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On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance

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  • Kenneth A. Froot
  • Paul G.J. O'Connell

Abstract

We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be "high" in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price. We develop tests of this alternative against the null that the supply of intermediary capital is perfectly elastic. We take the US catastrophe reinsurance market as an example, using detailed data from Guy Carpenter & Co., covering a large fraction of the catastrophe risks exchanged during 1970-94. Our results suggest that the price of reinsurance generally exceeds "fair" values, particularly in the aftermath of large events, that market power of reinsurers is not a complete explanation for such pricing, and that reinsurers' high costs of capital appear to play an important role.

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 97-24.

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Handle: RePEc:wop:pennin:97-24

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  1. Robert C. Merton, 1995. "A Functional Perspective of Financial Intermediation," Financial Management, Financial Management Association, vol. 24(2), Summer.
  2. Jeremy C. Stein, 1995. "An Adverse Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy," NBER Working Papers 5217, National Bureau of Economic Research, Inc.
  3. 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.
  4. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June.
  5. Kenneth A. Froot, 1997. "The Limited Financing of Catastrophe Risk: An Overview," NBER Working Papers 6025, National Bureau of Economic Research, Inc.
  6. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  7. Froot, Kenneth A. (ed.), 1999. "The Financing of Catastrophe Risk," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226266237, January.
  8. Neil A. Doherty & Clifford W. Smith, 1993. "Corporate Insurance Strategy: The Case Of British Petroleum," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 4-15.
  9. Cummins, J. David & Danzon, Patricia M., 1997. "Price, Financial Quality, and Capital Flows in Insurance Markets," Journal of Financial Intermediation, Elsevier, vol. 6(1), pages 3-38, January.
  10. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  11. Dwight M. Jaffee & Thomas Russell, 1996. "Catastrophe Insurance, Capital Markets and Uninsurable Risks," Center for Financial Institutions Working Papers 96-12, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," Center for Financial Institutions Working Papers 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
  13. Dong, Weimin & Shah, Haresh & Wong, Felix, 1996. "A Rational Approach to Pricing of Catastrophe Insurance," Journal of Risk and Uncertainty, Springer, vol. 12(2-3), pages 201-18, May.
  14. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
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