, segregation of collateral--in the form of multiple reinsurance companies, as well as catastrophe bond vehicles--can ameliorate inefficiencies due to reinsurance contracting constraints by improving welfare for those exposed to default risk. Numerical simulation illustrates how catastrophe bonds improve efficiency in market niches with correlated risks, or with uneven exposure of buyers to reinsurer default. INTRODUCTION The introduction of the catastrophe bond in the 1990s was hailed by many as the vanguard of a revolution in insurance. The optimists held that the catastrophe-linked security would follow in the footsteps of the mortgage-backed security, eventually dominating its market and connecting those desiring protection with deep, unexploited pools of risk-bearing capacity in the capital markets. The logic seemed straightforward. If catastrophe risks were small relative to the capital markets and were, as the available evidence suggested, uncorrelated with returns on other securities, then the cost of bearing those risks should be small. Securitization was seen as a savior for a risk-transfer market plagued by dysfunction. (1) Not all were convinced. Catastrophe bond structures, then as now, relied on full collateralization of the underlying risk transfer and offered protection only to a single client for a limited set of perils. In this sense, the catastrophe bond represented a retreat from the time-tested concept of diversification that allows reinsurers to protect insured value far in excess of the actual assets held as collateral for clients. This seemingly inefficient use of collateral was noted by Doherty (1997, pp. 717-718) and Niehaus (2002, p. 593). Their indictments were serious. If frictional costs (e.g., due to taxes, regulations, or agency costs) make capital and other collateral costly to hold, the risk transfer market must economize on collateral. A fully collateralized instrument (such as the catastrophe bond) obviously fails to do so. Viewed in this light, the greater puzzle lies in understanding the success the catastrophe bond has had in establishing itself in a niche within the risk transfer market, and the lesser puzzle its failure to live up to the revolutionary expectations of the 1990s. This leads to a deeper question regarding the generally high degree of collateral segregation within the risk transfer market. From the perspective of economizing on collateral, the most efficient market structure is a single reinsurer holding collateral accessible by all potential claimants. Yet, this is far from the reality of the market, where collateral has been segregated into scores of structures--including both traditional reinsurance companies and "alternative risk transfer" vehicles, such as catastrophe bonds and sidecars. What drives the risk transfer market to segregate collateral? Under what circumstances could this segregation be efficient? This article examines the issue of segregation by developing a theory of risk-transfer collateralization. Specifically, we study the efficient division of risk-bearing assets into reinsurance companies and catastrophe bond special purpose vehicles. Both serve as warehouses for collateral held to guarantee promises made to consumers. Our environment features two key imperfections: (1) contracting constraints that place limits on the complexity of state-contingent payments in risk-transfer contracts and (2) frictional costs associated with holding risk-bearing assets. …