Customizing Indemnity Contracts and Indexed Cat Bonds for Natural Hazard Risks

This article examines how reinsurance coupled with new financial instruments can expand coverage to areas exposed to catastrophe losses from natural disasters, and demonstrates how reinsurance and the catastrophe-linked financial instruments can be combined to lower the price of protection from its current level. A simple example illustrates the relative advantages and disadvantages of pure catastrophic bonds and pure indemnity reinsurance in supporting a structure of payments contingent on certain extreme events occurring. The authors suggest ways to combine these two instruments using customized catastrophe indices to expand coverage and reduce the cost of protection. This article states six principles for designing catastrophic risk transfer systems and discusses practical issues for implementation, and then concludes with suggestions for future research.