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Electronic trading of catastrophe risk


Electronic trading of catastrophe risk

The free trading of catastrophe risk on electronic platforms could be a major disruptor to the reinsurance market, says Clive O'Connell of McCarthy Denning.

One area in which the insurance market and the capital markets differ is in tradability of product. While trading in capital markets instruments is not only commonplace but necessary in order to give those markets liquidity, trading in insurance instruments, or policies as we more usually term them, is impossible.

Insurance instruments cannot be traded. It may be possible for one insurer to assume the obligations of another on a policy through novation but this can be achieved only with the consent of the insured. The benefits of an insurance policy cannot be traded.

For example, a resort owner in Barbados cannot sell its insurance policy to a hotelier in Trinidad for a considerable profit as a hurricane sweeps up the Caribbean.

The reason for this is that insurance contracts necessarily have insurable interest as a component. The insured must have an interest in what is being insured and must suffer a loss before it can be indemnified for it. An insurance contract without an insurable interest is not an insurance policy but a wagering agreement. It is simply a bet.

While one could bet on disasters occurring, public distaste would probably preclude bookmakers from advertising or even running a book on them. Indeed, one cannot bet on ships sinking. It is an offence under the Marine Insurance (Gambling Policies) Act 1909, legislation introduced to stop people having an interest in ships sinking.

This need for an insurable interest means that a market will not be able to develop in which catastrophe reinsurance, or indeed catastrophe insurance, products can be traded.

New platforms

The same is not the case for products created as capital markets instruments such as derivatives and bonds.

This why a number of people are exploring ways to create electronic platforms for the trading of catastrophe risk. The risk that they trade will necessarily be in the form of bonds or derivatives.

Such a platform would eliminate much of the frictional cost involved in purchasing insurance-linked securities (ILS) products and could make ILS available to everyone, not just insurers. The ramifications of such developments on the reinsurance and insurance industries are considerable.

Low cost products which boost cashflow in the event of a catastrophe would be very attractive. Money would be received before paying losses thus enabling insurers to act swiftly to pay their own insureds. Insureds themselves could buy and trade protections, quite literally as the wind blows. They would eliminate the need to prove loss, particularly tangential loss such as loss of profits and they would not have to wait for adjustment before receiving money.

The role of brokers could also be challenged, which is possibly why a number of brokers are playing a significant role in creating the platforms and, in so doing, defending their relevance.

The lack of insurable interest could however, also create some more significant problems, particularly if there is aggressive trading and purchasing of products immediately before a storm. The impact of a loss to the markets could be many multiples of the physical damage that occurs.

The free trading of catastrophe risk on electronic platforms could be a major disruptor to the reinsurance market and change the way risk is viewed in the future.

Clive O’Connell is Head of Insurance and Reinsurance at McCarthy Denning. He can be contacted at:  coconnell@mccarthydenning.com

Clive O'Connell, catastrophe

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