CATalytic Insurance: The Case of Natural Disasters

Why should developing countries buy expensive catastrophe (CAT) insurance? Abstracting from risk aversion or hedging motives, we find that insurance may have a catalytic role on external finance. Such effort is particularly strong in those low to middle income countries that face financial constraints when hit by a shock or in its anticipation. Insurance makes defaults less likely, thereby relaxing the country's borrowing constraint, and enhancing its access to capital markets. The presence of multilateral lenders that explicitly or implicitly provide inexpensive reconstruction funds in the aftermath of a natural disaster weakens but does not eliminate the demand for catalytic insurance.