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Australian risk managers need to look at innovative methods of financing catastrophes, such as through the capital markets, rather than relying on conventional insurance, according to an executive.

Traditional insurance products may not provide the best solution to catastrophe losses, and risk managers need to adopt a longer-term view and consider alternative financing methods, said Lambros Lambrou, executive director-risk financing for Sydney-based Aon Group Australia Ltd.

George Walker, director-research for Aon Group Australia's reinsurance broker arm, formerly Alexander Howden Australia Ltd., said risk managers need to consider all their risks and can then "hedge one against another to reduce the total outlay on risk financing."

"It's a far more sophisticated approach than in the past," he said.

He said Australian risk managers are getting more sophisticated about alternative financing.

Neil Doherty, professor of insurance and risk management at the University of Pennsylvania in Philadelphia, told the Aon Group Australia's biennial conference, Financial Risk Management for Natural Catastrophes, held recently on Queensland's Gold Coast, that catastrophe reinsurance is "costly and in short supply," generating "a backward demand for new capacity in traditional or innovative forms."

"Conventional reinsurance is characterized by relatively high levels of credit risk and moral hazard. By contrast, cat bonds are characterized by relatively low levels of credit risk and moral hazard," he said.

Mr. Doherty said risk managers can lock in the terms of post-loss financing through a line of credit with the interest rate fixed prior to any possible loss. That would allow a risk manager who might not be able to get a loan after a disaster to tap the credit at the previously agreed rate to pay for losses.

"A more radical approach is for the firm to sell a put option on its own stock, in which the holder of the option agrees to buy the firm's stock after a defined loss at a fixed price," he explained.

Capital markets offer considerable potential for spreading the risk of large catastrophe losses, Mr. Doherty said. "A single, $50 billion catastrophe exceeds the entire estimated world reinsurance capacity, whereas the same loss is considerably less than the standard deviation of trading on U.S. capital markets," he said.

Reinsurance contracts are "relationship-intensive, requiring costly brokering and monitoring," fueling risk managers' interest in alternative financial instruments.

Insurers also could use hedging techniques to avoid insolvency after a catastrophe, Mr. Doherty said. "A $50 billion-plus event, such as a repeat of the 1906 San Francisco earthquake, would cause widespread insolvencies both in primary insurers and reinsurers," he said.

Catastrophe bonds are the simplest form of hedging, he noted.

Dennis Mahoney, deputy chairman and chief executive of Aon Group Ltd. in London, said major corporations and, increasingly, midsize companies, are taking the view that self-insurance or self-reinsurance is preferable to buying insurance. "The fact that insurance covers some perils and excludes others undermines its usefulness," he said.

"A loss is a loss, whether it arises from an insurable risk, an uninsurable risk or a financial exposure. If the insurance industry can respond to these needs, it can develop a wider-based business platform," he said.

For example, U.S.-based weather insurer Worldwide Weather has expanded a hurricane policy to provide business interruption cover to companies, even if they have no direct property damage, because their earnings may be affected, Mr. Mahoney told the conference.