Insurance contracts and securitization

Abstract

High correlations between risks can increase required insurer capital and/or reduce the availability of insurance. For such insurance lines, securitization is rapidly emerging as an alternative form of risk transfer. The ultimate success of securitization in replacing or complementing traditional insurance and reinsurance products depends on the ability of securitization to facilitate and/or be facilitated by insurance contracts. The authors consider how insured losses might be decomposed into separate components, one of which is a type of "systemic risk" that is highly correlated among insureds. Such a correlated component might conceivably be hedged directly by individuals but is more likely to be hedged by the insurer. The authors examine how insurance contracts may be designed to allow the insured a mechanism to retain all or part of the systemic component. Examples are provided that illustrate this methodology in several types of insurance markets subject to systemic risk.