Catastrophe Insurance, Capital Markets, and Uninsurable Risks

Reinsurance or securitization: The case of natural catastrophe risk

“…Such literature has examined the advantages of financial markets, emphasizing their risk disaggregation (Doherty and Schlesinger, 2002) and capital supply (Jaffee and Russell, 1997) properties, and their lack of exposure to moral hazard and to default risk (Doherty, 1997;Lakdawalla 4 Most catastrophe bonds have been sold under Rule 144A to Qualified Institutional Buyers (QIBs); few QIBs can be considered liquidity traders, in the sense of consistently sustaining trading losses to informed traders.…”

Should the Government Provide Insurance for Catastrophes?

“…We assume that insurers hold equity capital to achieve a specified insolvency probability, ε. Insolvency probabilities are not driven to zero because holding capital in an insurance company is costly due to corporate income taxation, agency costs, regulatory costs, accounting rules, and other factors (Jaffee and Russell, 1997). The central limit theorem specifies that the following variable approaches normality as the sample size increases:…”

“…However, there are significant questions about the ability of the insurance industry to deal with the largest catastrophic events. For various reasons, it is infeasible and inefficient for the industry to hold sufficient capital to finance losses arising from very-high-severity, low-frequency events (Jaffee and Russell, 1997). This section provides an overview of the resources of the U.S. propertycasualty insurance industry and the global reinsurance industry to gauge the industry's capability to sustain losses from mega-catastrophes.…”

The basis risk of catastrophic-loss index securities

“…Insurance and reinsurance markets function well for relatively small, frequent events, but are not efficient mechanisms for financing large, infrequent events (Jaffee and Russell 1997). The total resources of the international reinsurance industry from 1993-1998 are shown in Figure 4.…”

“…However, because holding capital in an insurer is costly, an infusion of new capital is not likely to be an efficient solution to the CAT problem (Jaffee and Russell 1997). Costly capital arises due to the regulatory and agency costs of operating an insurance company as well as accounting and tax rules that penalize the accumulation of equity capital.…”