Customizing Reinsurance and Cat Bonds for Natural Hazard Risks

This paper has the following two objectives: to examine how reinsurance coupled with new financial instruments can expand coverage to those residing in areas subject to catastrophic losses from natural disasters, and to show how reinsurance and the catastrophe-linked financial instruments can be combined so that the price of protection can be lowered from its current level. To address these two questions we define the key stakeholders and their concerns with respect to catastrophic risks. We then construct a simple example to illustrate the relative advantages and disadvantages of catastrophe bonds and reinsurance in supporting a structure of payments contingent on certain events occurring (e.g. a severe flood in Poland or a major hurricane in Florida). On the basis of this comparison we suggest ways to combine these two instruments to expand coverage to those at risk and reduce the cost of protection. We suggest six principles for designing catastrophic risk transfer systems, and describe how they may be put into practice. The paper concludes by raising a set of questions for future research. The unexpectedly large insured losses from Hurricane Andrew in the Miami, Florida area in 1992 ($15.5 billion) and the Northridge earthquake in California in 1994 ($13.5 billion) has forced the insurance industry to reevaluate whether it can provide coverage to all property in hazard-prone areas against catastrophic losses in the future. New institutions have been created such as windstorm pools in Florida and the California Earthquake Authority (CEA) to supplement or replace traditional reinsurance. At the same time the capital markets have developed new financial instruments such as Act-of God bonds to provide protection against these large losses from natural disasters. To date, these new instruments have only made a small dent in the market for protection against the financial consequences of catastrophic events, although there is the expectation by many that they will play a larger role in the future. Our approach is to examine whether the private market can offer ways to provide financial backing to deal with these risks. More specifically, the private market can provide hedges against catastrophic risks through catastrophe-linked securities, traditional excess-of-loss reinsurance and certain customized reinsurance coverage schemes. This paper has the following two objectives: (1) to examine how reinsurance coupled with new financial instruments can expand coverage to those residing in areas subject to catastrophic losses from natural disasters, and (2) to show how reinsurance and the new financial instruments can be combined so that the price of protection can be lowered from its current level. To address these two questions we begin our analysis by defining the key stakeholders and their concerns with respect to catastrophic risks. We then construct a simple example to illustrate the relative advantages and disadvantages of catastrophe-linked securities and reinsurance in supporting a structure of payments contingent on certain events occurring (e.g. a severe flood in Poland or a major hurricane in Florida). On the basis of this comparison we suggest ways to combine these two instruments to expand coverage to those at risk and reduce the cost of protection. We suggest six principles for designing catastrophic risk transfer systems, and describe how they may be put into practice. The paper concludes by raising a set of questions for future research.

AN EXPERIMENTAL ANALYSIS OF CONDITIONAL COOPERATION

Experimental and empirical evidence identifies the existence of socialpreferences and proposes competing models of such preferences. In this paper, wefurther examine one such social preference: conditional cooperation. We run threeexperimental public goods games, the traditional voluntary contribution mechanism(VCM, also called the linear public goods game), the weak-link mechanism (WLM) andthe best-shot mechanism (BSM). We then analyze the existence and types ofconditional cooperation observed. We find that participants are responsive to the pastcontributions of others in all three games, but are most responsive to differentcontributions in each game: the median in the VCM, the minimum in the WLM and themaximum in the BSM. We conclude by discussing implications of these differences forbehavior in these three mechanisms. This paper thus refines our notions of conditionalcooperation to allow for different types of public good production functions and byextension, other contexts.experimental economics, conditional cooperation, public goods

Investment Decisions and Emissions Reductions : Results from Experiments in Emissions Trading

Emissions trading is an important regulatory tool in environmental policy making. Unfortunately the effectiveness of these regulations is difficult to measure in the field due to the unavailability of appropriate data. In contrast, experiments in the laboratory can provide guidance to regulators and legislatures about the performance of different market features in emission trading programs. This paper reports on the implementation of three different institutional designs, and presents experimental results investigating important features of emissions trading regimes: the ability to make investments in emissions abatement, ability to bank allowances and a declining emissions cap, both with and without uncertainty. These features are observed in virtually all existing air pollution emissions trading programs currently in place and will almost certainly be part of future applications. Like previous experimental studies of emissions trading, this paper shows that the efficiency gains expected from economic theory emerge observationally. We also show reduced efficiency when permits are bankable due to over-banking and when investments in emissions abatement are possible due to overinvesting. These tendencies do not worsen, however, when emissions caps decline.Emissions Trading, Investment in Abatement, Banking, Laboratory Experiments

Order Stability in Supply Chains: Coordination Risk and the Role of Coordination Stock

The bullwhip effect describes the tendency for the variance of orders in supply chains to increase as one moves upstream from consumer demand. We report on a set of laboratory experiments with a serial supply chain that tests behavioral causes of this phenomenon, in particular the possible influence of coordination risk. Coordination risk exists when individuals' decisions contribute to a collective outcome and the decision rules followed by each individual are not known with certainty, for example, where managers cannot be sure how their supply chain partners will behave. We conjecture that the existence of coordination risk may contribute to bullwhip behavior. We test this conjecture by controlling for environmental factors that lead to coordination risk and find these controls lead to a significant reduction in order oscillations and amplification. Next, we investigate a managerial intervention to reduce the bullwhip effect, inspired by our conjecture that coordination risk contributes to bullwhip behavior. Although the intervention, holding additional on-hand inventory, does not change the existence of coordination risk, it reduces order oscillation and amplification by providing a buffer against the endogenous risk of coordination failure. We conclude that the magnitude of the bullwhip can be mitigated, but that its behavioral causes appear robust.National Science Foundation (U.S.) (Grant SES-0214337)Mary Jean and Frank P. Smeal College of Business Administration (Center for Supply Chain Research)Sloan School of Management (Project on Innovation in Markets and Organizations

Interference and inequality in quantum decision theory

The quantum decision theory is examined in its simplest form of two-condition two-choice setting. A set of inequalities to be satisfied by any quantum conditional probability describing the decision process is derived. Experimental data indicating the breakdown of classical explanations are critically examined with quantum theory using the full set of quantum phases.Comment: LaTeX Elsevier format 10 pages, 6 figures, reference section expanded, 2nd (and final) versio

Risk, ambiguity and quantum decision theory

In the present article we use the quantum formalism to describe the effects of risk and ambiguity in decision theory. The main idea is that the probabilities in the classic theory of expected utility are estimated probabilities, and thus do not follow the classic laws of probability theory. In particular, we show that it is possible to use consistently the classic expected utility formula, where the probability associated to the events are computed with the equation of quantum interference. Thus we show that the correct utility of a lottery can be simply computed by adding to the classic expected utility a new corrective term, the uncertainty utility, directly connected with the quantum interference term.Comment: 1 figur

Local Residential Sorting and Public Goods Provision: A Classroom Demonstration

This classroom exercise illustrates the Tiebout (1956) hypothesis that residential sorting across multiple jurisdictions leads to a more efficient allocation of local public goods. The exercise places students with heterogeneous preferences over a public good into a single classroom community. A simple voting mechanism determines the level of public good provision in the community. Next the classroom is divided in two, and students may choose to move between the two smaller communities, sorting themselves according to their preferences for public goods. The exercise places a cost on movement at first, then allows for costless sorting. Students have the opportunity to observe how social welfare rises through successive rounds of the exercise, as sorting becomes more complete. One may also observe how immobile individuals can become worse off because of incomplete sorting when the Tiebout assumptions do not hold perfectly.classroom experiments, public goods, residential sorting, Tiebout hypothesis.