Catastrophe reinsurance and risk capital in the wake of the credit crisis

Property and casualty (“P&C”) insurance companies rely on “risk capital” to absorb large losses that unexpectedly deplete claims‐paying resources and reduce underwriting capacity. The purpose of this paper is to review the similarities and differences between two different types of risk capital raised by insurers to cover losses arising from natural catastrophes: internal risk capital provided by investors in insurance company debt and equity; and external risk capital provided by third parties. The paper also explores the distinctions between four types of external catastrophe risk capital: reinsurance, industry loss warranties, catastrophe derivatives, and insurance‐linked securities. Finally, how the credit crisis has impacted alternative sources of catastrophe risk capital in different ways is considered.

The discussion is based on the conceptual framework for analyzing risk capital developed by Merton and Perold.

In 2008, the P&C insurance industry was adversely affected by significant natural catastrophe‐related losses, floundering investments, and limited access to capital markets, all of which put upward pressure on catastrophe reinsurance premiums. But the influx of new risk capital that generally accompanies hardening markets has been slower than usual to occur in the wake of the credit crisis. Meanwhile, disparities between the relative costs and benefits of alternative sources of catastrophe risk capital are even more pronounced than usual.

Although many insurance companies focus on how much reinsurance to buy, this paper emphasizes that a more important question is how much risk capital to acquire from external parties (and in what form) vis‐à‐vis investors in the insurance company's own securities.