The Underinsurance of Catastrophe Risk: An Analysis of Supply Side Effects in the Catastrophe Bond Market

Abstract

Natural catastrophes are quickly becoming one of the biggest challenges facing the insurance industry and policymakers. The economic impact of even a single underinsured catastrophe event can be devastating, lasting far beyond the initial physical damage by crippling businesses and homeowners. Moreover, this problem is only expected to get worse in the future as catastrophe events become more frequent as a result of climate change, and more devastating as a result of increasing urbanization around the globe. Despite the extraordinary threat posed by catastrophe risk, we find that much of the world remains significantly underinsured in both absolute and relative terms. We further consider the causes of this phenomenon and investigate the potential of the catastrophe bond market for addressing underinsurance. We find that in contrast to traditional reinsurance markets, the catastrophe bond market does not suffer from the same supply side effects due to capital constraints, indicating the potential of catastrophe bonds to change the landscape of the catastrophe insurance industry and to help address the global underinsurance problem.