Optimal insurance coverage of low probability-high severity risks
Alexis Louaas and
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Alexis Louaas: X-DEP-ECO - Département d'Économie de l'École Polytechnique - X - École polytechnique
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Catastrophic risks are often characterized by a low probability and a high severity. Taking these specificities into account, we analyze the intrinsic reasons for which catastrophic risks may be more or less insurable, independently from the market failures frequently observed in practice. On the demand side, we characterize individual preferences under which the willingness to pay for the coverage of large losses remains significant, although their occurrence probability is very small. On the supply side, the correlation between individual losses affects the insurance pricing through the insurers' cost of capital. Analyzing the interaction between demand and supply yields the key determinants of insurability and of a socially optimal risk sharing strategy.
Keywords: Disaster insurance; catastrophic risk; risk aversion; capital costs (search for similar items in EconPapers)
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