RFS Advance Access originally published online on March 29, 2008
Review of Financial Studies 2009 22(3):959-993; doi:10.1093/rfs/hhn021
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Nondiversification Traps in Catastrophe Insurance Markets
Harvard University
University of California at Berkeley
University of California at Berkeley
Address correspondence to Rustam Ibragimov, Department of Economics, Harvard University, 1875 Cambridge St., Cambridge, MA 02138; telephone: 617-496-4795; fax: 617-495-7730; e-mail: ribragim{at}fas.harvard.edu.
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Abstract |
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We develop a model for markets for catastrophic risk. The model explains why insurance providers may choose not to offer insurance for catastrophic risks and not to participate in reinsurance markets, even though there is a large enough market capacity to reach full risk sharing through diversification in a reinsurance market. This is a "nondiversification trap." We show that nondiversification traps may arise when risk distributions have heavy left tails and insurance providers have limited liability. When they are present, there may be a coordination role for a centralized agency to ensure that risk sharing takes place.
We thank Greg Duffee, William Ellsworth, Christine Parlour, Jacob Sagi, Eric Talley, Gordon Woo, and participants at the NBER Insurance Project workshop for valuable comments. We also thank Steve Evans for help with one of the proofs. Finally, we thank the editor, Matthew Spiegel, and the referee, for valuable suggestions.