Innovation in Corporate Risk Management: the Case of Catastrophe Risk

Abstract

Recent financial innovation in managing catastrophe risk, such as catastrophe bonds and catastrophe options, may be seen as a specific response to the problem of insurance and reinsurance capacity. This view is bolstered by a clear upward revision of estimates of loss potential. An equally compelling case can be made that such innovation is a natural expression of a conceptual revolution, in which the nature of risk and its impact on firms, has been reworked. This so called revolution is known in financial circles simply as “risk management”.

The first prong of new risk management, why risk is costly to firms, arose from an apparent contradiction between the theory and practice of financial management. The second prong of risk management is that it is inclusive in nature. I will start with a summary of the results of recent literature on why risk is costly to firms and I will identify the generic pairs of strategies that are available to manage risk costs. The structure reveals how reinsurance, financial instruments, insurance policy design, leverage management and organizational form can be used jointly or selectively to manage insurer risk.