Analysis of Empirical Implications - Paper Example

Introduction

While determining the price of risk while in the catastrophe bond market, they consider the first payment which is known as the primary market to the later on upon the reselling of the exchange in the secondary market. In the secondary market, most investors prefer to withhold their bonds while at the same time invest in other new bonds until they mature: this increases the activeness in the secondary market. From this, they focus more on the price of the bond when initially issued while in the primary market.

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Many practitioners and academics have also come up with the ideas that the catastrophe bond has lowered the risk at which other people can enter thus creating the congestion in the whole reinsuring market. The anti-competitive effect in the price of reinsuring catastrophe bonds has brought about the fear of wide range of selection because of the unevenness in the information: this has become a very important factor when determining the price of a catastrophe bond. The different types of insurers have a different effect on introductory cat bonds. In the parametric trigger, an increase in the premiums paid is dependent on many factors, including the low-risk type in the insurance program (Kelly, Letson, Nelson, Nolan, and Solis, 2012). The major factor that affects the low-risk insurers is the underwriting business, but due to the cross-subsidization and rent alleviation, it has increased the ability for them to compete healthily with the high-risk insurers. This gives the chance to the low-risk insurers when it comes to competing with the high-risk insurers while the price of reinsuring becomes more sensitive. In this case the ability of the two profit change in the sense that they can also meet somewhere in the middle, the high-risk insurers reduce while the low-risk insurer's increases. This provides a conducive environment to grow faster as compared to the rate at which a high-risk insurer can grow.

However, measuring the effect of cat bond on an individual may not be possible because according to the model it is measured according to the expected type given to the available information in the public. This means that in this kind of environment there cannot be the high-risk insurers or the low-risk insurers. Since the heterogeneity are diversified, there is always a difference in the amount of profits made by the investors. It also explains the differences observed in premiums paid by different companies (Kelly, Letson, Nelson, Nolan, and Solis, 2012). The ability of the reinsurance company to respond to the agreed bond is also known as the increase in asymmetric information and the decrease in the basis risk. Insurers tend to have more asymmetric information in countries with less information when dealing with the information about the insurer's risk. In the areas, where there is a high risk of a natural disaster occurring the insurance have a high concentration of exposure. In this model, the cat bonds are not put in play but in the introduction of factors like monitory cost, the credit that is at risk or the cost of the transaction the model no longer applies: despite the fact that bonds are not being used it is still considered important.

Management of Catastrophe Risk

Earthquakes, wildfires, tornados, hurricanes are examples of Natural catastrophes that can jeopardize the financial stability of a commercial company. Catastrophe modeling is the process of using computer-assisted calculations to estimate the possible losses from the occurrence of a catastrophic event. These models help risk managers in effective assessment of a catastrophic risk and thus make an informed decision (Harrington, 2006).

Catastrophe modeling is the best method in the identification of extreme events that are a threat to an enterprise as well as quantifying the insurance coverage needed to protect the organization from financial impacts. Thousands of years of earthquakes, severe thunderstorms, and other natural and man-made events can be simulated by catastrophe models. The simulated events are studied together with property exposure to determine the likelihood of the occurrence of one or more events. Full range of potential losses is provided in the output of the model which then an organization can analyze. Despite the low probability of occurrence of these events, risk managers ought to understand the likelihood of these high impact events so as to be able to determine the suitable coverage to buy, the deductible level to choose and the cost of that coverage.

Risk managers are able to align their organization's risk tolerance with their insurance coverage due to the statistical measure of potential losses provided by the catastrophe model. However, if determined by the risk manager that the coverage is unnecessary, the company can arrange their corporate risk management program so as to concentrate on more realistic loss probabilities (Kelly, Letson, Nelson, Nolan, and Solis, 2012). Catastrophe modeling is widely embraced in the insurance industry and almost universally for large organizations. Catastrophe models generally improve the reliability of information on which critical business decisions are based such as;

The marginal impact of acquisition or sale - When a large portfolio of properties is involved, the risk manager should investigate the effect, of either the sale or acquisition, on the organization's risk profile. Elements such as the location, value as well as their relation to the existing portfolio influence the organization's overall exposure.

Geographical consolidation - Catastrophe models can show a company's geographical distribution of exposure in addition to the main drivers of a company's catastrophe risk inclusive of the company's region and business that have the greatest marginal impact on losses.

Allocation of insurance costs among business units - A model-based analysis can be used in the allocation of the cost of insurance back to either individuals or business units. Catastrophe models enable the organization to assess fully the net benefit of geographically diverse assets.

