The market for catastrophe risk: a clinical examination

Abstract

This paper examines the market for catastrophe event risk --i.e., financial claims that are linked to losses associated with natural hazards, such as hurricanes and earthquakes.This market is in transition as new approaches for transferring risk are being explored.The paper studies several recent transactions by USAA which use reinsurance capacity from capital markets, rather than only from reinsurers.We identify two puzzles concerning the cat protection purchased in these transactions: there is no coverage for the largest, most severe events; and premiums appear well above actuarial value.We demonstrate that both features deviate from what theory would predict, yet are characteristic of many transactions, not simply those of USAA.We then explore a number of possible explanations for the facts.The most compelling are combinations of capital market imperfections and market power on the part of reinsurers.Conclusions for broader capital market and risk management issues are discussed.