Indexing Catastrophe Securities

Abstract

The recent development of indexed catastrophe (CAT) securities is a concern in the insurance literature. We refer to the two existing prominent explanations as the systematic risk approach and the moral hazard approach. Under the systematic risk approach, the systematic risk portion is hedged by index-triggered securities, and the remaining nonsystematic risk is hedged through indemnity-triggered vehicles including traditional insurance. Under the moral hazard approach, indexing protects firms from losses without incurring moral hazard problems. We argue that indexing is at most supplementary in both approaches. We suggest two alternative rationales for indexing CAT securities. First, if firms are concerned with downside risks rather than variation, then indexing is optimal, since indexing can remove downside risks without incurring costs for upside risks. The amount of proceeds is determined by balancing financing costs and costs of downside risks. Second, the observability of loss is another key factor for indexing, even when firms are concerned with variability. We identify the important sources of high observation costs as (i) the inherent difficulty in identifying CAT losses; (ii) the impossibility of taking over the firm by the bondholders under a CAT event; and (iii) the non-separability of cash flows between from a CAT event and from other operations of the firm.