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Reinsurance for Catastrophes and Cataclysms

In: The Financing of Catastrophe Risk

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  • David M. Cutler
  • Richard J. Zeckhauser

Abstract

This paper examines the optimal design of insurance and reinsurance policies. We first consider reinsurance for catastrophes: risks which are large for any one insurer but not for the reinsurance market as a whole. Reinsurance for catastrophes is complicated by adverse selection. Optimal reinsurnace in the presence of adverse selection depends critically on the source of information asymmetry. When information on the probability of a loss is private but the magnitude of the loss is public optimal reinsurance employs a deductible-style deductible-style excess-of-loss policy, and when is is private but the proba- bility of a loss is common, optimal reinsurance covers small and large risks, but makes the primary insurer responsible for moderate risks. There is a dramatic divergence between these designs, which suggests that traditional approaches to design may be misguided. We then consider reinsurance for cata- clysms: risks that are so large that a loss can threaten the solvency of re- insurance such as a major earthquake, while others derive from common risks-changes in conditions that affect many individuals-such as the liability revolution or or escalating medical care costs. We argue that cataclysms must be reinsured in either broad securities markets or by the government. Beyond their one- period loss potential, cataclysms pose another risk: risk levels change over time. A simulation model traces the implications of evolving risk levels for long-term patterns of losses and premiums, where the latter reflect learning learning about loss distributions. Premium risk emerges as an important part of risk, which reinsurance and primary insurance markets do not adequately diversify."

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Bibliographic Info

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This chapter was published in:

  • Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, number froo99-1.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 7952.

    Handle: RePEc:nbr:nberch:7952

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Sara Borden & Asani Sarkar, 1996. "Securitizing property catastrophe risk," Current Issues in Economics and Finance, Federal Reserve Bank of New York, Federal Reserve Bank of New York, vol. 2(Aug).
    2. Cochrane, John H, 1995. "Time-Consistent Health Insurance," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(3), pages 445-73, June.
    3. Pratt, John W & Zeckhauser, Richard J, 1989. " The Impact of Risk Sharing on Efficient Decision," Journal of Risk and Uncertainty, Springer, Springer, vol. 2(3), pages 219-34, September.
    4. Louis Kaplow, 1989. "Incentives and Government Relief for Risk," NBER Working Papers 3007, National Bureau of Economic Research, Inc.
    5. David Cummins & Christopher Lewis & Richard Phillips, 1999. "Pricing Excess-of-Loss Reinsurance Contracts against Cat as trophic Loss," NBER Chapters, in: The Financing of Catastrophe Risk, pages 93-148 National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:
    1. John Lewis, 2010. "Reinsurers as financial intermediaries in the market for catastrophic risk," DNB Occasional Studies, Netherlands Central Bank, Research Department 802, Netherlands Central Bank, Research Department.
    2. Cutler David M. & Zeckhauser Richard J., 1998. "Adverse Selection in Health Insurance," Forum for Health Economics & Policy, De Gruyter, De Gruyter, vol. 1(1), pages 1-33, January.
    3. Anonymous & Roe, Terry L., 1999. "Policy Reform, Market Stability, And Food Security; Proceedings Of A Conference Of The International Agricultural Trade Research Consortium," Policy Reform, Market Stability, and Food Security Conference, June 26-27, 1998, Alexandria Virginia, International Agricultural Trade Research Consortium 14538, International Agricultural Trade Research Consortium.
    4. Skees, Jerry & Hazell, P. B. R. & Miranda, Mario, 1999. "New approaches to crop yield insurance in developing countries:," EPTD discussion papers, International Food Policy Research Institute (IFPRI) 55, International Food Policy Research Institute (IFPRI).
    5. Harrington, Scott E. & Niehaus, Greg, 2003. "Capital, corporate income taxes, and catastrophe insurance," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 12(4), pages 365-389, October.
    6. Froot, Kenneth A., 2001. "The market for catastrophe risk: a clinical examination," Journal of Financial Economics, Elsevier, Elsevier, vol. 60(2-3), pages 529-571, May.
    7. Torben Andersen, 2001. "Managing Economic Exposures of Natural Disasters: Exploring Alternative Financial Risk Management Opportunities and Instruments," IDB Publications 8934, Inter-American Development Bank.
    8. Meuwissen, Miranda P. M. & Van Asseldonk, Marcel A. P. M. & Huirne, Ruud B. M., 2003. "Alternative risk financing instruments for swine epidemics," Agricultural Systems, Elsevier, Elsevier, vol. 75(2-3), pages 305-322.
    9. World Bank, 2003. "Financing Rapid Onset Natural Disaster Losses in India : A Risk Management Approach," World Bank Other Operational Studies 14649, The World Bank.
    10. Jakob Eberl & Darko Jus, 2012. "Evaluating policies to attain the optimal exposure to nuclear risk," RSCAS Working Papers, European University Institute 2012/50, European University Institute.
    11. Hans H. Glismann & Klaus Schrader, 2001. "Ein funktionst├╝chtiges System privater Arbeitslosenversicherung," Kiel Working Papers 1076, Kiel Institute for the World Economy.
    12. Skees, Jerry R., 2000. "A role for capital markets in natural disasters: a piece of the food security puzzle," Food Policy, Elsevier, Elsevier, vol. 25(3), pages 365-378, June.

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