RT Journal Article
SR Electronic
T1 Reinsurance or CAT Bond? <em>How to Optimally Combine Both</em>
JF The Journal of Fixed Income
FD Institutional Investor Journals
SP 65
OP 87
DO 10.3905/jfi.2017.27.2.065
VO 27
IS 2
A1 Denis-Alexandre Trottier
A1 Van Son Lai
YR 2017
UL https://pm-research.com/content/27/2/65.abstract
AB 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