An Update on the Use of Modern Financial Instruments in the Insurance Sector
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An Update on the Use of Modern Financial Instruments in the Insurance Sector Ernst N. Csiszar 1222 North Astor Street, Chicago, IL 60610, U.S.A. E-mail: [email protected]
The world’s financial markets have exploded with new products and new techniques such as derivatives and securitizations, giving rise to huge new markets. The author reviews recent developments in insurance-linked securities (ILS), financial products that link insurance and reinsurance with these new markets. Pricing and availability problems after Hurricane Katrina have led to newer types of products making their way into these markets. While catastrophe bonds still make up a significant portion of ILS, the risk of not recovering reinsurance receivables, for instance, can now be transferred to the financial markets via credit derivatives. Catastrophe risk can also be packaged as a credit derivative. New participants, like hedge funds and specialized mutual funds, have also caused a revival of exchange-traded ILS. Trading in catastrophe futures and weather derivatives is thriving. Sidecars were revived. Contingent capital is readily available. New perils, combined with others, are being covered. Insurance and reinsurance companies can no longer treat these instruments as a matter of relative pricing between traditional products and ILS. After Katrina, access to multiple sources of capital has become an essential strategic objective. The Geneva Papers (2007) 32, 319–331. doi:10.1057/palgrave.gpp.2510134 Keywords: insurance-linked securities; derivatives market; credit derivatives; catastrophe bonds; reinsurance receivables; corporate strategy
Introduction Financial markets are experiencing an explosion of innovation that started in the early 1980s and continues through today. While raising capital through stocks and bonds is still important to these markets, that activity has nearly become a sideshow. The trading of stocks and bonds has been overtaken by trading in derivatives and in securitized instruments. Derivatives are complex financial instruments that ‘‘derive’’ their value from some other underlying asset or index, while securitized instruments transfer a risk unwanted by one party to another party more inclined to take that risk. In combination, derivatives and securitized instruments have created huge new markets and new opportunities for issuers, investors, and intermediaries alike. Many industries were quick to understand and use these new instruments to their advantage. Financial institutions in particular were quick to grasp the benefits from, say, bundling and transferring mortgages into the financial markets or from selling a credit derivative by splicing the credit risk from the interest rate risk on a bond. On the other hand, insurance and reinsurance companies were off to a slow start. While some insurance companies seemed to be interested in exploring and experimenting with some of these new instruments, most were reluctant to commit significant resources to
The Geneva Papers on Risk and Insurance — Issues and Practice
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