Universities-Research Conference on Insurance Markets and Catastrophe Risk

May 11-12, 2012
Kenneth Froot of Harvard Business School and Howard Kunreuther and Erwann Michel-Kerjan of the University of Pennsylvania's Wharton School, Organizers

Dwight Jaffee, University of California at Berkeley, and Thomas Russell, Santa Clara University

The Welfare Economics of Catastrophic Loss

Jaffee and Russell analyze the welfare implications for private sector and federal government responses to catastrophic events, including post-disaster government aid, insurance, and mitigation activities. Recent papers have considered how the government's large and expanding post-disaster aid, for events such as the 9/11 attacks and Katrina, can be constrained given the overall fiscal crisis facing the country. This paper looks instead at the fundamental principles of welfare economics under uncertainty and applies them to the design of public and private catastrophe loss programs. The analysis focuses on the distinction between ex ante and ex post welfare criteria, as well as on issues of incentives such as may arise from the Samaritan's dilemma. The authors conclude that an ex post criteria of welfare evaluation provides a role for disaster relief and mandatory insurance that has not been systematically integrated into the discussions involving disaster aid, insurance, and mitigation.

Antony Millner, University of California at Berkeley

On Welfare Frameworks and Catastrophic Climate Risks

Recent theoretical work in the economics of climate change has suggested that climate policy is highly sensitive to 'fat-tailed' risks of catastrophic outcomes (Weitzman, 2009b). Such risks are suggested to be an inevitable consequence of scientific uncertainty about the effects of increased greenhouse gas concentrations on climate. Criticisms of this controversial result fall into three categories: The first suggests it may be irrelevant to cost-benefit analysis of climate policy; the second challenges the fat-tails assumption; and the third questions the behavior of the utility function assumed in the result. Millner analyzes these critiques and suggests that those in the first two categories have formal validity, but apply only to the restricted setup of the original result, which may be extended to address their concerns. Thus they are ultimately unconvincing. Critiques in the third category are robust, however they open up new ethical and empirical challenges for climate economics that previously have been neglected, such as: how should we 'value' catastrophes as a society? Millner demonstrates that applying results from social choice to this problem can lead to counter-intuitive results, in which society values catastrophes as infinitely bad, even though each individual's utility function is bounded. Finally, he suggests that the welfare functions traditionally used in climate economics are ill-equipped to deal with climate catastrophes in which population size changes. Drawing on recent work in population ethics, he proposes an alternative welfare framework with normatively desirable properties, which has the effect of dampening the contribution of catastrophes to welfare.

Emek Basker, University of Missouri, and Javier Miranda, Bureau of the Census

Taken by Storm: Business Survival in the Aftermath of Hurricane Katrina

Basker and Miranda use the damage caused by the 2005 hurricane season in Louisiana and Mississippi as a natural experiment to study business survival in the aftermath of a cost shock. Their analysis uses establishment-level data on business activity in the retail, restaurant, and hotel sectors from the Census Bureau's Longitudinal Business Database (LBD) and Economic Census, combined with geo-spatial damage maps from the Federal Emergency Management Agency (FEMA) documenting the exact location of damaged structures by hurricanes Katrina and Rita. Difference-in-difference and triple-difference regressions reveal that, even after controlling for establishment-level productivity and inherent differences in survival rates between small and large firms, establishments in large chains were more likely to recover from catastrophic structural damage. Among establishments that belong to smaller firms, those located closer to banks were more likely to recover.

Tatyana Deryugina, University of Illinois at Urbana-Champaign

The Role of Transfer Payments in Mitigating Shocks: Evidence from the Impact of Hurricanes

Little is known empirically about how aggregate economic shocks are mitigated by social safety nets. Deryugina examines the effect of hurricanes on U.S. counties. While she finds no significant changes in population, earnings, and the employment rate within ten years after landfall, there is a substantial increase in non-disaster government transfers. An affected county receives additional non-disaster government transfers totaling $654 per capita, which suggests that the lack of changes in basic economic indicators may be in part due to existing social safety nets. The fiscal costs of natural disasters are also much larger than the cost of disaster aid alone.

Jing Cai, University of California at Berkeley

Social Networks and the Decision to Insure: Evidence from Randomized Experiments in China

Using data from a two-year randomized experiment in rural China, Cai studies the influence of social networks on the decision to adopt a new weather insurance product and the mechanisms through which social networks operate. Cai provided financial education to a random subset of farmers in the first year of the experiment and found a large social network effect on insurance take-up: for farmers without the information, having an additional friend receiving financial education raises take-up by almost half as much as obtaining financial education directly. That is a spillover effect equal to offering a 12 percent reduction in the average insurance premium. By varying the information available to subjects about their peers' take-up decisions and using randomized default options, Cai shows that the positive social network effect is not driven by scale effects, imitation, or informal risk-sharing, but instead by the diffusion of insurance knowledge. One year later, social networks continue to affect insurance demand: observing an above-median share of friends receiving payouts increases insurance take-up at a rate equivalent to about 50 percent of the impact of receiving payouts directly. Cai also find that social network effects are larger in villages where households are more strongly connected, and when the people who receive financial education first are more central in the social network.

