Alternative catastrophe risk financing mechanisms through weather derivatives have begun to emerge and are regarded by some observers as playing a role in the continued viability of the insurance sector. Other authors suggest that these instruments will continue to be a niche product because of inability to come up with adequate pricing for these mechanisms as offered through the capital markets. Such products also raise the awareness and visibility of natural disasters and climate change issues within the financial markets (Swiss Re, 1996; Credit Suisse Group, 1998; Lester, 1999; Mahoney, 1999; Punter, 1999).

Contingent Capital Securities. The two types of capital contingency securities available to investors are contingent surplus notes and catastrophe equity puts. Investors in these securities become—at the insurer's option—creditors of or equity investors in the insurer. The exercised "notes" and "puts" are shown as surplus on an insurer's balances sheet and thus increase assets without an offsetting increase in the liability portion of the balance sheet. The insurer can draw from surplus to pay unreserved catastrophe losses and have the funds (surplus) necessary to take on new exposures.

Catastrophe Risk Securities. Two forms of "cat risk securities" are available that transfer underwriting risk to investors: catastrophe bonds and catastrophe insurance options. Primary insurers and reinsurers can make use of these securities. Both benefit insurers by making monies available to offset catastrophe losses. In contrast to contingent capital securities, these instruments do not bolster an insurer's surplus; they provide funds for the payment of losses. They are reflected as both an asset and as a liability on the insurer's financial statements.

These approaches are relatively new, and their efficacy and robustness must be evaluated (see Tol, 1998; Peara, 1999; Swiss Re, 1999b; Bantwal and Kunreuther, 2000; GAO, 2000a; Nutter, 2000; Jamison, 2000; Mills et al., 2001). Among the questions to address include:

• In a more competitive environment, would insurers and reinsurers be inclined to participate in or encourage (subsidize) risk-reduction measures?
• Do derivatives signal a potential means by which self-insurers can expand their capacity, thereby providing greater competition for primary insurers and reinsurers?
• Will the occurrence(s) of catastrophic weather-related events turn away investors after an event?
• Do existing catastrophe and climate modeling techniques yield information necessary to adequately evaluate financial risks and thus the prices of these derivatives?

Of 11 major trends in investing, catastrophe bonds were rated by members of the International Securities Market Association as least likely to have significant impacts on securities markets in the future (Freeman, 2000).

Despite doubts about these new instruments, banks and insurance companies consider this a growing business. In 1999, the cumulative volume of weather-related bonds/derivatives reached US$3 billion. It can be assumed that an increasing number of such instruments will be available to hedge against climate risks. This, in turn, will allow banks to get the "insurance" coverage they need for their lending activities (Nicholls, 2000).