Market Imperfections and Catastrophe Insurance: Building the Case for Government Intervention

1. Market Imperfections and Catastrophe Insurance:Building the Case for Government Intervention Kenneth A. Froot Harvard University (c) Froot

2. Insurance Risk Sharing • Purpose of insurance is to share risk • How good is the sharing of pervasive event risks? • What could explain the lack of large event risk sharing? • What are the implications for intermediation? • Focus on reinsurance of large catastrophic risks from natural perils (e.g., hurricane, earthquake, freeze, fire, etc.) • Objective event probabilities estimated by modelers • Less scope for moral hazard and adverse selection (c) Froot

3. Historically Much Cat Risk is Retained • Insurerspurchasing catastrophe reinsurance protect mostly against small events • Many insurers purchase no reinsurance • Similar for cat covers of nonfinancial corporations • Not because insurance capital is so large (c) Froot

4. Percentage of US Cat Exposure Reinsured by Insurance Companies (c) Froot

5. Why So Little Risk Transfer? • In a perfect world • elasticity of supply and demand are high Demand = Supply price quantity (c) Froot

6. What distortions diminish risk transfer? Demand • Two types of explanations • 1. Supply of Insurance/Reinsurance capacity is low Supply price quantity (c) Froot

7. What distortions diminish risk transfer? Supply • Two types of explanations • 2. Demand for Insurance / Reinsurance capacity is low Demand price quantity (c) Froot

8. What distortions diminish risk transfer? • Supply is low (and prices high) because • 1. Reinsurance capital is not cheap • 2. Reinsurers have market power • 3. The private reinsurance production process is inefficient • 4. Moral hazard / adverse selection • Demand is low because • 5. Awareness is low (also, mitigation is low) • 6. Insurers are regulated, and regulation suppresses final price • 7. Ex-post subsidies expected from governments • 9. Behavioral factors make unlikely events seem irrelevant (c) Froot

9. Do these distortions diminish risk transfer? • Demand-driven distortions can’t be solved by direct government intervention in bulk risk financing • Can be improved by other forms of intervention • Increase penetration and mitigation • Ensure that regulation does not artificially suppress price • Note: requires more, not less, reliance on market mechanisms • Create commitment mechanisms making ex-post subsidies costly • Promote information release to overcome behavior biases (c) Froot

10. Do these distortions diminish risk transfer? • Supply-driven distortions are more complex • If the problem is • High private capital costs, • Then intervention may help • Market power, • Then regulate don’t produce • High costs of production, • Then no distortion to counteract • Adverse selection, • Then costs of government becoming informed (c) Froot

11. Choosing Among These • Some facts to help separate out competing explanations… (c) Froot

12. Reinsurance Price / Quantity Pairs (c) Froot

13. Price: Premium / Expected Loss : (c) Froot

14. The Impact of Unrelated Perils on Prices (c) Froot

15. Capital Supply Changes Help Explain Facts Demand Supply price quantity (c) Froot

16. Capital Supply Changes Help Explain Facts • Specifically, three corporate finance distortions interact • 1. Internal capital valuable because capital market imperfections make external finance costly. • 2. Internal capital valuable because product market imperfections make insureds ‘overpay’ for safer coverage • 3. Internal capital costly because agency costs and corporate taxation add a corporate cost of ‘carry’ • 1 and 2 push companies toward holding excess capital, 3 pushes toward reduced capital (c) Froot

17. In the absence of these distortions, corporate value increases 1-for-1 with capital Value with Perfect markets Value 0 Quantity of capital deployed (given risk underwritten) (c) Froot

18. With distortion 3, value increases less than 1-for-1 with capital Value Value of internal capital = Value of capital deployed less taxes and agency 0 Quantity of capital deployed (given risk underwritten) (c) Froot

19. Adding distortions 1 and 2, value increases strongly at low amounts of capital Value Value with agency, taxes, capital & product market imperfections 0 Quantity of capital deployed (given risk underwritten) (c) Froot

20. Some Implications of these Distortions • 1. Privately deployed insurance capital is always scarcer than under perfect markets (c) Froot

21. Some Implications of these Distortions • 2. There is an optimal amount of external capital to deploy; it minimizes distortions for given risks. (c) Froot

22. Some Implications of these Distortions • 3. An additional dollar has higher marginal value as internal capital rather than as external capital. Firms should treat internal capital as scarce. A marginal event loss has a greater impact on undercapitalized companies. (c) Froot

23. Some Implications of these Distortions • 4. Uncertainty in underwriting performance reduces insurer value, and does so by relatively more for less-well-capitalized firms. (c) Froot

24. Some evidence to support this • Event losses from September 11, 2001 had a more negative impact on the market value of more-poorly-rated insurance firms From Cummins and Lewis, 2002, “Catastrophic events, parameter uncertainty, and the breakdown of implicit long-term contracting in the insurance market (c) Froot

25. Some evidence to support this • Excess, risk-adjusted returns 1995-2001 on a panel of insurers are decreasing in the realized volatility of company earnings Controlling for company rating makes these results stronger (c) Froot

26. But Markets are Resilient: Marginal Reinsurance Coverage 8 Years After Hurricane Andrew : (c) Froot

27. Can Government Intervention Solve? • 3. Internal capital costly because agency costs and corporate taxation add a corporate cost of ‘carry’ • Tax policy can reduce corporate capital carry cost, but not agency-based carry costs. • Government financing is pay-as-you-go, eliminating capital carry. • 2. Internal capital valuable because product market imperfections make insureds ‘overpay’ for safer coverage • Little that government should do to interfere with private tastes. • 1. Internal capital valuable because capital market imperfections make external finance costly. • Some governments have lower credit risk than the best firms, potentially reducing deadweight costs of external finance. • Short-run costs of raising external capital are greater than long-run costs. (c) Froot

28. Intervention creates distortions as well • Dynamic inefficiencies • Market responses and adjustments in pricing and cover. • Experiment in US with terrorist protection. (c) Froot

29. Conclusions • There is both theory and evidence to suggest that financial and product market imperfections prevent the first-best provision of catastrophic protection. • Policies aimed at removing the distortions may be counterproductive (e.g., reducing tax-based carry costs) but should be explored. • Policies aimed at partially supplanting market finance (for the bulk of exposures) should focus primarily on temporary distortions (c) Froot