Why Have Exchange-Traded Catastrophe Instruments Failed to Displace Reinsurance?

Abstract

In spite of the fact that they can draw on a larger, more liquid and more diversified pool of capital than the equity of reinsurance companies, financial markets have failed to displace reinsurance as the primary risk-sharing vehicle for natural catastrophe risk. We show that this failure can be explained by differences in information gathering incentives between financial markets and reinsurance companies. Using a simple model of an insurance company that seeks to transfer a fraction of its risk exposure either through financial markets or through traditional reinsurance, we find that the supply of information by informed traders in financial markets may be excessive relative to its value for the insurance company, causing reinsurance to be preferred. We show that whether traditional reinsurance or financial markets are ultimately selected depends crucially on the information acquisition cost structure and on the degree of redundancy in the information produced. Limits on the ability of informed traders to profitably take advantage of their information make the use of financial markets more likely.

Keywords: Catastrophe risk, insurance, reinsurance, financial markets, private and public financing

JEL Classification: G22, G32