Post by Jinjing on Sept 30, 2013 1:37:36 GMT 4
Catastrophe Risk Transfer
Ajay Subramanian
Georgia State University
Jinjing Wang
Georgia State University - J. Mack Robinson College of Business
September 5, 2013
papers.ssrn.com/sol3/papers.cfm?abstract_id=2321415
Abstract:
We provide a novel explanation for the predominance of retention and reinsurance relative to securitization in the transfer of catastrophe risks using a signaling model. When an insurer has private information about its portfolio, its choice between reinsurance and securitization serves as a signal of the risk of its portfolio. The insurer's choice reflects the tradeoff between the lower adverse selection costs of reinsurance due to the superior monitoring resources of reinsurers against the costs arising from reinsurers' market power. We show that Perfect Bayesian Equilibria of the signaling game have a partition form where the lowest risk insurers choose reinsurance, intermediate risk insurers choose partial securitization, and high risk insurers choose full securitization. An increase in the size of potential losses increases the trigger level of risk above which insurers choose securitization. Consequently, catastrophe risks, which are broadly characterized by losses of large magnitudes, are only securitized by very high risk insurers, thereby leading to the relative predominance of capital retention and reinsurance in catastrophe risk transfer. Our results also explain why catastrophe bonds have high premia and their credit ratings are usually below investment grade.