On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance

Kenneth Froot and Paul G.J. O'Connell

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be "high" in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price. We develop tests of this alternative against the null that the supply of intermediary capital is perfectly elastic. We take the US catastrophe reinsurance market as an example, using detailed data from Guy Carpenter & Co., covering a large fraction of the catastrophe risks exchanged during 1970-94. Our results suggest that the price of reinsurance generally exceeds "fair" values, particularly in the aftermath of large events, that market power of reinsurers is not a complete explanation for such pricing, and that reinsurers' high costs of capital appear to play an important role.

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Related works:
Journal Article: On the pricing of intermediated risks: Theory and application to catastrophe reinsurance (2008)
Working Paper: On The Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance (1997)
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