TY - JOUR T1 - Reinsurance or CAT Bond? <em>How to Optimally Combine Both</em> JF - The Journal of Fixed Income SP - 65 LP - 87 DO - 10.3905/jfi.2017.27.2.065 VL - 27 IS - 2 AU - Denis-Alexandre Trottier AU - Van Son Lai Y1 - 2017/09/30 UR - https://pm-research.com/content/27/2/65.abstract N2 - We study how traditional reinsurance and CAT bonds can be combined to build an optimal catastrophe insurance program. We develop a contingent claims model to investigate the imperfections and limitations of the reinsurance market stemming from financial distress costs and default risk. We find that the pricing markup and credit risk is typically larger for reinsurance contracts that cover the higher and less probable layers of losses. We show that the optimal hedging strategy is to cover small losses using reinsurance and to hedge higher losses by issuing a CAT bond. Our results demonstrate that this strategy significantly lowers the insurer’s cost of protection, expands his underwriting capacity, and yields higher shareholder values.TOPICS: Fixed income and structured finance, derivatives applications ER -