Financial Markets and Financial Intermediaries: The Case of Catastrophe Insurance *

The purpose of this paper is to examine the role of capital markets in restoring the operation of a private market in catastrophe insurance. The paper develops a model of insurance markets in which risks are correlated at a point in time and discusses the role of capital markets in that framework. Traditional capital market instruments (debt, equity, and contingent loans) are shown to be imperfect in meeting the needs of the catastrophe insurance industry. Newly designed instruments such as catastrophe bonds and catastrophe options, however, are shown to have many desirable features which could in principle permit the reestablishment of a private catastrophe insurance market. Revised version as of January 15, 1999 Paper prepared for the NBER Insurance Conference, February 12 and 13, 1999. * The authors would like to thank Howard Kunreuther for valuable comments on an earlier version of this paper. 1.