Coping with Catastrophic Risk: The Role of (Non)-Participating Contracts

This paper examines how the two fundamental principles in risk allocation, i.e., the mutuality principle and the transfer principle, can be implemented in order to manage efficiently catastrophic risk. From a decomposition of the insurable loss into idiosyncratic and systemic components, we show that the systemic risk is first filtered through a participating policy with a variable premium based on the realized systemic loss, and then it is transferred through an insurance contract providing a coverage on the variable premium. This model is reconsidered to examine the financing of catastrophe risk with alternative risk transfer solutions. Group captives, offering participating policies, are shown to be market enhancing.