On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance

35 Pages Posted: 23 Sep 1997

See all articles by Kenneth Froot

Kenneth Froot

Harvard University Graduate School of Business; National Bureau of Economic Research (NBER)

Paul G.J. O'Connell

FDO Partners, LLC

Multiple version iconThere are 2 versions of this paper

Date Written: April 1997

Abstract

We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be ?high? in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price. We develop tests of this alternative against the null that the supply of intermediary capital is perfectly elastic. We take the US catastrophe reinsurance market as an example, using detailed data from Guy Carpenter & Co., covering a large fraction of the catastrophe risks exchanged during 1970-94. Our results suggest that the price of reinsurance generally exceeds ?fair? values, particularly in the aftermath of large events, that market power of reinsurers is not a complete explanation for such pricing, and that reinsurers' high costs of capital appear to play an important role.

JEL Classification: G22

Suggested Citation

Froot, Kenneth and O'Connell, Paul G.J., On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance (April 1997). Available at SSRN: https://ssrn.com/abstract=51681 or http://dx.doi.org/10.2139/ssrn.51681

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