Catastrophe index-linked securities and reinsurance as substituties

The use of catastrophe bonds (cat bonds) 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 the presumably lower transaction costs compared to (re)insurance products. Insurance coverage usually incurs costs of acquisition, monitoring and loss adjustment, all of which can be reduced by making use of the financial markets. Additionally, 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. Although these aspects have been identified in economic literature, to our knowledge there has been no publication so far that formally addresses the trade-off between basis risk and transaction cost. In this paper, therefore, 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 transaction cost, and show that the availability of cat bonds affects the structure of optimal reinsurance contract design in an interesting way, as it leads to an increase of indemnity for small losses and a decrease of indemnity for large losses

Catastrophic events as threats to society: Private and public risk management strategies

Dramatic events in the recent past have drawn attention to catastrophe risk management problems. The devastating terrorist attacks of September 11th, 2001 incurred the highest insured losses to date. Furthermore, a trend of increasing losses from natural catastrophes appears to be observable since the late 1980s. The increase in catastrophe losses triggered intensive discussion about risk management of catastrophic risk, focusing on three issues. First, considering the loss potential of certain catastrophic events, the insurance markets' capacity does not seem to be sufficient. An approach to address this capacity issue can be seen in passing certain catastrophic risks to investors via securitization. Second, after the events of September 11, 2001, the government's role as a bearer of risk became an increasingly important issue. Finally, as has been recently demonstrated by the floods in Europe of August 2002, problems of protecting against catastrophic threats do not only exist on the supply side but also on the demand side. Thus policymakers are considering the establishment of mandatory insurance for fundamental risks such as flood and windstorm. This paper will address aspects of these three issues. In particular, we are concerned with the extent to which state or government involvement in the management of catastrophic risk is reasonable. --catastrophic risk,risk management,public-private partnership

Improving risk allocation through cat bonds

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. --Insurance,Financial Markets,Decision Making and Risk

The impact of intermediary remuneration in differentiated insurance markets

This article deals with the impact of intermediaries on insurance market transparency and performance. In a market exhibiting product differentiation and coexistence of perfectly and imperfectly informed consumers, competition among insurers leads to non-existence of a pure-strategy market equilibrium. Consumers may become informed about product suitability by consulting an intermediary. We explicitly model two intermediary remuneration systems: commissions and fees. We find that social welfare under fees is first-best efficient but fees lead to lower expected profits of insurers and non-existence of a pure-strategy market equilibrium. Commissions, in contrast, cause 'overinformation' of consumers relative to minimal social cost, but yield a full-information equilibrium in pure strategies associated with higher expected profits of insurers. This might explain why intermediaries are generally compensated by insurers. --product differentiation,intermediation,insurance oligopoly

When prices hardly matter: Incomplete insurance contracts and markets for repair goods

This paper looks at markets characterized by the fact that the demand side is insured. In these markets a consumer purchases a good to compensate consequen¬ces of unfavorable events, such as an accident or an illness. Insurance policies in most lines of insurance base indemnity on the insured’s actual expenses, i.e., the insured would be partially or completely reimbursed when purchasing certain goods. In this setting we discuss the interaction between insurance and repair markets by focusing, on the one hand, upon the development of prices and the structure of markets with insured consumers, and, on the other hand, the resulting backlash on optimal insurance contracting. We show that even in the absence of ex post moral hazard the extension of insurance coverage will lead to an increase in prices as well as to a socially undesirable increase in the number of repair service suppliers, if repair markets are imperfect

When prices hardly matter: Incomplete insurance contracts and markets for repair goods

This paper locks at markets charaterized by the fact that the demand side is insured. In these markets a consumer purchases a good to compensate consequences of unfavorable events, such as an accident or an illness. Insurance policies in most lines of insurance base indemnity on the insured's actual expenses, i. e., the insured would be partially or completely reimbursed when purchased certain goods. In this setting we discuss the interaction between insurance and repair markets by focusing, on the one hand, upon on development of prices and the market structure in markets with insured customers, and, on the other hand, the resulting backlash on optimal insurance contracting. --insurance,incomplete contracts,repair markets

