Financial Innovation in the Management of Catastrophe Risk

Catastrophic events such as hurricane and earthquakes are the dominant source of risk for many property casualty insurers. Primary insurers usually limit the scale and geographic scope of their operations in order to focus on core competencies such as marketing, underwriting and loss control. But his often leaves them without sufficient geographic spread to diversify catastrophe risk. The traditional hedge for the primary insurer is reinsurance. Specialist reinsurers achieve a spacial spread of risk and can therefore bear catastrophe risk that is undiversifiable to the primary. But the transaction costs associated with reinsurance, and therefore premiums, are high. High premiums, coupled with the fact that catastrophe losses exhibit little correlation with capital market indices, has attracted considerable activity in Wall Street in searching for new instruments that securitize catastrophe risk. Indeed many players are now talking of catastrophe risk being a new “asset class” and new instruments such as catastrophe options and catastrophe bonds are starting to appear. The rationale for these new instruments is usually developed as follows. Recent catastrophe events such as Hurricane Andrew and the Northridge earthquake have imposed costs on the insurance industry of an order of magnitude not thought possible only a decade ago. More sophisticated modeling now presents potential losses to the industry of $50 billion or more. Examples would be Andrew hitting Miami, a major quake on the New Madrid Fault and a repeat of the 1906 San Francisco earthquake. These events could wipe out 25$200 billion. Two such events, or one such event combined with continued mass tort claims (e.g. successful plaintiff claims in tobacco litigation) could cripple the whole industry. However, losses of this size would hardly cause a ripple in capital markets. The U.S. capital market currently currently consists of securities representing some $13 trillion of investor wealth and the loss scenarios cited above amount to less than one standard deviation of daily trading volume. Presentations by merchant bankers, reinsurance brokers and others have echoed this potential for diversifying catastrophe risk within the capital market. The high transactions costs of reinsurance offers potential for hedging instruments to be offered to primary insurers that are both competitive with current reinsurance and which offer investors high rates of return. Moreover, since catastrophe risk is uncorrelated with market indices, the benchmark for such investments is just the risk free rate. Pricing new instruments requires that the expected loss be estimated with some. Until recently, insurers and reinsurers had a comparative advantage in information on catastrophic events. But in the past decade a number of modeling firms have developed models that combine seismic and meteorological information with data on the construction, siting, and value of individual buildings. These models can be used to simulate the economic effects of many thousands of storms and earthquakes. Although such models are used by the insurance firms and reinsurers, mainly for loss estimation and re-balancing their exposure, the same models are now available to other companies and investors. The arrival of the modelers and their models is eroding the comparative information advantage of insurers and reinsurers and opening the door to new players. Insurers will retain their comparative advantage over, say, merchant banks in related insurance services such as marketing, underwriting and loss settlement facilities. But the stage has been set for an unbundling of insurance products with insurers retaining marketing underwriting and settlement services and risk bearing by-passing the reinsurance industry and being provided more directly from the capital market. But the combination of high transaction costs for reinsurance and the vast capacity of the capital market for diversification, is not sufficient to ensure the success of these new instruments. The costs associated with reinsurance do not necessarily reflect monopoly rent. Relationships between primary insurers and reinsurers involve moral hazard; the relationship relaxes the incentive for the insurer to underwrite carefully or to settle claims efficiently. Consequently, the reinsurer will monitor the primary. Moreover, long term relationships are often formed to counter such expropriation. The apparently high transaction costs of reinsurance may simply reflect the resolution of moral hazard. If new instruments such as catastrophe options and bonds are to compete successfully with reinsurance, they must be able resolve incentive conflicts between the primary insurer and the ultimate risk bearer. Indeed, if moral hazard is not resolved, using past insurance loss data to estimate the potential returns for purchasers of catastrophe bonds, etc, is spurious. The purpose of this paper is to examine and categorize new catastrophe hedging instruments. These instruments will then be compared with traditional risk management strategies adopted by primary insurers in order to compare their relative efficiency at resolving incentive conflicts. Each instrument offers a different combination of credit risk, basis risk and moral hazard. For example, catastrophe reinsurance is subject to significant credit risk and moral hazard, but does not encounter significant basis risk. I will argue that the differential performance of the traditional and new instruments offers primary insurers with a richer portfolio of risk management strategies, though no strategy is dominant in its performance on all three criteria.

