b. What does catastrophe risk present problems of liquidity? What can’t private insurers or reinsurers solve this by borrowing? claims are lumpy. large amounts of claims need to be paid at same time. cannotfund current losses with current premiums. reinsurance funds shortfall out of its own capital, but capital of reinsurance industry is only so large. can’t borrow to solve this issue because no one wants to lend to an institution introuble. catastrophes may not be independent risk so there is fear of another disaster occurring making the situation worse. also, reinsurers want to diversify their risk, may not relend to same company again.
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losses are nothing most of the time or huge – lumpy. need large reserve all the time or borrowing when you need it. why doesn’t that work here? everything is uncertain, don’t know exact loss immediately, people unwilling to lend you money, also how would you even pay it back? by raising premiums but this wouldn’t work bc raising premiums for customers would piss them off especiallyfor the customers who were not involved in the risk or loss. and this is a competitive market!c. What are the alternative methods of handling the risk? Discuss their advantages and disadvantages.catastrophe derivatives = market for futures, options and swaps. oadv. = market all about risk and huge amount of capital (more than reinsurers) to absorb risk. Disadv. = attempts have not been successfulcatastrophe bonds = sell bonds and then invest proceeds (and premiums collected) in treasuries, which provide collateral. premiums are also invested so bonds pay substantially more than treasury rate. oadv. = same as above: huge market in trillions of dollars so even a multibillion dollar loss is just a drop. oDisadv. = volume of cat bonds still small, bondholders face risk that debt owed them will be cancelled obond and derivative market: they’re HUGE so the amount of a loss in these markets is like a medium bad day – not a big deal.Government programs = disaster relief: takes form of subsidized loans or grantsfor rebuilding. national risk pooling via tax system. oAdv. = allows for pooling, enormous adv. over private reinsurers in dealingw liquidity program created by large catastrophe losses bc does not need to set aside expensive equity capital to cover potential loss – can simply borrow as needed and pay off debt w future tax revenueoDisadv. = moral hazard bc people buy less insurance and invest less in reduction measures bc they know help will come and it is free d. Should catastrophe insurance be compulsory? Is there a moral hazard problem? moral hazard problem if disaster relief is a guarantee. moral hazard problem with regulate catastrophe insurance, although could be reduced through copaysand deductibles.
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