Optimal insurance coverage of low probability-high severity risks

Alexis Louaas (1) , Pierre Picard (2)

1 X-DEP-ECO - Département d'Économie de l'École Polytechnique
2 X - École polytechnique

Catastrophic risks are often characterized by a low probability and a high severity. Taking these specificities into account, we analyze the intrinsic reasons for which catastrophic risks may be more or less insurable, independently from the market failures frequently observed in practice. On the demand side, we characterize individual preferences under which the willingness to pay for the coverage of large losses remains significant, although their occurrence probability is very small. On the supply side, the correlation between individual losses affects the insurance pricing through the insurers' cost of capital. Analyzing the interaction between demand and supply yields the key determinants of insurability and of a socially optimal risk sharing strategy.

Mots clés: Disaster insurance; catastrophic risk; risk aversion; capital costs

Domaines: Économie et finance quantitative [q-fin]; Sciences de l'Homme et Société; Economies et finances

Alexis Louaas, Pierre Picard. Optimal insurance coverage of low probability-high severity risks. 2018. ⟨hal-01924408⟩