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Improving risk allocation through cat bonds

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  • Nell, Martin
  • Richter, Andreas
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    Abstract

    Catastrophe bonds (cat bonds) often use index triggers, such as, for instance, parametric descriptions of a catastrophe. This implies the problem of the so-called basis risk, resulting from the fact that, in contrast to traditional reinsurance, this kind of coverage cannot be a perfect hedge for the primary's insured portfolio. On the other hand, cat bonds offer some very attractive economic features: Besides their usefulness as a solution to the problems of moral hazard and default risk, an important advantage of cat bonds can be seen in presumably lower risk premiums compared to (re)insurance products. Cat bonds are only weakly correlated with market risk, implying that in perfect financial markets these securities could be traded at a price including just small risk premiums. Furthermore, there is empirical evidence that risk aversion of reinsurers is an important reason for high reinsurance prices. In this paper we introduce a simple model that enables us to analyze cat bonds and reinsurance as substitutional risk management tools in a standard insurance demand theory environment. We concentrate on the problem of basis risk versus reinsurers' risk aversion and show that the availability of cat bonds affects the structure of an optimal reinsurance contract as well as the reinsurance budget. Primarily, reinsurance is substituted by index-linked coverage for large losses. --

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    Bibliographic Info

    Paper provided by University of Hamburg, Institute for Risk and Insurance in its series Working Papers on Risk and Insurance with number 10.

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    Date of creation: 2002
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    Handle: RePEc:zbw:hzvwps:10

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    Keywords: Insurance; Financial Markets; Decision Making and Risk;

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    1. Cummins, J. David & Lalonde, David & Phillips, Richard D., 2004. "The basis risk of catastrophic-loss index securities," Journal of Financial Economics, Elsevier, Elsevier, vol. 71(1), pages 77-111, January.
    2. 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.
    3. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, Elsevier, vol. 2(3), pages 225-243, September.
    4. 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.
    5. 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.
    6. 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.
    7. J. David Cummins & Neil A. Doherty & Anita Lo, 1999. "Can Insurers Pay for the "Big One"? Measuring the Capacity of an Insurance Market to Respond to Catastrophic Losses," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-11, Wharton School Center for Financial Institutions, University of Pennsylvania.
    8. Doherty, Neil A & Dionne, Georges, 1993. " Insurance with Undiversifiable Risk: Contract Structure and Organizational Form of Insurance Firms," Journal of Risk and Uncertainty, Springer, Springer, vol. 6(2), pages 187-203, April.
    9. Bruce C. Greenwald & Joseph E. Stiglitz, 1990. "Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior," NBER Working Papers 3359, National Bureau of Economic Research, Inc.
    10. Kenneth A. Froot, 1997. "The Limited Financing of Catastrophe Risk: An Overview," NBER Working Papers 6025, National Bureau of Economic Research, Inc.
    11. Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, number froo99-1, October.
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