Insuring the uninsurable : brokers and incomplete insurance contracts

How do markets spread risk when events are unknown or unknowable and where not anticipated in an insurance contract? While the policyholder can "hold up" the insurer for extra contractual payments, the continuing gains from trade on a single contract are often too small to yield useful coverage. By acting as a repository of the reputations of the parties, we show the brokers provide a coordinating mechanism to leverage the collective hold up power of policyholders. This extends both the degree of implicit and explicit coverage. The role is reflected in the terms of broker engagement, specifically in the ownership by the broker of the renewal rights. Finally, we argue that brokers can be motivated to play this role when they receive commissions that are contingent on insurer profits. This last feature questions a recent, well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer. Klassifikation: G22, G24, L1

Moral Hazard in Reinsurance Markets

This paper attempts to identify moral hazard in the traditional reinsurance market. We build a multi-period principle agent model of the reinsurance transaction from which we derive predictions on premium design, monitoring, loss control and insurer risk retention. We then use panel data on U.S. property liability reinsurance to test the model. The empirical results are consistent with the model's predictions. In particular, we find evidence for the use of loss sensitive premiums when the insurer and reinsurer are not affiliates (i.e., not part of the same financial group), but little or no use of monitoring. In contrast, we find evidence for the use of monitoring when the insurer and reinsurer are affiliates, where monitoring costs are lower, but little use of price controls.

Insurance Contracts and Securitization

High correlations between risks can increase required insurer capital and/orreduce the availability of insurance. For such insurance lines, securitizationis rapidly emerging as an alternative form of risk transfer. The ultimatesuccess of securitization in replacing or complementing traditional insuranceand reinsurance products depends on the ability of securitization to facilitateand/or be facilitated by insurance contracts. We consider how insuredlosses might be decomposed into separate components, one of which is atype of “systemic risk” that is highly correlated amongst insureds. Such acorrelated component might conceivably be hedged directly by individuals,but is more likely to be hedged by the insurer. We examine how insurancecontracts may be designed to allow the insured a mechanism to retain all orpart of the systemic component. Examples are provided, which illustrate ourmethodology in several types of insurance markets subject to systemic risk.

Insuring the Uninsurable: Brokers and Incomplete Insurance Contracts

How do markets spread risk when events are unknown or unknowable and where not anticipated in an insurance contract? While the policyholder can "hold up" the insurer for extra contractual payments, the continuing gains from trade on a single contract are often too small to yield useful coverage. By acting as a repository of the reputations of the parties, we show the brokers provide a coordinating mechanism to leverage the collective hold up power of policyholders. This extends both the degree of implicit and explicit coverage. The role is reflected in the terms of broker engagement, specifically in the ownership by the broker of the renewal rights. Finally, we argue that brokers can be motivated to play this role when they receive commissions that are contingent on insurer profits. This last feature questions a recent, well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer.Incomplete Insurance Contracts, Brokerage, Contingent Commissions, Reputation

Importance-performance analysis of retail website service quality

This study intends to empirically explore the customer’s perceived ranking of the importance of a range of on-line services, and their perceptions of the retailers’ performance in delivering these services. An online questionnaire survey has been conducted to gather the data from respondents. The data was analysed using Importance-Performance Analysis (IPA). The findings suggest areas of e-service quality where retailers could improve, based on the customers’ perceptions of the retailers’ performance against the importance of some e-service quality features and/or services on offer. Consequently, this study highlights that retailers should take active steps to understand their customers’ requirements, before developing an online customer services strategy. From a practical perspective, retailers could also apply the questionnaire developed for this study to canvas the opinions of customers, to help identify areas in which their performance needs to be improved

Insuring non-verifiable losses

Insurance contracts are often complex and difficult to verify outside the insurance relation. We show that standard one-period insurance policies with an upper limit and a deductible are the optimal incentive-compatible contracts in a competitive market with repeated interaction. Optimal group insurance policies involve a joint upper limit but individual deductibles and insurance brokers can play a role implementing such contracts for the group of clients. Our model provides new insights and predictions about the determinants of insurance

