Ebook Catastrophe Bonds and Reinsurance: The Competitive Effect of Information-Insensitive Triggers

Catastrophic events, such as hurricanes and earthquakes are one of the main risks that insurers and reinsurers face. These hazards can result in huge losses and financing problems. For a long time reinsurance contracts have been the only way to hedge against these losses. However, since the early 1990s, new risk transfer instruments have emerged as an alternative to traditional reinsurance contracts. The emergence of the new instruments came along with the availability of new triggers that determine the contract’s payoff. Traditional reinsurance contracts’ payoffs are based on the policyholder’s realized loss (indemnity payment or indemnity trigger). As an alternative, new risk transfer instruments have evolved where the payoff is often based on index or parametric triggers. A prominent example for such contracts are catastrophe (cat) bonds.

One of the characteristics of index triggers is that the contract’s payoff is largely, and in the case of a parametric trigger, completely, independent of the insurer’s realized loss. For that reason, a main advantage of index or parametric triggers is their positive effect on moral hazard (e.g., Niehaus and Mann, 1992, and Doherty, 1997). We provide a new argument in favor of such triggers: information insensitive triggers help to overcome the potential problems of adverse selection in the reinsurance market due to asymmetric information between reinsurers about an insurer’s risk.

Asymmetric information in the reinsurance market. Reinsurers typically have a close and long-term relation to their insurers. In the course of the business relation, reinsurers acquire information that helps to assess the insurer’s risk and to price non-proportional reinsurance policies. For example, they obtain inside information about an insurer’s business model, underwriting and reserving policy, book of business, internal decision processes, ability to screen policies (applicants) and efficiency in claims settlement. A large part of this information is “soft” and cannot easily and credibly be conveyed to third parties.