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Catastrophe Bonds, Reinsurance, and the Optimal Collateralization of Risk-Transfer

  • Darius Lakdawalla
  • George Zanjani

Catastrophe bonds feature full collateralization of the underlying risk transfer, and thus abandon the insurance principle of economizing on collateral through diversification. We examine the theoretical foundations beneath this paradox, finding that fully collateralized instruments have important uses in a risk transfer market when insurers cannot contract completely over the division of assets in the event of insolvency, and, more generally, cannot write contracts with a full menu of state-contingent payments. In this environment, insureds have different levels of exposure to an insurer's default. When contracting constraints limit the insurer's ability to smooth out such differences, catastrophe bonds can be used to deliver coverage to those most exposed to default. We demonstrate how catastrophe bonds can improve welfare in this way by mitigating differences in default exposure, which arise with: (1) contractual incompleteness, and (2) heterogeneity among insureds, which undermines the efficiency of the mechanical pro rata division of assets that takes place in the event of insurer insolvency.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12742.

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Date of creation: Dec 2006
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Handle: RePEc:nbr:nberwo:12742
Note: CF PE AP
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  1. Kenneth A. Froot, 1999. "The Market for Catastrophe Risk: A Clinical Examination," NBER Working Papers 7286, National Bureau of Economic Research, Inc.
  2. Robert E. Hoyt & Kathleen A. McCullough, 1999. "Catastrophe Insurance Options: Are They Zero-Beta Assets?," Journal of Insurance Issues, Western Risk and Insurance Association, vol. 22(2), pages 147-163.
  3. Richard D. Phillips & J. David Cummins & Franklin Allen, 1996. "Financial Pricing of Insurance in the Multiple Line Insurance Company," Center for Financial Institutions Working Papers 96-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. Dwight Jaffee, 2006. "Monoline Restrictions, with Applications to Mortgage Insurance and Title Insurance," Review of Industrial Organization, Springer, vol. 28(2), pages 83-108, 03.
  5. Niehaus, Greg, 2002. "The allocation of catastrophe risk," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 585-596, March.
  6. 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, vol. 91(2), pages 304-11, April.
  7. Zanjani, George, 2002. "Pricing and capital allocation in catastrophe insurance," Journal of Financial Economics, Elsevier, vol. 65(2), pages 283-305, August.
  8. Silke Brandts, 2005. "ART versus reinsurance: the disciplining effect of information insensitivity," FMG Discussion Papers dp545, Financial Markets Group.
  9. Doherty, Neil A & Schlesinger, Harris, 1990. "Rational Insurance Purchasing: Consideration of Contract Nonperformance," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 243-53, February.
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