Copyright 2001 The New York Times Company
The New
York Times
October 25, 2001, Thursday, Late Edition -
Final
SECTION: Section C; Page 2; Column
1; Business/Financial Desk
LENGTH: 1025
words
HEADLINE: Economic Scene;
Catastrophe bonds
could fill the gaps in
reinsurance.
BYLINE: By Hal R. Varian; This column
appears here every Thursday. Hal R. Varian is an economics professor and dean of
the School of Information Management and Systems at the University of California
at Berkeley. E-mail: hal@sims.berkeley.edu.
BODY:
THE insurance industry faces claims of at least $40 billion tied to the
World Trade Center attacks, and it remains exposed to significant risk from
future incidents. Retail insurance companies are considering exclusions for
terrorist damage, leaving property owners unable to buy the coverage they need.
The problem lies in the
reinsurance industry, the
wholesale market where insurers lay off large risks to pools of investors
willing to absorb them. Warren E. Buffett's
reinsurance
company, General Re, has done well in the last few years offering property
reinsurance because there have not been major hurricanes or
earthquakes. But its luck ran out last month: General Re has said it is liable
for over $2 billion of the total industry losses in the Sept. 11 attacks.
Earthquakes and hurricanes, unpleasant as they are, present manageable risks:
insurers know roughly how often they occur in various places, what their likely
magnitudes are and how much property damage might be expected.
Terrorist
risk is much harder to quantify, leading to the current paralysis in the
reinsurance market. The insurance industry has been lobbying in Washington to
make the federal government the insurer of last resort against terrorism, which
means that taxpayers will end up bearing the financial risk of future attacks.
Britain adopted a government-backed reinsurance market several years ago
and, so far, it has worked reasonably well. But there is another way to
supplement traditional reinsurance markets that has been attracting increasing
attention: catastrophe bonds. These bonds, generally sold to large institutions,
have typically been tied to natural disasters, like earthquakes or hurricanes,
but they could, in principle, be used to provide financial backing for terrorism
insurance.
Here is how they work. A financial intermediary, like a
reinsurance company or an investment bank, issues a bond tied to a particular
insurable event, like a Los Angeles earthquake. If there is no earthquake,
investors are paid a generous interest rate. But if the earthquake occurs and
the claims exceed an amount specified in the bond, investors sacrifice their
principal and interest.
How generous does the interest rate have to be?
That is left up to the market. If the bond sales offer cheaper reinsurance
coverage than do traditional private placements used in the reinsurance market,
these bonds, known as cat bonds, are a preferred method of finance.
Cat
bonds are a form of "contingent security," a concept first formulated by Kenneth
J. Arrow of Stanford University, winner of the 1972 Nobel in economic science.
Back in 1952, Professor Arrow came up with the idea of a security that
would pay a fixed amount of money depending on whether or not some event
occurred. He showed that portfolios of such contingent securities could be used
to allocate virtually any kind of risk in an efficient manner.
The
analysis by Professor Arrow was long thought to be of only theoretical interest.
But it turned out that all sorts of options and other derivatives could be best
understood using contingent securities. Now Wall Street rocket scientists draw
on this 50-year-old work when creating exotic new derivatives.
There are
a number of special cases of contingent securities. Consider a security tied to
my house burning down. This would certainly affect my net worth, but would have
negligible impact on the owners of the other 70 million housing units in the
United States.
This kind of personal risk can easily be shared among
many people, each paying only a small amount if the event occurs, and homeowners
insurance is to ease this kind of risk sharing.
This works fine for
small independent risks, but there are other sorts of events that impose large
costs on many people at the same time, like earthquakes or hurricanes. Insurance
companies are able to deal with such events using reinsurance markets, where the
risk is transferred to large investors.
There are other financial
institutions that also allow for risk transfer for this sort of widespread risk.
The orange juice futures market in Chicago is essentially a market in a
contingent security tied to whether it freezes in Orlando, Fla.
A
futures market allows market participants who bear a significant risk (like
farmers worried that their crop might be destroyed) to transfer some of that
risk to others, who are, of course, paid to absorb it. The futures market allows
shifting of risk rather than a simple sharing of risk.
Risk sharing and
risk shifting are familiar terms, but there is another phenomenon worth noting,
something I like to call "risk shafting." This is when some risk -- often a
particularly large risk -- is transferred to a third party who is forced to bear
it involuntarily.
In many cases, these third parties are taxpayers, who
are not even aware of their potential liability.
Hence the debate that
is going on in Washington now: should the insurance industry be able to transfer
the risk from future terrorist attacks to taxpayers? Or would it be better to
use existing reinsurance markets or new financial instruments like catastrophe
bonds to shift the risk to those willing and able to bear it if appropriately
compensated?
Cat bonds have some attractive features. They can spread
risks widely and can be subdivided indefinitely, allowing each investor to bear
only a small part of the risk. The money backing up the insurance is paid in
advance, so there is no default risk to the insured.
As the market for
cat bonds matures, secondary markets may develop, particularly if the bonds
become standardized and bundled into portfolios. If so, the market price of cat
bonds will reflect the market perceptions of the likelihood of the event
associated with the bond, just as price changes on the orange juice futures
market reflect the likelihood of a freeze in Florida.
The market for cat
bonds is still immature, and is only a fraction of the size of traditional
reinsurance. But cat bonds and other sorts of contingent securities may well end
up being part of the long-run solution to the problems of the reinsurance
industry.
http://www.nytimes.com
GRAPHIC:
Photo: Insurers face claims of at least $40 billion related to the World Trade
Center terrorist attacks. (Associated Press)
LOAD-DATE: October 25, 2001