Convergence of Insurance and Financial Markets: Hybrid and Securitized Risk‐Transfer Solutions

ABSTRACT One of the most significant economic developments of the past decade has been the convergence of the financial services industry, particularly the capital markets and (re)insurance sectors. Convergence has been driven by the increase in the frequency and severity of catastrophic risk, market inefficiencies created by (re)insurance underwriting cycles, advances in computing and communications technologies, the emergence of enterprise risk management, and other factors. These developments have led to the development of hybrid insurance/financial instruments that blend elements of financial contracts with traditional reinsurance as well as new financial instruments patterned on asset-backed securities, futures, and options that provide direct access to capital markets. This article provides a survey and overview of the hybrid and pure financial markets instruments and provides new information on the pricing and returns on contracts such as industry loss warranties and Cat bonds. INTRODUCTION One of the most significant economic developments of the past quarter century has been the convergence of the previously separate segments of the financial services industry. Convergence has coincided with the increasing globalization of the financial services sector and has been facilitated by the deregulation of financial markets in Europe, the United States, and Asia. The development of dynamic financial markets for derivatives and other innovative securities as well as advances in computer, modeling, and telecommunications technologies have accelerated convergence. An important factor driving convergence is the increasing focus on shareholder value maximization by corporations worldwide. Convergence has also occurred in retail markets with bancassurance gaining significant market share in many countries. Convergence has been somewhat slower to develop in the market for risk transfer within the property-liability insurance industry, a market traditionally dominated by reinsurance. In part, this is attributable to the informational opacity of insurance markets, where underwriting information is carefully guarded and market participants earn rents by exploiting private information. Insurance markets are also especially susceptible to informational asymmetries between buyers and insurers and between insurers and reinsurers, raising transactions costs and inhibiting financial innovations that require transparency. The inherent conservatism of insurance companies and the resulting market inertia also play a role in impeding convergence. Powerful economic forces have combined in recent years to accelerate convergence between the property-liability insurance and financial markets. The first and perhaps most important driver of convergence is the growth in property values in geographical areas prone to catastrophic risk. Trillions of dollars of property exposure exist in disaster prone areas in the United States, Europe, and Asia, resulting in sharp increases in insured losses from property catastrophes. In 1992, Hurricane Andrew caused unprecedented losses of $24 billion (2007 dollars). This event was dwarfed by the losses in 2005, when Hurricanes Katrina, Rita, and Wilma (KRW) and other events combined to cause insured losses of $114 billion (Swiss Re, 2008). Such losses are very large relative to the total equity capital of global reinsurers (Guy Carpenter, 2008) but represent less than half of I percent of the value of U.S. stock and bond markets. The recognition that it is more efficient to finance this type of risk in securities markets has led to the development of innovative financial instruments such as catastrophic risk (Cat) bonds and options. The second major driver of convergence is the reinsurance underwriting cycle. It is well known that reinsurance markets undergo alternating periods of soft markets, when prices are relatively low and coverage is readily available, and hard markets, when prices are high and coverage supply is restricted. …