Climate Risk and Optimal Reinsurance: A Theoretical Analysis

This paper develops a dynamic model of the insurer’s optimal reinsurance and asset allocation with climate risk. The insurer exhibits constant relative risk aversion utility preference and allocates her wealth between one riskless bond and one risky stock in the financial market with constant investment opportunities, along with an optimal decision on a proportion of insurance claims for reinsurance. We demonstrate that merely considering a random occurrence of climate disasters does not directly affect the insurer’s optimal decisions. Stochastic variations of the effects of climate risk turn out to be crucial for the insurer to make optimal adjustments in reinsurance and portfolio choice in response to climate risk. We also show that in the presence of climate risk, misestimating the correlation between insurance claims and stock market returns can be very costly to the insurer by taking suboptimal policies.