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

Authors


  • The authors can be contacted via e-mail: dlakdawa@sppd.usc.edu and gzanjani@gsu.edu, respectively. Lakdawalla thanks the RAND Corporation’s Center for Terrorism Risk Management and Policy for their financial support. The views expressed in this article are those of the authors, and do not necessarily reflect the views of the Federal Reserve Bank of New York, the Federal Reserve System, the RAND Corporation, Georgia State University, the University of Southern California, or the RAND Center for Terrorism Risk Management and Policy. We thank Robert Craig, Ken Garbade, Robert M. Hall, Thomas Holzheu, Stewart C. Myers, Daniel Pu Liu, Kjell Sumegi, and seminar participants at the 2006 NBER Insurance Project Workshop, the University of Illinois, Georgia State University, the University of Wisconsin, the University of South Carolina, the 2006 Risk Theory Seminar, the 2007 Infiniti Conference, and the 2007 EFMA Annual Meeting for helpful comments and discussions. We thank Michael Suher for research assistance.

Abstract

Catastrophe bonds feature full collateralization of the underlying risk transfer and thus abandon the reinsurance principle of economizing on collateral through diversification of risk transfer. Our analysis demonstrates that this feature places limits on catastrophe bond penetration, even if the structure possesses frictional cost advantages over reinsurance. However, we also show that catastrophe bonds have important uses when buyers and reinsurers cannot contract 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, segregation of collateral—in the form of multiple reinsurance companies, as well as catastrophe bond vehicles—can ameliorate inefficiencies due to reinsurance contracting constraints by improving welfare for those exposed to default risk. Numerical simulation illustrates how catastrophe bonds improve efficiency in market niches with correlated risks, or with uneven exposure of buyers to reinsurer default.

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