Prospect Theory and the Appeal of Catastrophe Bonds

People tend to express strong dislike for default risk in their insurance coverage. Survey participants demand premium reductions of over 20% for a 1% risk of default. We suggest that a similar dynamic is evident in insurers’ reinsurance purchases. Insurers are willing to pay significantly more for catastrophe (Cat) bond protection where the risk of default is minimal. The risk of default in traditional reinsurance coverage is generally small (much less than 1%) but it is sufficient to make Cat bonds appealing due their reducing this risk. This behavior is explained by the weighting function of prospect theory. Address for Correspondence: shayansen@hotmail.com