When prices hardly matter: Incomplete insurance contracts and markets for repair goods

This paper looks at markets characterized by the fact that the demand side is insured. In these markets a consumer purchases a good to compensate consequen¬ces of unfavorable events, such as an accident or an illness. Insurance policies in most lines of insurance base indemnity on the insured’s actual expenses, i.e., the insured would be partially or completely reimbursed when purchasing certain goods. In this setting we discuss the interaction between insurance and repair markets by focusing, on the one hand, upon the development of prices and the structure of markets with insured consumers, and, on the other hand, the resulting backlash on optimal insurance contracting. We show that even in the absence of ex post moral hazard the extension of insurance coverage will lead to an increase in prices as well as to a socially undesirable increase in the number of repair service suppliers, if repair markets are imperfect.insurance; incomplete contracts; repair markets

The optimal pricing strategy for an insurer when risk preferences are stochastically distributed

The present paper analyzes the demand for insurance when the insurer has incomplete information about types of potential customers. We assume that customers´ risk preferences cannot be distinguished by the insurer. Therefore, the standard result in insurance economics that the insurer discriminates perfectly in prices cannot be applied. Instead, the present article examines the optimal pricing rule for an insurer faced with stochastic distribution of risk preferences. Within this general model framework, we show that an optimal strategy always exists. Both fixed and proportionate premium loadings (relative to expected loss) are considered. -- Der vorliegende Artikel analysiert die optimale Prämienpolitik eines Versicherers bei stochastischer Verteilung der Nachfragertypen auf Basis einer Preis-Absatz-Funktion. Dem Versicherer ist hier lediglich die Wahrscheinlichkeitsverteilung der individuellen Nachfragertypen bekannt und eine üblicherweise postulierte vollständige Preisdiskriminierung des Versicherers ist daher nicht möglich. Die allgemeine Preis-Absatz-Funktion des Versicherers variiert in Abhängigkeit der verwendeten Modellparameter. Wir zeigen, dass in diesem allgemeinen Modellrahmen stets eine optimale Preispolitik des Versicherers existiert. Dabei wird in Bezug auf den aktuariell fairen Wert der Police sowohl ein fixer als auch ein proportionaler Prämienzuschlag des Versicherers berücksichtigt.insurance demand,optimal insurance pricing,stochastically distributed risk preferences

When prices hardly matter: Incomplete insurance contracts and markets for repair goods

This paper looks at markets characterized by the fact that the demand side is insured. In these markets a consumer purchases a good to compensate consequences of unfavorable events, such as an accident or an illness. Insurance policies in most lines of insurance base indemnity on the insured’s actual expenses, i.e., the insured would be partially or completely reimbursed when purchasing certain goods. In this setting we discuss the interaction between insurance and repair markets by focusing, on the one hand, upon the development of prices and the market structure in markets with insured customers, and, on the other hand, the resulting backlash on optimal insurance contracting.Incomplete Contracts, Insurance, Repair Markets

Managed Claims: Zur Notwendigkeit einer vertikalen Integration von Versicherungs- und Reparaturleistungen

The paper deals with the so called external moral hazard. This problem occurs, when-ever insurance companies bear the repair costs of the insured in the case of a damage. The insurance coverage results in a decrease of the price elasticity of demand and therefore in higher prices for repair services and goods, since markets for repair goods are usually imperfect and prices are thus above marginal costs. Empirical evidence is given that the price increase for repair services and goods due to external moral hazard is quite substantial. It is argued in this paper that the only way to tackle external moral hazard efficiently is a vertical integration of insurance on the one hand and the supply of repair goods and services on the other hand: Insurance companies have either to provide repair goods and services by themselves or make cooperation agreements with providers. --