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Reinsurance for Catastrophes and Cataclysms

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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

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5913.

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Date of creation: Feb 1997
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Publication status: published as David M. Cutler, Richard J. Zeckhauser. "Reinsurance for Catastrophes and Cataclysms," in Kenneth A. Froot, editor, "The Financing of Catastrophe Risk" University of Chicago Press (1999)
Handle: RePEc:nbr:nberwo:5913

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References

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  1. J. David Cummins & Christopher M. Lewis & Richard D. Phillips, 1998. "Pricing Excess-of-loss Reinsurance Contracts Against Catastrophic Loss," Center for Financial Institutions Working Papers 98-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Sara Borden & Asani Sarkar, 1996. "Securitizing property catastrophe risk," Current Issues in Economics and Finance, Federal Reserve Bank of New York, issue Aug.
  3. Louis Kaplow, 1991. "Incentives and Government Relief for Risk," NBER Working Papers 3007, National Bureau of Economic Research, Inc.
  4. Pratt, John W & Zeckhauser, Richard J, 1989. " The Impact of Risk Sharing on Efficient Decision," Journal of Risk and Uncertainty, Springer, vol. 2(3), pages 219-34, September.
  5. Cochrane, John H, 1995. "Time-Consistent Health Insurance," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 445-73, June.
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Cited by:
  1. Torben Andersen, 2001. "Managing Economic Exposures of Natural Disasters: Exploring Alternative Financial Risk Management Opportunities and Instruments," IDB Publications 8934, Inter-American Development Bank.
  2. Harrington, Scott E. & Niehaus, Greg, 2003. "Capital, corporate income taxes, and catastrophe insurance," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 365-389, October.
  3. David M. Cutler & Richard J. Zeckhauser, 1998. "Adverse Selection in Health Insurance," NBER Chapters, in: Frontiers in Health Policy Research, volume 1, pages 1-32 National Bureau of Economic Research, Inc.
  4. Froot, Kenneth A., 2001. "The market for catastrophe risk: a clinical examination," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 529-571, May.
  5. John Lewis, 2010. "Reinsurers as financial intermediaries in the market for catastrophic risk," DNB Occasional Studies 802, Netherlands Central Bank, Research Department.
  6. 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, vol. 75(2-3), pages 305-322.
  7. Hans H. Glismann & Klaus Schrader, 2001. "Ein funktionstüchtiges System privater Arbeitslosenversicherung," Kiel Working Papers 1076, Kiel Institute for the World Economy.
  8. Juan José Durante & Kurt S. Focke & Guillermo J. Collich & Mario Marcel & Torben Andersen, 2010. "Natural Disasters Financial Risk Management : Technical and Policy Underpinnings for the Use of Disaster-Linked Financial Instruments in Latin America and the Caribbean," IDB Publications 11118, Inter-American Development Bank.
  9. Torben Andersen, 2002. "Innovative Financial Instruments for Natural Disaster Risk Management," IDB Publications 30738, Inter-American Development Bank.
  10. Skees, Jerry R., 2000. "A role for capital markets in natural disasters: a piece of the food security puzzle," Food Policy, Elsevier, vol. 25(3), pages 365-378, June.
  11. Jakob Eberl & Darko Jus, 2012. "Evaluating policies to attain the optimal exposure to nuclear risk," RSCAS Working Papers 2012/50, European University Institute.
  12. 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 14538, International Agricultural Trade Research Consortium.

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