Abstract
People tend to express strong dislike for default risk in their insurance coverage. Survey participants demand premium reductions of over 20% for a 1% risk of default.
In this paper we suggest that a similar dynamic is also evident in insurers’ reinsurance purchases. Insurers are willing to pay significantly more for catastrophe (Cat) bond protection where the risk of default is minimal compared to traditional reinsurance coverage. The risk of default in traditional reinsurance coverage is generally quite small (ie much less than 1%) but it is still sufficient to make Cat bonds appealing due to the reduction in default risk. This behaviour is explained by the weighting function of prospect theory.
Volume
Winter
Year
2023
Description
People tend to express strong dislike for default risk in their insurance coverage. Survey participants demand premium reductions of over 20% for a 1% risk of default.
In this paper we suggest that a similar dynamic is also evident in insurers’ reinsurance purchases. Insurers are willing to pay significantly more for catastrophe (Cat) bond protection where the risk of default is minimal compared to traditional reinsurance coverage. The risk of default in traditional reinsurance coverage is generally quite small (ie much less than 1%) but it is still sufficient to make Cat bonds appealing due to the reduction in default risk. This behaviour is explained by the weighting function of prospect theory.
In this paper we suggest that a similar dynamic is also evident in insurers’ reinsurance purchases. Insurers are willing to pay significantly more for catastrophe (Cat) bond protection where the risk of default is minimal compared to traditional reinsurance coverage. The risk of default in traditional reinsurance coverage is generally quite small (ie much less than 1%) but it is still sufficient to make Cat bonds appealing due to the reduction in default risk. This behaviour is explained by the weighting function of prospect theory.
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