Nondiversification Traps in Catastrophe Insurance Markets

Abstract

We develop a model for markets for catastrophic risk. The model explains why insurance providers may choose not to offer insurance for catastrophic risks and not to participate in reinsurance markets, even though there is a large enough market capacity to reach full risk sharing through diversification in a reinsurance market. This is a “nondiversification trap.” We show that nondiversification traps may arise when risk distributions have heavy left tails and insurance providers have limited liability. When they are present, there may be a coordination role for a centralized agency to ensure that risk sharing takes place.