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Catastrophic Climate Risk and The Limits of Private Markets

Adam Solomon, Assistant Professor at the NYU Stern Department of Finance Increasing climate risk is making property insurance unaffordable and unavailable, revealing frictions in the reinsurance and catastrophe bond markets designed to absorb such tail events. I study a novel policy response in Australian home insurance: government-provided, mandatory, risk-based reinsurance for cyclone damage. In this program, the government reinsures the cyclone risk, while the private market covers the remaining idiosyncratic risk. I find that public reinsurance leads to a 21 percent decrease in home insurance premiums and an 11 percent increase in the probability of insurance being offered at all. I demonstrate these effects are not a subsidy; the benefits stem from eliminating large, pre-existing markups in private reinsurance and catastrophe bond markets and flow to the insurers most constrained by them. The primary driver of this markup reduction is the neutralization of the high premium for spatially-correlated risk, with increased competition leading to additional indirect benefits. This shows that insurance dysfunction is downstream from the frictions in tail-risk reinsurance, and targeted, cost-neutral, interventions in the latter can improve the former.