Managing catastrophic risk through insurance and securitization

Abstract

This article has presented a normative model to investigate the role of insurance and securitization in the management of catastrophic risk. The variable participating insurance contract, defined as a linear combination of fully participating policy and non-participating policy, has turned out to be an optimal hedging tool. Individuals insure the idiosyncratic component of their loss exposure through a participating contract and then the systemic component is hedged through securitized products offered by financial markets. In the case of additive risk component, the optimal variable participating policy can be replicated with a fully participating insurance policy offered at a fair price and a separate hedging contract. For the case of multiplicative component, the key role of a mutual insurer has been stressed. This role could be played by cooperatives in agriculture. They could offer a variable participating policy to insured farmers, and pass off the systemic risk, which is not assumed by the policy-holders, in the capital markets. Innovative hedging instruments, like area yield insurance futures and options contracts, provide such an opportunity.