Catastrophic Risk: Analysis and Management

Acknowledgments ix

About the author xi

PART I IDENTIFICATION AND ANALYSIS OF CATASTROPHIC RISK 1

1 Catastrophe and Risk 3

1.1 Introduction 3

1.2 The nature of catastrophe 5

1.2.1 A definition 5

1.2.2 Frequency 5

1.2.3 Vulnerability 8

1.2.4 Measuring severity 11

1.3 The scope of impact 11

1.4 Catastrophe and the risk management framework 13

1.5 Overview of the book 15

2 Risk Identification I: Perils 17

2.1 Natural catastrophe 18

2.1.1 Geophysical 19

2.1.2 Meteorological/atmospheric 22

2.1.3 Other natural disasters 26

2.2 Man-made catastrophe 29

2.2.1 Terrorism 29

2.2.2 Industrial contamination 31

2.2.3 Technological failure 32

2.2.4 Financial dislocation 33

2.3 Mega-catastrophe and clash loss 34

3 Risk Identification II: Regional Vulnerability 35

3.1 Spatial impact of natural catastrophes 36

3.1.1 Bermuda and the North American Atlantic Coast 36

3.1.2 Florida 36

3.1.3 North American West Coast 37

3.1.4 US Great Plains/Midwest 38

3.1.5 Caribbean 39

3.1.6 Mexico 39

3.1.7 Japan 40

3.1.8 South Asia/Southeast Asia 41

3.1.9 Middle East/Near East 43

3.1.10 Europe 43

3.2 Spatial impact of man-made catastrophes 44

3.2.1 North America 46

3.2.2 Europe 47

3.2.3 Asia/Pacific 47

3.3 Urban vulnerabilities 47

4 Modeling Catastrophic Risk 49

4.1 The development and use of models 49

4.2 The goals of catastrophe modeling 50

4.3 General model construction 51

4.3.1 Phase one: Hazard/peril assessment 52

4.3.2 Phase two: Vulnerability assessment 55

4.3.3 Phase three: Contract assessment 59

4.3.4 A general example 60

4.3.5 Other perils 63

4.4 Challenges 64

4.4.1 Model characteristics and assumptions 65

4.4.2 Model validation 66

4.4.3 Tail risks 67

4.4.4 Data quality and granularity 67

PART II MANAGEMENT OF CATASTROPHIC RISK 69

5 Catastrophe and the Risk Management Framework 71

5.1 Active risk management 71

5.1.1 Enterprise value, liquidity, and solvency 72

5.1.2 Loss control, loss financing, and risk reduction 74

5.2 Risk monitoring 81

5.3 Private and public sector efforts 82

5.4 Sources of capital 83

5.4.1 Insurers/reinsurers 83

5.4.2 Investment funds 84

5.4.3 Financial institutions 85

5.5 Toward active risk management 85

6 Catastrophe Insurance and Reinsurance 87

6.1 Insurable risk and insurance 87

6.1.1 Full insurance 88

6.1.2 Partial insurance 88

6.1.3 Captives 89

6.2 Catastrophe insurance 89

6.3 Reinsurance 92

6.3.1 Facultative and treaty reinsurance 92

6.3.2 Proportional and excess of loss agreements 93

6.4 Catastrophe reinsurance 95

6.5 Market cycles 98

6.6 Internal risk management 101

6.7 Challenges 103

6.7.1 Pricing difficulties 103

6.7.2 Earnings and capital volatility 104

6.7.3 Concentrations 106

6.7.4 Limits to insurability/uninsurable risks 106

6.7.5 Lack of insurance/reinsurance penetration 107

6.7.6 Capacity constraints 107

6.7.7 Contagion effects and systemic concerns 108

7 Catastrophe Bonds and Contingent Capital 111

7.1 Overview of securitization 111

7.2 Catastrophe bonds 112

7.2.1 Standard structures 112

7.2.2 Innovations 120

7.2.3 Market focus and direction 123

7.3 Contingent capital 124

7.3.1 Standard structures 125

7.3.2 Contingent debt 126

7.3.3 Contingent equity 128

7.4 Challenges 131

7.4.1 Structural flaws 132

7.4.2 Regulatory differences 132

8 Catastrophe Derivatives 135

8.1 Overview of derivatives 135

8.1.1 Exchange-traded derivatives 136

8.1.2 OTC derivatives 137

8.2 Exchange-traded catastrophe derivatives 139

8.3 OTC Catastrophe derivatives 140

8.3.1 Catastrophe reinsurance swaps 140

8.3.2 Pure catastrophe swaps 142

8.3.3 Synthetic OTC structures 142

8.4 Challenges 144

8.4.1 Index construction and basis risks 144

8.4.2 Lack of contract transparency 144

8.4.3 One-way markets 145

8.4.4 Pricing difficulties 145

8.4.5 Regulatory barriers 145

9 Public Sector Management and Financing 147

9.1 Forms of public sector involvement 147

9.1.1 Ex ante loss control measures 147

9.1.2 Insurance/reinsurance 148

9.1.3 Ex post crisis management 156

9.1.4 Financing and subsidies 157

9.1.5 Financial regulation 158

9.2 Challenges 159

9.2.1 Voluntary versus mandatory measures 159

9.2.2 Public and private sector responsibilities 160

9.2.3 Lack of market access and capacity 161

10 Outlook and Conclusions 163

10.1 Loss control 163

10.1.1 Loss control implementation 163

10.1.2 Enforcing urban planning 163

10.2 Quantification 164

10.2.1 Modeling requirements 164

10.2.2 Transparency 164

10.2.3 Complexity of terrorism 165

10.3 Loss financing 165

10.3.1 Vulnerabilities and risk capacity 165

10.3.2 Discriminatory funding and insurance 166

10.4 Government participation 166

10.4.1 Optimal government role 166

10.4.2 Limited government resources 167

10.4.3 Adverse incentives 167

10.4.4 Market deregulation 168

10.5 General management 168

10.5.1 Sub-optimal management 168

10.5.2 Sustainability of solutions 169

10.5.3 Preparing for the mega-catastrophe 169

10.5.4 Amalgamated solutions 169

10.5.5 Learning from past events 170

Bibliography 171

Index 175