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The Market for Catastrophe Risk: A Clinical Examination

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  • Kenneth A. Froot

Abstract

This paper examines the market for catastrophe event risk -- i.e., financial claims that are linked to losses associated with natural hazards, such as hurricanes and earthquakes. This market is in transition as new approaches for transferring risk are being explored. The paper studies several recent transactions by USAA which use reinsurance capacity from capital markets rather than only from reinsurers. We identify two puzzles concerning the cat protection purchased in these transactions: there is no coverage for the largest, most severe events; and premiums appear well above actuarial value. We demonstrate that both features deviate from what theory would predict, yet are characteristic of many transactions, not simply those of USAA. We then explore a number of possible explanations for the facts. The most compelling are combinations of capital market imperfections and market power on the part of reinsurers. Conclusions for broader capital market and risk management issues are discussed.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7286.

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Date of creation: Aug 1999
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Publication status: published as Froot, Kenneth A. "The Market For Catastrophe Risk: A Clinical Examination," Journal of Financial Economics, 2001, v60(2-3,May), 529-571.
Handle: RePEc:nbr:nberwo:7286

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  1. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
  2. Mayers, David & Smith, Clifford W, Jr, 1982. "On the Corporate Demand for Insurance," The Journal of Business, University of Chicago Press, vol. 55(2), pages 281-96, April.
  3. Neil A. Doherty & Clifford W. Smith, 1993. "Corporate Insurance Strategy: The Case Of British Petroleum," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 6(3), pages 4-15.
  4. David M. Cutler & Richard J. Zeckhauser, 1999. "Reinsurance for Catastrophes and Cataclysms," NBER Chapters, in: The Financing of Catastrophe Risk, pages 233-274 National Bureau of Economic Research, Inc.
  5. Kenneth A. Froot & Paul G.J. O'Connell, . "On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-24, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Kenneth A. Froot, 1999. "Introduction to "Financing of Catastrophe Risk, The"," NBER Chapters, in: The Financing of Catastrophe Risk, pages 1-22 National Bureau of Economic Research, Inc.
  7. Mayers, David & Smith, Clifford W, Jr, 1983. "The Interdependence of Individual Portfolio Decisions and the Demand for Insurance," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 304-11, April.
  8. Doherty, Neil A & Schlesinger, Harris, 1983. "The Optimal Deductible for an Insurance Policy When Initial Wealth Is Random," The Journal of Business, University of Chicago Press, vol. 56(4), pages 555-65, October.
  9. Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, number froo99-1, October.
  10. Froot, Kenneth A. (ed.), 1999. "The Financing of Catastrophe Risk," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226266237, March.
  11. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 35-55, March.
  12. Gur Huberman & David Mayers & Clifford W. Smith Jr., 1983. "Optimal Insurance Policy Indemnity Schedules," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 14(2), pages 415-426, Autumn.
  13. Lee, Charles M C & Shleifer, Andrei & Thaler, Richard H, 1991. " Investor Sentiment and the Closed-End Fund Puzzle," Journal of Finance, American Finance Association, American Finance Association, vol. 46(1), pages 75-109, March.
  14. Anne Gron, 1994. "Capacity Constraints and Cycles in Property-Casualty Insurance Markets," RAND Journal of Economics, The RAND Corporation, vol. 25(1), pages 110-127, Spring.
  15. Dwight M. Jaffee & Thomas Russell, 1996. "Catastrophe Insurance, Capital Markets and Uninsurable Risks," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-12, Wharton School Center for Financial Institutions, University of Pennsylvania.
  16. Paul Kleindorfer & Howard Kunreuther, 1999. "Challenges Facing the Insurance Industry in Managing Catastrophic Risks," NBER Chapters, in: The Financing of Catastrophe Risk, pages 149-194 National Bureau of Economic Research, Inc.
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