The Intermediation of Financial Risks: Evolution in the Catastrophe Reinsurance Market

Each time a major and costly catastrophic peril occurs, a chorus arises from within the insurance community and beyond. The critics claim that the reinsurance market is inadequate, even dysfunctional, in cheaply redistributing risks. They cite frustration with the high prices and limited availability of capacity that follows the catastrophe, with the limited choice of sometimes-questionable credit risks, etc. Yet, in spite of these problems, the reinsurance market continues on. It doesn’t appear to have been extinguished or even hindered by the unwillingness of insurers to cede their risks. Nevertheless, insurers rightlywish to knowwhyit should be so expensive andrare to find reinsurers who arewilling to take on extreme catastrophic risks.After all, natural perils are both objectively modelable and unsystematic in their occurrences–qualities that, if anything, should make it relatively more attractive to supply reinsurance capital. Most recently, in the aftermath ofHurricane Katrina, the market has continued to show signs of trouble in providing capital cheaply and quickly. Why, with all the last decade’s improvements infinancial intermediation and risk sharing, aren’t things easier? At times of excess demand, onewould think there is an opportunity to add to reinsurance supply. A badly needed product that sells at prices well above the cost of production should be supplied aggressively. This conundrum of short supply combined with high prices makes the topic of financing catastrophes a fertile one for academics and practitioners alike. In this article, I provide evidence concerning the imperfections in the reinsurance market. I try to get at some of the root causes of these imperfections—e.g., the behavior of ratings firms and the agency problems associated with the corporate form of ownership. I also summarize the recent evolution of intermediation for catastrophic risk. A simple frameworkfor anintegrated theory of optimal financial policy for insurersandreinsurers is discussed. Finally, policy implications for intermediation of financial risks in view of evolving financial solutions for catastrophic risk are proposed.