Insuring Against Natural Catastrophic Losses: The Policy Challenge

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Kent Smetters' presentation for

Roundtable - A National Framework for Natural Hazard Risk Reduction and Management: Developing a Research Agenda

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Insuring Against Natural Catastrophic Losses: The Policy Challenge

  1. 1. Insuring Against Natural Catastrophic Losses: The Policy Challenge Kent Smetters The Wharton School and NBER
  2. 2. Common Arguments for Intervention <ul><li>Future Losses are Difficult to Forecast </li></ul><ul><li>Large risks </li></ul><ul><li>Time Inconsistent Policies (“Samaritan’s Dilemma) </li></ul><ul><li>Externalities </li></ul><ul><li>Incomplete trading markets </li></ul>
  3. 3. This talk: A Contrarian View <ul><li>Mostly unfettered insurance and capital markets capable of insuring large losses </li></ul><ul><ul><li>Even 10 times the $40 billion Katrina loss </li></ul></ul><ul><li>$400 billion capital market loss is common (in fact, daily) in world capital markets (e.g., S&P500) </li></ul><ul><li>Markets routinely insure novel , large and correlated risks </li></ul>
  4. 4. But Current Insurance Market is Not Unfettered <ul><li>Any “failure” resides with gov’t policy. </li></ul><ul><li>Gov’t tax, accounting, and regulatory policies => costly for insurers to hold capital. </li></ul><ul><li>Also hindering securitizing underlying losses. </li></ul>
  5. 5. Future Losses Difficult to Forecast <ul><li>Argument: Hard for insurers to construct loss distributions </li></ul><ul><ul><li>I.e., “Structural breaks” each year </li></ul></ul><ul><li>Response: </li></ul><ul><ul><li>FWT: Doesn’t explain why gov’t can do better </li></ul></ul><ul><ul><li>Prevalence of Other Risky Markets </li></ul></ul>
  6. 6. Prevalence of Other Risky Markets <ul><li>Initial Public Offerings : </li></ul><ul><ul><li>Trillions of dollars in venture capital even w/o time series or close substitutes </li></ul></ul><ul><ul><li>Value of firms influenced by gov’t policies </li></ul></ul><ul><li>Earthquake Insurance </li></ul><ul><ul><li>Models still in their infancy </li></ul></ul><ul><ul><li>National Indemnity: $1.5 billion CEA reinsurance </li></ul></ul><ul><ul><li>Cat bonds issued for Midwest, Tokyo, elsewhere </li></ul></ul><ul><li>Commercial aircraft and satellites & Marine insurance both offered long before time series evidence became available </li></ul>
  7. 7. <ul><li>Court decisions lead to large, correlated, and unanticipated losses in liability markets, yet markets still quite vibrant even with some constraints </li></ul><ul><li>Ex. Environment liability : courts reinterpret “sudden and accidental” clauses </li></ul><ul><ul><li>Losses for hazardous waste sites and asbestos through just 1995 as high as $150 billion </li></ul></ul><ul><ul><li>Yet market still alive, although more restricted due to court decisions (absolute exclusions and EIL) </li></ul></ul>
  8. 8. <ul><li>Ex. Product liability : courts have effectively tossed out cost-benefit analysis as a defense </li></ul><ul><ul><li>Grimshaw v. Ford Motor Company , 1981 </li></ul></ul><ul><ul><li>Other court decisions as well </li></ul></ul><ul><ul><li>Create very unpredictable losses </li></ul></ul><ul><ul><li>Yet liability insurance is still vibrant </li></ul></ul><ul><ul><ul><li>Insured tort claims in the year 2001 alone amounted to $146.30 billion , not including: payments for medical malpractice; self-insured losses; “one time” tobacco settlements; punitive damages. </li></ul></ul></ul>
  9. 9. Large Risks <ul><li>Argument: Losses are large => correlated </li></ul><ul><li>Of course, other insured and capital market losses mentioned above are large and correlated </li></ul><ul><li>Cummins, Doherty and Lo (2002) estimate U.S. insurers could finance about 92.8 percent of a $100 billion catastrophic loss. </li></ul><ul><ul><li>This estimate was made before 9/11 and Katrina </li></ul></ul><ul><ul><li>Estimate would change after 9/11 and Katrina </li></ul></ul><ul><ul><ul><li>Ex. catastrophic insurance capacity doubled within 5 after Andrew </li></ul></ul></ul>