Catastrophe Mitigation Strategy

While dealing with catastrophe bond, every investor would like to reduce the amount of money they will have to spend in the process of compensating the individual or the country that has faced the natural disaster they had insured against. There are three major ways in which the investors use when trying to mitigate the situation. These are:

Modification of the Risk

This is when the insurer comes up with advice on how they can prevent the natural disaster from occurring. They offer advice like creating pipe installation, storm shutters so that in the event of the catastrophe occurring they can minimize the damage that will happen. They do this by the use of premium credit.

Restriction of Coverage

The insurer comes up with ways the can reduce the risk of the catastrophe from occurring, this is done limiting them when it comes to compensation for the coverage. This is done by the putting in place strict policies that are in agreement to reduce the amount to be paid in case there is a natural disaster (Feinberg, Shelor, Cross, and Grossmann, 2006).

Minimize Loss Adjustment Expenses

The insurer, in this case, decides to start collecting materials that may be needed in the case of a natural disaster occurring, in doing this the insurer is preparing for the natural calamity by putting ready resources and organizing how the resources can be availed to the affected area. By doing this the insurer reduces the financial expense they would have had to incur. At times, when such disaster occur some distributors take advantage and increase the prices of the material which would become more costly if the insurer had to wait until the catastrophe has occurred for him to purchase the material. Insurance companies are in a position to be able to control the exposure of the catastrophe and their financial position by following:

Catastrophe Avoidance Strategies

When it comes to insurance, it is sometimes considered hard catastrophe risk with the insurance against property, so the insurance companies need to be very careful when it comes to managing the exposure in order to avoid paying out a lot of money in the case of a single event occurring. An example is the use of Probable Maximum Loss (PML) potential, this is where the insurer cancels out some compensation on other factors or even avoiding taking insurance in places that have a higher possibility of facing a natural disaster. In order to do this the insurer's company should be able to do their research and be able to point out the areas that have a high chance of experiencing the loss. The ability of one to identify areas that allow them to maintain their portfolio and also be able to bear the risk is what is needed in the case of catastrophe bond insurers. The insurer should always have to major factor when dealing with ensuring areas (Harrington, 2006). Until the insurers are able to clearly understand the potential of a catastrophe occurring and be in a position where they can come up with an underwriting guideline that will be fair and effective to both parties they should not just jump into contacts.

Catastrophe Retention Strategies

In this strategy, the company checks its ability to withstand itself financially in the case of an event happening. The company can do this by either pre-event or post-event, by doing this it tends to strengthen the position of the capital. Pre-event is when the company negotiates with the added advantage. In this strategy all parties: shareholders, investors and policyholders be able to understand the kind of risk they may be taking. This is done before because at times when a catastrophe occurs it may cause impairment or an increase in the cost of the new capital.

Catastrophe Transfer Strategies

When you talk of a transfer strategy it tends to shift the effect of the natural disaster to another third party. Most of the time they shift the predetermined fee, which is normally the long-term expected expense on the natural disaster. This is mostly done to the people who are in a better position to absorb and maintain the financial effect of the catastrophe bond. Investors with diversified portfolios or robust finance are in better position to absorb such catastrophic event. In order for an insurer to be able to maintain in a catastrophe bond, they need to understand the occurrence of the mega natural disaster and the potential magnitude of the catastrophe itself. (Kunreuther and Pauly, 2006). Catastrophe bond can only be understood when the information about how likely the chances of occurring can be. This is one of the major factors that can help an insurance company be able to make a wise decision in catastrophe bond (Feinberg, Shelor, Cross, and Grossmann, 2006).

Reasons Why the Insurer Offers a Contract With an Exogenous Trigger

One of the reasons why the reinsurer has to make a contract with another third party is because they have to find a source of a large number of funds that will be required in the case of compensating the natural disaster. In the case of a natural disaster happening the amount required to compensate such tragedy may be too much for them to handle, so the look for investors with large sum amount.

Secondly, the reinsurer has to have funds that have to be deposited into an account for the purpose of dealing with a natural disaster. In some cases, an individual may choose an account where the funds should be deposited. In this case, the reinsurer has to have an up hand when it comes to sourcing its finances. The reinsurer may not have the added advantage of being able to deal with the risk that may be associated with the exogenous event. While at the same time there is no added worth when it comes to dealing with long-term relations or reputation. This is why there is a special p...