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An Industrial Organization Theory of Risk Sharing

  • M. Martin Boyer
  • Charles M. Nyce

Examining the global reinsurance market for catastrophic losses, we propose a new theory of optimal risk sharing that finds its inspiration in the economic theory of the firm. Our model offers a theoretical foundation for the vertical and horizontal tranching of insurance contracts (also known respectively as proportional and excess of loss reinsurance contracts). Using a two-factor production model popular in industrial economics, we show how reinsurance should be optimally layered (with attachment and detachment points) for a given book of business. This allows us to find the minimum insurance premium necessary to cover the cost of catastrophic events. We conclude with public policy implications by showing the conditions under which government intervention in the catastrophic loss insurance industry can reduce the cost to society of bearing risk and increase its welfare.

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Paper provided by CIRANO in its series CIRANO Working Papers with number 2011s-78.

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Length: 47 pages
Date of creation: 01 Dec 2011
Date of revision:
Handle: RePEc:cir:cirwor:2011s-78
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  1. Cassandra R. Cole & David A. Macpherson & Patrick F. Maroney & Kathleen A. McCullough & James W. (Jay) Newman, Jr & Charles Nyce, 2011. "The Use of Postloss Financing of Catastrophic Risk," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 14(2), pages 265-298, 09.
  2. 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.
  3. J. David Cummins & Georges Dionne & Robert Gagné & Abdelhakim Nouira, 2006. "Efficiency of Insurance Firms with Endogenous Risk Management and Financial Intermediation Activities," Cahiers de recherche 06-06, HEC Montréal, Institut d'économie appliquée.
  4. 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 98-11, Wharton School Center for Financial Institutions, University of Pennsylvania.
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