Customizing Reinsurance and Cat Bonds for Natural Hazard Risks

This paper has the following two objectives: to examine how reinsurance coupled with new financial instruments can expand coverage to those residing in areas subject to catastrophic losses from natural disasters, and to show how reinsurance and the catastrophe-linked financial instruments can be combined so that the price of protection can be lowered from its current level. To address these two questions we define the key stakeholders and their concerns with respect to catastrophic risks. We then construct a simple example to illustrate the relative advantages and disadvantages of catastrophe bonds and reinsurance in supporting a structure of payments contingent on certain events occurring (e.g. a severe flood in Poland or a major hurricane in Florida). On the basis of this comparison we suggest ways to combine these two instruments to expand coverage to those at risk and reduce the cost of protection. We suggest six principles for designing catastrophic risk transfer systems, and describe how they may be put into practice. The paper concludes by raising a set of questions for future research. The unexpectedly large insured losses from Hurricane Andrew in the Miami, Florida area in 1992 ($15.5 billion) and the Northridge earthquake in California in 1994 ($13.5 billion) has forced the insurance industry to reevaluate whether it can provide coverage to all property in hazard-prone areas against catastrophic losses in the future. New institutions have been created such as windstorm pools in Florida and the California Earthquake Authority (CEA) to supplement or replace traditional reinsurance. At the same time the capital markets have developed new financial instruments such as Act-of God bonds to provide protection against these large losses from natural disasters. To date, these new instruments have only made a small dent in the market for protection against the financial consequences of catastrophic events, although there is the expectation by many that they will play a larger role in the future. Our approach is to examine whether the private market can offer ways to provide financial backing to deal with these risks. More specifically, the private market can provide hedges against catastrophic risks through catastrophe-linked securities, traditional excess-of-loss reinsurance and certain customized reinsurance coverage schemes. This paper has the following two objectives: (1) to examine how reinsurance coupled with new financial instruments can expand coverage to those residing in areas subject to catastrophic losses from natural disasters, and (2) to show how reinsurance and the new financial instruments can be combined so that the price of protection can be lowered from its current level. To address these two questions we begin our analysis by defining the key stakeholders and their concerns with respect to catastrophic risks. We then construct a simple example to illustrate the relative advantages and disadvantages of catastrophe-linked securities and reinsurance in supporting a structure of payments contingent on certain events occurring (e.g. a severe flood in Poland or a major hurricane in Florida). On the basis of this comparison we suggest ways to combine these two instruments to expand coverage to those at risk and reduce the cost of protection. We suggest six principles for designing catastrophic risk transfer systems, and describe how they may be put into practice. The paper concludes by raising a set of questions for future research.

Selling Less Information for More: Garbling with Benefits

The expected value of information in a standard portfolio investment problem with ex-post payment can increase when the information is garbled prior to its sale. Distorting the information helps to resolve the incentive problem decreasing the buyer’s default risk and thereby increasing the seller’s expected revenues

Risk Tolerance, Self-Interest, and Social Preferences

We use an experimental method to investigate whether systematic relationships exist across distinct aspects of individual preferences: risk aversion in monetary outcomes, altruism in a twoperson context, and social preferences in a larger group context. Individual preferences across these three contexts are measured, and there is no possibility for risk sharing, wealth effects, or updating expectations of the population choices. We find that social preferences are related to demographic variables, including years of education, gender, and age. Perhaps most importantly, self allocation in a two-person dictator game is related to social preferences in a group context. Participants who are more generous in a dictator game are more likely to vote against their selfinterest in a group decision-making task which we interpret to be expressions of social preferences