#08-02
Why Have Exchange-Traded Catastrophe Instruments Failed to Displace Reinsurance?
Rajna Gibson, Michel A. Habib and Alexandre Ziegler
Abstract: Financial markets can draw on a larger, more liquid, and more diversified pool
of capital than the equity of reinsurance companies, yet they have failed to displace
reinsurance as the primary risk-sharing vehicle for natural catastrophe risk. We show
that such 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 through financial markets or 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. Whether traditional reinsurance
or financial markets dominate depends on the information acquisition cost
structure and on the degree of redundancy in the information produced. Limits on
the ability of informed traders to 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 classifications: G22, G32
