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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. Risk management theory suggests protection by insurers and other corporations against the largest cat events is most valuable. We show, however, that historically most insurers have purchased relatively little cat reinsurance against large events. We also find that premiums are high relative to expected losses, especially after cat events. We then examine clinical evidence to understand why the theory fails. Specifically, we examine transactions that look to capital markets, rather than traditional reinsurance markets, for risk-bearing capacity. These provide hints as to why the theory fails. We explore these hints in eight theoretical explanations and find the most compelling to be supply restrictions associated with capital market imperfections and market power exerted by traditional reinsurers.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8110.

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Date of creation: Feb 2001
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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:8110

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  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, American Finance Association, vol. 48(5), pages 1629-58, December.
  6. Froot, Kenneth A. & O'Connell, Paul G.J., 2008. "On the pricing of intermediated risks: Theory and application to catastrophe reinsurance," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(1), pages 69-85, January.
  7. David M. Cutler & Richard J. Zeckhauser, 1997. "Reinsurance for Catastrophes and Cataclysms," NBER Working Papers 5913, National Bureau of Economic Research, Inc.
  8. Paul Kleindorfer & Howard Kunreuther, 1999. "Challenges Facing the Insurance Industry in Managing Catastrophic Risks," NBER Chapters, National Bureau of Economic Research, Inc, in: The Financing of Catastrophe Risk, pages 149-194 National Bureau of Economic Research, Inc.
  9. Froot, Kenneth A. (ed.), 1999. "The Financing of Catastrophe Risk," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226266237, 01-2013.
  10. 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, University of Chicago Press, vol. 56(4), pages 555-65, October.
  11. Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number froo99-1.
  12. 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.
  13. Kenneth A. Froot, 1999. "Introduction to "Financing of Catastrophe Risk, The"," NBER Chapters, National Bureau of Economic Research, Inc, in: The Financing of Catastrophe Risk, pages 1-22 National Bureau of Economic Research, Inc.
  14. Mayers, David & Smith, Clifford W, Jr, 1982. "On the Corporate Demand for Insurance," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 55(2), pages 281-96, April.
  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. 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.
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