  10. 10. <ul><li>Government policy itself is the problem </li></ul><ul><li>Government Tax Policy Constrains Capital </li></ul><ul><ul><li>“ Triple tax” on reserves </li></ul></ul><ul><ul><li>Bermuda reserves severely limits investments </li></ul></ul><ul><ul><li>Could instead allow reinsurers to deduct expected catastrophic losses, as in some European nations, rather than just actual or highly predictable losses. </li></ul></ul>
  11. 11. <ul><li>Accounting Prevents Onshore Securitization </li></ul><ul><ul><li>NAIC’s Securitization Group, 1999, 2001 </li></ul></ul><ul><ul><li>No U.S. state outside IL has allowed an insurer to include a derivative instrument as a claim-amount recoverable asset on its balance sheet. </li></ul></ul><ul><ul><ul><li>Moreover, only securities with no basis risk allowed </li></ul></ul></ul><ul><ul><ul><li>NAIC cautious about basis risk; RAA intense lobbying </li></ul></ul></ul><ul><ul><li>Regulatory jurisdiction unclear w/ basis risk </li></ul></ul><ul><ul><ul><li>McCarran-Ferguson Act: insurance is state issue </li></ul></ul></ul><ul><ul><ul><li>Securities market: federal issue </li></ul></ul></ul><ul><ul><ul><li>Not clear what jurisdiction securities w/ basis risk fall into in light of Union Labor Life v. Pireno , 1982 </li></ul></ul></ul><ul><ul><li>Need to clear up these matters (maybe federalization) </li></ul></ul>
  12. 12. Time Inconsistent Policies <ul><li>Argument: Gov’t cannot credibly commit ex ante to not bailing out the non-insured. Hence, subsidized insurance encourages some freeriders to purchase it </li></ul><ul><ul><li>Similar argument used to rationalize NFIP </li></ul></ul><ul><ul><li>Of course, potentially requires large subsidy </li></ul></ul><ul><ul><ul><li>Otherwise, people will just hold out for freebie </li></ul></ul></ul><ul><ul><ul><li>NFIP loses about $800 million each year </li></ul></ul></ul>
  13. 13. <ul><li>Response: </li></ul><ul><li>Mandatory Coverage is More Efficient than Price Subsidies for Non-Diversifiable Risks (e.g., Mandatory Social Security programs) </li></ul><ul><ul><li>Political sensitive groups: farmers, small business owners and homeowners </li></ul></ul><ul><ul><li>Not worried about over-insurance </li></ul></ul><ul><li>No Policy is Probably Most Efficient for Diversifiable Risks </li></ul><ul><ul><li>Are worried about over-insurance (firms can already diversify through capital markets) </li></ul></ul>
  14. 14. Externalities <ul><li>Argument: People ignore third-party damages, thereby under-invest in safety </li></ul><ul><ul><li>Most important in concentrated areas subject to cat risk (e.g., high-rise buildings) </li></ul></ul><ul><li>Response: </li></ul><ul><ul><li>Argument assumes Coase Theorem fails (i.e., risk not capitalized in property values): testable </li></ul></ul><ul><ul><li>Even if Coase fails, you only need 3 rd party liability (torts) to achieve optimal solution </li></ul></ul>
  15. 15. Incomplete trading markets <ul><li>Argument: Incomplete trading exists b/t generations => cannot hedge large shocks inter-temporally. But the gov’t can do so with its taxation authority. </li></ul><ul><ul><li>Motivated by OLG, lifecycle model with non-negativity constraint on inter-generational transfers from parents to kids or inoperative reverse transfers from kids to parents </li></ul></ul><ul><ul><li>Not relevant in standard neoclassical (Ramsey) growth model (Ricardian Equivalence holds) </li></ul></ul>
  16. 16. <ul><li>Probably best argument thus far, but considerable care is needed </li></ul><ul><ul><li>Could do more harm than good </li></ul></ul><ul><li>Exact nature of shock is important </li></ul><ul><ul><li>If nat cat loss is like depreciation shock then it should be shared across many generations </li></ul></ul><ul><ul><ul><li>Output not permanently affected, only temporarily </li></ul></ul></ul><ul><ul><li>If nat cat loss more like a hit to total factor productivity, then gov’t intervention reduces efficiency. </li></ul></ul>
  17. 17. Summary <ul><li>Any “failure” resides with existing gov’t policy </li></ul><ul><li>Need to fix tax, accounting, and regulatory policies; also allow for more securitization </li></ul>

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