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Reinsurance or CAT Bond? How to Optimally Combine Both

Denis-Alexandre Trottier and Van Son Lai
The Journal of Fixed Income Fall 2017, 27 (2) 65-87; DOI: https://doi.org/10.3905/jfi.2017.27.2.065
Denis-Alexandre Trottier
is a PhD student in Financial Engineering at Laval University in Quebec, Canada
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Van Son Lai
is a professor of finance at Laval University in Quebec, Canada and an affiliated senior research professor at IPAG Business School in Paris, France
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Abstract

We study how traditional reinsurance and CAT bonds can be combined to build an optimal catastrophe insurance program. We develop a contingent claims model to investigate the imperfections and limitations of the reinsurance market stemming from financial distress costs and default risk. We find that the pricing markup and credit risk is typically larger for reinsurance contracts that cover the higher and less probable layers of losses. We show that the optimal hedging strategy is to cover small losses using reinsurance and to hedge higher losses by issuing a CAT bond. Our results demonstrate that this strategy significantly lowers the insurer’s cost of protection, expands his underwriting capacity, and yields higher shareholder values.

TOPICS: Fixed income and structured finance, derivatives applications

  • © 2017 Pageant Media Ltd
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The Journal of Fixed Income: 27 (2)
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Fall 2017
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Reinsurance or CAT Bond? How to Optimally Combine Both
Denis-Alexandre Trottier, Van Son Lai
The Journal of Fixed Income Sep 2017, 27 (2) 65-87; DOI: 10.3905/jfi.2017.27.2.065

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Reinsurance or CAT Bond? How to Optimally Combine Both
Denis-Alexandre Trottier, Van Son Lai
The Journal of Fixed Income Sep 2017, 27 (2) 65-87; DOI: 10.3905/jfi.2017.27.2.065
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