Sovereign Catastrophe Risk Financing

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The Theory and Practice of Insurance

Sovereign Catastrophe Risk Financing
Limitations of Traditional Insurance and the Potential of Alternative Risk Transfer Solutions

Supervised by: Prof. Christopher L. Culp

Authors: Martin Reinhard ID- No: 05-723-648 martinreinhard@gmx.ch Aicha Khuder ID- No: 11-106-937 aicha_khuder@yahoo.de Susanna Kullenberg ID- No: 11-111-499 susanna.kullenberg@gmail.com

Bern, February 27th 2012

Table of Content
Abstract ............................................................................................................................................................... 3 Impact of Natural Catastrophes on Society ........................................................................................................ 4 How governments protect themselves and their people from the negative impact of natural catastrophes ....... 5 Ex- post financing instruments ....................................................................................................................... 6 Ex- ante financing instruments ...................................................................................................................... 7 Limitations of Traditional Insurance and the Potential of Parametric and Index-based products and ART .... 10 Public Private Partnerships (PPP)..................................................................................................................... 12 Comprehensive Disaster Risk Management (CDRM) ..................................................................................... 14 Real Life Examples of Public Private Partnerships .......................................................................................... 14 FONDEN Mexico - A combination of a public fund and CatBonds ............................................................ 15 CCRIF – A combination of public insurance pooling and private reinsurance .......................................... 16 The World Bank’s Cat DDO - A combination of contingent capital and options ........................................ 17 Conclusion ........................................................................................................................................................ 18 Bibliography ..................................................................................................................................................... 20

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Abstract
In the light of increasing societal losses due to natural catastrophes, this paper focuses on the topic of how the (re)insurance industry cooperates with the public sector to protect the latter from the negative financial impact of natural disasters. In particular, it treats the question how governments commonly protect themselves and what risk transfer solutions the insurance industry can offer to governments to improve their protection against the losses of natural disasters that are not privately insured, and which ultimately would have to be borne by society, tax payers or by the government itself. In this context, the paper outlines the limitations of traditional (re)insurance and emphasizes the potential and importance of alternative risk transfer solutions for the public sector. To show how these methods are used in practice, three real life examples are introduced; one using an alternative risk transfer to the capital market in form of a catastrophe bond, the second a reinsurance solution and the last one contingent debt financing in combination with a derivative option.

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Impact of Natural Catastrophes on Society
Over the last decades, losses due to natural catastrophes have been increasing significantly. It is estimated that over 3.4 billion people worldwide are negatively affected by natural perils.1 There are several reasons for this increase. The economic development combined with a growing and increasingly urbanized population has resulted in a much more dense concentration of assets prone to natural...
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