The effectiveness of asset, liability and equity hedging against catastrophe risk: the cases of winter storms in North America and Europe

• DOI: http://doi.org/10.1111/eufm.12143
• Date: 01 November 2018
• Published date: 01 November 2018

DOI: 10.1111/eufm.12143

ORIGINAL ARTICLE

The effectiveness of asset, liability and equity

hedging against catastrophe risk: the cases of

winter storms in North America and Europe

Yang-Che Wu

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Ming Jing Yang

Department and Graduate Institute of

Finance, College of Finance, Feng Chia

University, Taichung 40724, Taiwan

Emails: mjyang@fcu.edu.tw;

wuyangche@fcu.edu.tw

Abstract

The winter storms in North America and Europe are

responsible for the majority of the insured natural

catastrophe losses. This study analyzes the effectiveness

of insurers hedging against the winter storm risk in terms of

asset (catastrophe derivatives), liability (catastrophe bonds)

and equity (catastrophe equity puts) risk management

perspectives. The analysis results of the various financial

performances show that our suggested hedging strategies

are effective based on the long-term positive profit and the

improvement in the insolvency ratios. The conclusions of

this study provide the insurers with less volatile premiums

and more diversified portfolios under catastrophe risk

management.

KEYWORDS

catastrophe derivatives, catastrophe bonds, catastrophe equity puts,

catastrophe risk management

JEL CLASSIFICATION

G32, G11, C15

The authors are grateful to the Editor (Professor John Doukas), two anonymous referees, and participants of the European

Financial Management Association (EFMA) 2016 Annual Meeting (Basel, Switzerland) for their helpful comments and

valuable suggestions.

Eur Financ Manag. 2018;24:893–918. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

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INTRODUCTION

The economic costs of global natural disasters have been increasing dramatically in recent decades.

Natural catastrophe risk has become a very important issue for global economies and societies. Since a

natural catastrophe is a far-reaching significant event and it destroys the accumulated infrastructure and

production capital in the economy instantaneously, it causes a severe deterioration in the production

capacity of an economy, see Tatano, Homma, Okada, & Tsuchiya (2004). According to Bevere, Orwig,

& Sharan (2015), the insured losses from the global natural catastrophes and the severe convective

storms between 1990 and 2014 grew at average annual rates of 7.7% and 9.0%, respectively. As shown

in Figure 1, the insured losses from the winter storms are estimated at over 50% of the total insured

natural catastrophe losses for the period of 1998–2014. In 2014, catastrophe-related losses in

North America were primarily caused by convective winter storms. In Europe, the insured losses

totalling USD 6.6 billion in 2014 primarily also resulted from convective storms and heavy

precipitation. Millions of houses were damaged and people were left homeless after the catastrophic

natural disasters, creating significant losses to both economies and societies. Therefore, catastrophe

risk management is essential for all different entities, including insurers, individuals, capital market

investors and governments, to maintain sustainable economic growth. There are several ways to

manage the catastrophe risk, as discussed below.

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Catastrophe risk management through government intervention

Governments can spread out t he catastrophe economic lo sses over time by using some f inancing

plans, such as the issue of sta te government bonds, feder al reinsurance policies, et c. In addition,

governments can also subsidiz e state insurance policies and help s tate governments provide

insurance at lower rates, but eve n with government subsidies, it is probably still not enoug h to cover

the catastrophe risk. Moreov er, governments can also intervene in the insurance marke t by assisting

insurance companies in genera ting tax-deferred catastrop he reserves, which will ensure that

insurance companies will have mor e capital for payouts in the event of catastr ophic disasters.

Government intervention can increase the availabili ty and affordability of ins urance in natural

catastrophe risk management (see Kunreuther, 2016). However, there w ould be a serious moral

hazard problem associated wi th a government intervening to bail out insurance companie s.

FIGURE 1 Insured NatCat losses and insured storm losses. This figure presents the insured losses (in

millions of USD, based on the 2014 price level) from the winter storms, which are estimated at over 50% of the

total insured natural catastrophe losses for the period of 1998–2014.

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WU AND YANG