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

40 Pages Posted: 7 Dec 2006 Last revised: 27 Oct 2022

See all articles by Darius N. Lakdawalla

Darius N. Lakdawalla

University of Southern California - Schaeffer Center for Health Policy and Economics; RAND Corporation; National Bureau of Economic Research (NBER)

George H. Zanjani

University of Alabama - Department of Economics, Finance and Legal Studies

Date Written: December 2006

Abstract

Catastrophe bonds feature full collateralization of the underlying risk transfer, and thus abandon the insurance principle of economizing on collateral through diversification. We examine the theoretical foundations beneath this paradox, finding that fully collateralized instruments have important uses in a risk transfer market when insurers cannot contract completely 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, insureds have different levels of exposure to an insurer's default. When contracting constraints limit the insurer's ability to smooth out such differences, catastrophe bonds can be used to deliver coverage to those most exposed to default. We demonstrate how catastrophe bonds can improve welfare in this way by mitigating differences in default exposure, which arise with: (1) contractual incompleteness, and (2) heterogeneity among insureds, which undermines the efficiency of the mechanical pro rata division of assets that takes place in the event of insurer insolvency.

Suggested Citation

Lakdawalla, Darius N. and Zanjani, George H., Catastrophe Bonds, Reinsurance, and the Optimal Collateralization of Risk-Transfer (December 2006). NBER Working Paper No. w12742, Available at SSRN: https://ssrn.com/abstract=948655

Darius N. Lakdawalla (Contact Author)

University of Southern California - Schaeffer Center for Health Policy and Economics ( email )

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RAND Corporation ( email )

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National Bureau of Economic Research (NBER)

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George H. Zanjani

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

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Tuscaloosa, AL 35487
United States

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