The Financing of Catastrophe Risk (National Bureau of by Kenneth A. Froot

By Kenneth A. Froot

Is it attainable that the coverage and reinsurance industries can't deal with an incredible disaster? Ten years in the past, the thought that the final expense of a unmarried catastrophic occasion may perhaps exceed $10 billion used to be unthinkable. With ever expanding property-casualty dangers and unabated development in hazard-prone parts, insurers and reinsurers now envision the opportunity of catastrophe losses of $50 to $100 billion within the United States.Against this backdrop, the capitalization of the assurance and reinsurance industries has turn into an important difficulty. whereas it continues to be not going unmarried occasion may perhaps completely bankrupt those industries, an immense disaster may possibly position organizations less than critical rigidity, jeopardizing either coverage holders and traders and inflicting profound ripple results during the U.S. economy.The Financing of disaster possibility assembles a powerful roster of specialists from academia and to discover the nerve-racking but practical assumption that a huge catastrophic occasion is inevitable. The essays supply tangible technique of either reassessing and elevating the extent of preparedness during the coverage and reinsurance industries.

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The theoretical incentives for corporate risk management fall into three broad categories: reducing the cost of financial distress, reducing agency costs, and tax Anne Gron is assistant professor of management and strategy at the J. L. Kellogg Graduate School of Management, Northwestern University. The author thanks Anne Beatty, David Govrin, Nicholas Polson, and Raghu Rajan for helpful comments, suggestions, and advice as well as conference participants. , and the Wharton Financial Institutions Center generously provided access to data and additional information.

A rating of A+ or A+ is rated as “superior,” while a rating of C or C- is “marginal” and a rating of D “below minimum standards” (BestS Key Rating Guide, 1993). I expect insurers with greater leverage and lower financial ratings to have a higher probability of financial distress. Insurer size, measured as net assets, is likely to be associated with a lower probability of financial distress, all else being equal, because the insurer has a greater ability to sustain a large loss. The liquidity measure is the percentage of assets held in liquid funds (the sum of short-term investments and cash on hand divided by net assets).

As demonstrated in Gron (1994a, 1994b) and Winter (1988, 1994), these types of capital market imperfections are associated with increases in industry profitability following large industry losses. Firms with greater leverage and lower liquidity are likely to have greater costs of financial distress. Risk-averse individuals with large, undiversified stakes in a corporation will benefit from corporate risk management (Mayers and Smith 1982; Smith and Stulz 1985; Mayers and Smith 1990). This includes managers as well as owners when ownership is concentrated.

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