This paper examines possible barriers to securitization, focusing on behavioral responses to such novel instruments. These barriers include the difficulties of conveying the associated risks, even to investors who are sophisticated about finance (but still uncertain about model risk and structural uncertainties). Our analyses will draw on results in behavioral decision making and psychology. They will lead to proposals for empirical research and general strategies for making securities design more consonant with investor behavior.

Poor households with little or no wealth are particularly vulnerable to risks that reduce incomes and increase expenditures. This book addresses many of the risk-coping strategies for the rural poor, with a focus on micro level and household actions. Largely, these discussions concern risks that can be shared within a community or extended family. While effective for independent risks, these strategies are rather ineffective for covariate or systemic risks. This paper focuses on private and public mechanisms for managing such covariate risk for natural disasters. When many households within the same community face risks that create contemporaneous losses for all, the coping mechanisms discussed in other papers in this project are likely to fail. Such covariate risks are not uncommon in many developing countries, especially where farming remains a major source of income. The paper focuses on risks that are related to weather events (excess rain, droughts, freezes, high winds, etc.) that have a severe impact on rural incomes. Weather insurance could cover the covariate risk for a community of poor households through formal and informal risk-sharing arrangement among households that are purchasing these weather contracts. Given some recent Mexican innovations that are targeted at helping the poor cope with catastrophic weather events, we use Mexico as a case study to support some of our general concepts.

Dramatic events in the recent past have drawn attention to catastrophe risk management problems. The devastating terrorist attacks of September 11th, 2001 incurred the highest insured losses to date. Furthermore, a trend of increasing losses from natural catastrophes appears to be observable since the late 1980s. The increase in catastrophe losses triggered intensive discussion about risk management of catastrophic risk, focusing on three issues. First, considering the loss potential of certain catastrophic events, the insurance markets ’ capacity does not seem to be sufficient. An approach to address this capacity issue can be seen in passing certain catastrophic risks to investors via securitization. Second, after the events of September 11, 2001, the government’s role as a bearer of risk became an increasingly important issue. Finally, as has been recently demonstrated by the floods in Europe of August 2002, problems of protecting against catastrophic threats do not only exist on the supply side but also on the demand side. Thus policymakers are considering the establishment of mandatory insurance for fundamental risks such as flood and windstorm. This paper will address aspects of these three issues. In particular, we are concerned with the extent to which state or government involvement in the management of catastrophic risk is reasonable.