On The Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance / Kenneth A. Froot, Paul G. J. O'Connell.

Format:

Book

Author/Creator:

Froot, Kenneth A.

Contributor:

National Bureau of Economic Research.

O'Connell, Paul G. J.

Series:

Working Paper Series (National Bureau of Economic Research) no. w6011.

NBER working paper series no. w6011

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Other Title:

On The Pricing of Intermediated Risks

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1997.

Summary:

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.

Notes:

Print version record

April 1997.