Extreme events, global warming, and insurance-linked securities: How to trigger the "tipping point"

Abstract

Large-scale disasters have occurred at an accelerated rhythm in the past 5 years. Further, the continuous increase of exposed values in high-risk areas and the potential impact of global warming on the intensity of weather-related events shall accelerate the number and increase the scale of mega-catastrophes in the near future. That is a new era for catastrophe risk management that calls for the development of new solutions, in complement to the traditional insurance and reinsurance. The authors discuss some of the main drivers of the radical shift that happened in the insurance-linked securities (ILS) market after the 2005 hurricane season in the Atlantic basin, which has rapidly become one of the world peak zones in terms of exposure. They explain why, despite this very encouraging evolution, the market has not expanded more (contrary to credit derivatives for instance). They propose three complementary ways to increase interest in these instruments that could effectively trigger the tipping point toward a much more significant volume of capital entering the ILS market: (1) increasing investors' interest through tranching, (2) addressing the basis risk challenge through index-based derivatives, and (3) innovating through the development of new products; the authors introduce the concept of derivative solutions based on equity volatility dispersion. © 2008 The International Association for the Study of Insurance Economics.