Madness in the Municipality

The author speaks about his life and all of the diversity he sees in Cambridge, Massachusetts

E-strategy in the UK retail grocery sector

After a decade of Internet trading, retailers in the UK have experienced mixed fortunes with their Internet-based ventures. Online shopping success stories include; Tesco’s, which has positioned itself as a world leader in online grocery retailing by providing an Internet-based home delivery of over 40,000 products and making the service available to almost 95 per cent of UK residents. Similarly, Sainsbury’s offers 71% per cent of UK residents the opportunity to shop online however the company does not have the same international recognition. Waitrose too has expanded its Internet-based shopping services, aided by its acquisitions in OCADO. By contrast, Somerfield, and more recently Iceland have stopped their Internet shopping operations due to poor trading results and economic difficulties, despite the fact that Iceland was the first grocery retailer to offer online shopping to the majority of the UK mainland. The key aims of this paper are to explore how major grocery retailers coming to the one line market; to consider why some are more successful than others and to develop an understanding of the role of strategic thinking in online retailing. More specifically, the paper will initially, investigate the strategic options open to retailers developing activities online and finally, discuss the extent to which e-strategies represent a long-term approach to planning. The paper presents a literature review, which provides the conceptual foundations for investigation of the significance of e-strategy development within retailing. This model is then compared with evidence from secondary data sources and business results from leading UK grocery retailers in order to debate and analyse the likely importance of e-strategies in the success of online grocery retailing in the UK

A very modern professional: the case of the IT service support worker

The IT profession has retained a reputation as a ‘privileged area of the labour market’ (Webster, 2005, p.4; Bannerji, 2011). Workers practicing IT skills have been at the forefront of the competitive drive for innovation and efficiency gains promoted by a neoliberal enterprise ideology (Blackler et al, 2003). In the last two decades, as systems thinking (e.g. Ackoff, 1999) and customer-centric practices (e.g. Levitt, 2006) have converged in a globally powerful IT service management (ITSM) ‘best practice’ discourse (Trusson et al, 2013), the IT service support worker has emerged to be a worker-type of considerable socio-economic importance. Aside from keeping organizational information systems operative, when such systems fail these workers are called upon to rapidly restore the systems and thus head-off any negative commercial or political consequences. Yet these workers are acknowledged only as objectified resources within the ITSM ‘best practice’ literature (e.g. Taylor, Iqbal and Nieves, 2007) and largely overlooked as a distinctive contemporary worker-type within academic discourse. This paper, through analysis of salary data and qualitative data collected for a multiple case study research project, considers the extent to which these workers might be conceived of as being ‘professionals’. The project approached the conceptual study of these workers through three lenses. This paper focuses on the project’s consideration of them as rationalised information systems assets within ‘best practice’ ITSM theory. It also draws upon our considerations of them as knowledge workers and service workers. We firstly situate the IT service support worker within a broader model of IT workers comprising four overlapping groupings: managers, developers, technical specialists and IT service support workers. Three types of IT service support worker are identified: first-line workers who routinely escalate work; second-line workers; and ‘expert’ single-line workers. With reference to close associations made with call centre workers (e.g. Murphy, 2011) the status of IT service support workers is explored through analysis of: (i) salary data taken from the ITJOBSWATCH website; and (ii) observational and interview data collected in the field. From this we challenge the veracity of the notion that the whole occupational field of IT might be termed a profession concurrently with the notion that a profession implies work of high status. Secondly, the paper explores two forces that might be associated with the professionalization of IT as an occupation: (i) rationalisation of the field (here promoted by the British Computer Society); and (ii) formalisation of IT theoretical/vocational education. A tension is identified, with those IT service support workers whose work is least disposed to rationalisation and whose complex ‘stocks of knowledge’ (Schutz, 1953) have been acquired through time-spent practice laying claim to greater IT professional status. Thirdly, consideration is given to individuals’ personal career orientations: occupational, organizational and customer-centric (Kinnie and Swart, 2012). We find that whilst organizations expect IT service support workers to be orientated towards serving the interests of the organization and its clients, the most individualistically professional tend towards being occupationally orientated, enthusiastically (re)developing their skills to counter skills obsolescence in an evolving technological arena (Sennett, 2006)