Why have exchange-traded catastrophe instruments failed to displace reinsurance?

Abstract

In spite of the fact that they can draw on a larger, more liquid and more diversiedpool of capital than the equity of reinsurance companies, nancial markets have failedto displace reinsurance as the primary risk-sharing vehicle for natural catastropherisk. We show that this failure can be explained by dierences in information gatheringincentives between nancial markets and reinsurance companies. Using a simple modelof an insurance company that seeks to transfer a fraction of its risk exposure eitherthrough nancial markets or through traditional reinsurance, we nd that the supplyof information by informed traders in nancial markets may be excessive relative to itsvalue for the insurance company, causing reinsurance to be preferred. We show thatwhether traditional reinsurance or nancial markets are ultimately selected dependscrucially on the information acquisition cost structure and on the degree of redundancyin the information produced. Limits on the ability of informed traders to protablytake advantage of their information make the use of nancial markets more likely.