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Convergence of Insurance and Financial Markets: Hybrid and Securitized Risk-Transfer Solutions
INTRODUCTION
One of the most significant economic developments of the past quarter century has been the convergence of the previously separate segments of the financial services industry. Convergence has coincided with the increasing globalization of the financial services sector and has been facilitated by the deregulation of financial markets in Europe, the United States, and Asia. The development of dynamic financial markets for derivatives and other innovative securities as well as advances in computer, modeling, and telecommunications technologies have accelerated convergence. An important factor driving convergence is the increasing focus on shareholder value maximization by corporations worldwide. Convergence has also occurred in retail markets with bancassurance gaining significant market share in many countries.Convergence has been somewhat slower to develop in the market for risk transfer within the property-liability insurance industry, a market traditionally dominated by reinsurance. In part, this is attributable to the informational opacity of insurance markets, where underwriting information is carefully guarded and market participants earn rents by exploiting private information. Insurance markets are also especially susceptible to informational asymmetries between buyers and insurers and between insurers and reinsurers, raising transactions costs and inhibiting financial innovations that require transparency. The inherent conservatism of insurance companies and the resulting market inertia also play a role in impeding convergence.Powerful economic forces have combined in recent years to accelerate convergence between the property-liability insurance and financial markets. The first and perhaps most important driver of convergence is the growth in property values in geographical areas prone to catastrophic risk. Trillions of dollars of property exposure exist in disaster prone areas in the United States, Europe, and Asia, resulting in sharp increases in insured losses from property catastrophes. In 1992, Hurricane Andrew caused unprecedented losses of $24 billion (2007 dollars). This event was dwarfed by the losses in 2005, when Hurricanes Katrina, Rita, and Wilma (KRW) and other events combined to cause insured losses of $114 billion (Swiss Re, 2008). Such losses are very large relative to the total equity capital of global reinsurers (Guy Carpenter, 2008) but represent less than half of 1 percent of the value of U.S. stock and bond markets. The recognition that it is more efficient to finance this type of risk in securities markets has led to the development of innovative financial instruments such as catastrophic risk (Cat) bonds and options.The second major driver of convergence is the reinsurance underwriting cycle. It is well known that reinsurance markets undergo alternating periods of soft markets, when prices are relatively low and coverage is readily available, and hard markets, when prices are high and coverage supply is restricted. The existence of hard markets increases the difficulties faced by insurers in predicting costs and managing risks. Because underwriting cycles tend to have low correlations with securities market returns, convergence has the potential to moderate the effects of the reinsurance underwriting cycle and thereby create value for insurers and insurance buyers.A third major driver of convergence consists of advances in computing and communications technologies. These technologies have facilitated the collection and analysis of underwriting exposure and loss data as well as the development of catastrophe modeling firms. These firms have developed sophisticated models of insurer exposures and loss events, facilitating risk management and enhancing market transparency. The fourth major driver of convergence has been the development of holistic or enterprise-wide risk management (ERM), whereby traditionally separate functions such as the management of insurable risks, commodity risks, currency risks, interest rate risks, and other risks have begun to be merged under a single risk-management umbrella. ERM has increased the familiarity of corporate managers with financial instruments and enhanced their receptiveness to innovative solutions.A fifth major driver of financial convergence, which primarily reflects market imperfections, is the various regulatory, accounting, tax, and rating agency factors (RATs). RATs serve in some cases as market facilitators, enabling (re)insurers to develop products to control regulatory and tax costs, but they also can serve as impediments to market development (Cummins, 2005; World Economic Forum, 2008). A sixth driver of convergence is modern financial theory that has enabled market participants to acquire a much deeper understanding of risk management and facilitated financial innovation.The objective of this article is to provide an overview and analysis of financial innovations in the market for property-liability risk ...See the full content of this document
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