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Pricing Risk Transfer Transactions1

Published online by Cambridge University Press:  29 August 2014

Morton N. Lane
Morton N. Lane*
Affiliation:
Lane Financial LLC, Kenilworth, USA
*
Lane Financial LLC, 321 Melrose Avenue, Kenilworth, IL 60043-1136, USA
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Should the pricing of reinsurance catastrophes be related to the price of the default risk embedded in corporate bonds?

If not, why not?

A risk is a risk is a risk, in whatever market it appears. Shouldn't the risk-prices in these different markets be comparable? More basically perhaps, how should reinsurance prices and bond prices be set? How does the market currently set them? These questions are central to the inquiry contained in this paper.

Avoiding unnecessary suspense, our answers are: Yes, cat prices should be related to credit prices because both risks contain a characteristic trade-off between the frequency of and severity of adverse events. We leave the question of how prices should be set to others and focus on the empirical question of how they have been set by the markets. In the process, we develop a fairly robust pricing mechanism and explore its potential uses in many different contexts.

The 1999 Insurance-Linked Securities (ILS) market (a.k.a., Cat Bond market) provides the empirical springboard to the discussion. The ILS market is only 4 years old. As such, it represents a new and unique intersection of reinsurance and financial markets. It provides a wonderful laboratory for exploring risk-pricing.

The ILS market, still in its experimental phase, appears to require more generous (cheap) pricing of insurance risk than does the bond market of default risk. So much so that academics have begun to weigh in on the question of why. Previously, insurance pricing discussions had been confined to practicing insurance professionals, particularly actuaries. For finance professionals, insurance pricing, much less reinsurance pricing, seldom made the index of their financial texts – though even that is beginning to change.

Type
Invited Article
Information
ASTIN Bulletin: The Journal of the IAA , Volume 30 , Issue 2 , November 2000 , pp. 259 - 293
Copyright
Copyright © International Actuarial Association 2000

Footnotes

1

This paper was presented on June 22, 2000, as a keynote speech at the AFIR 2000 Colloquium in Tromsø, Norway.

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