Reinsurance or Cat Bond? How to Optimally Combine Both

Posted: 21 May 2019

See all articles by Denis-Alexandre Trottier

Denis-Alexandre Trottier

Laval University, Faculté d'Administration, Département de Finance et Assurance, Students

Van Son Lai

Université Laval

Date Written: July 13, 2017

Abstract

We study how traditional reinsurance and CAT bonds can be combined to build an optimal catastrophe insurance programme. 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 will typically be 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 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.

Keywords: Catastrophe bonds, Reinsurance, Risk management, Contingent claims analysis

Suggested Citation

Trottier, Denis-Alexandre and Lai, Van Son, Reinsurance or Cat Bond? How to Optimally Combine Both (July 13, 2017). Journal of Fixed Income, Forthcoming, https://doi.org/10.3905/jfi.2017.27.2.065, Available at SSRN: https://ssrn.com/abstract=2735954 or http://dx.doi.org/10.2139/ssrn.2735954

Denis-Alexandre Trottier

Laval University, Faculté d'Administration, Département de Finance et Assurance, Students ( email )

Pavillon Palasis-Prince
Quebec, Quebec G1K 7P4
Canada

Van Son Lai (Contact Author)

Université Laval ( email )

FSA ULaval
Quebec G1V 0A6
Canada
418-656-2131, x3943 (Phone)

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