Shawn A. Cole, Harvard University; Xavier Giné, The World Bank; and James Vickery, Federal Reserve Bank of New York

How Does Risk Management Influence Production Decisions? Evidence from a Field Experiment

Rainfall variability is an important source of risk in much of the developing world. Cole, Giné, and Vickery test whether the provision of insurance against this risk affects investment and production decisions by small- and medium-scale farmers. Their empirical strategy involves randomized provision of rainfall insurance among a sample of landowner farmers in a semi-arid area of India. While they find little effect on total expenditures, the increased insurance induces farmers to substitute production activities towards high-return but higher-risk cash crops, consistent with theoretical predictions. These results support the view that financial innovation may help ameliorate costs associated with weather variability and other types of risk.

Raghav Gaiha, University of Delhi; Kenneth Hill, Harvard University; and Ganesh Thapa, International Fund for Agricultural Development

Have Natural Disasters Become Deadlier?

Gaiha, Hill, and Thapa seek to build on earlier work by identifying the factors associated with the frequency of natural disasters and the resulting mortality. They find that countries that were prone to natural disasters in the previous decade (1970-9) continued to be so in the next two decades. Geophysical factors (for example, whether landlocked, distance to coast) were important in explaining inter-country variation in the occurrence of natural disasters, but income had no effect. Deaths varied with the number of disasters and with (lagged) deaths in the previous decade, pointing to (presumably) persistent government failures in preventing deaths where the deaths were high. Poor countries suffered more deaths; larger countries suffered more deaths. Even moderate learning can save a large number of deaths (through early warning systems, better coordination between governments and communities likely to be affected, and the like). Also, faster growth would help to avert deaths, providing more resources for disaster prevention and mitigation capabilities. A combination of learning from past experience and more resources for disaster prevention and mitigation would result in a massive reduction in deaths from disasters. A challenge for development assistance is to combine growth acceleration with speedy relief and durable reduction in vulnerability to natural disasters.

Enrico Biffis, Imperial College Business School, and Pietro Millossovich, Cass Business School

Optimal Insurance with Counterparty Default Risk

Biffis and Millossovich study the design of optimal insurance contracts when the insurer can default on its obligations. In their model, default arises endogenously from the interaction of the insurance premium, the indemnity schedule, and the insurer's assets. This allows them to understand the joint effect of insolvency risk and background risk on optimal contracts. The results may shed light on the aggregate risk retention schedules observed in catastrophe reinsurance markets, and can assist in the design of (re)insurance programs and guarantee funds.

Bartosz Mackowiak, European Central Bank, and Mirko Wiederholt, Northwestern University

Inattention to Rare Events

Why were people so unprepared for the global financial crisis, the European debt crisis, and the Fukushima nuclear accident? To address this question, Mackowiak and Wiederholt study a model in which agents make state-contingent plans — think about actions in different contingencies - subject to the constraint that agents can process only a limited amount of information. The model predicts that agents are unprepared in a state when the state has a low probability, when the optimal action in that state is uncorrelated with the optimal action in normal times, and when actions are strategic complements. The authors compare the equilibrium allocation of attention to the efficient allocation of attention, and characterize analytically the conditions under which society would be better off if agents thought more carefully about optimal actions in rare events.

Barry Goodwin, North Carolina State University

Copula-Based Models of Systemic Risk in U.S. Agriculture: Implications for Crop Insurance and Reinsurance Contracts

The federal crop insurance program has been a major fixture of U.S. agricultural policy since the 1930s. The program continues to grow in size and prominence and now represents the most prominent farm policy instrument, accounting for more government spending than any other farm commodity program. In 2011, over $114 billion in crop value was insured under the program. Crop revenue insurance, first introduced in the 1990s, now accounts for nearly 70 percent of the total liability in the program. The plans cover losses that result from a revenue shortfall that can be triggered by multiple, dependent sources of risk-either low prices, low yields, or a combination of both. The actuarial practices currently applied in rating these plans essentially involve the application of a Gaussian copula model to the pricing of dependent risks. Goodwin evaluates the suitability of this assumption by considering a number of alternative copula models, including a relatively new innovation in copula modeling—the vine copula. This approach uses combinations of pair–wise copulas of conditional distributions to model multiple sources of risk. He finds that this approach is generally preferred by model fitting criteria in the applications considered here. He demonstrates that alternative approaches to modeling dependencies in a portfolio of risks may have significant implications for the pricing of such risks.

Charles Huyck, ImageCat, Inc., and Adam Rose, University of Southern California

Improving Catastrophe Modeling for Business Interruption Insurance Needs

While CAT modeling of property damage is well developed, CAT modeling of business interruption (BI) is still in a relative state of infancy. One reason is the complication of behavioral and recovery policy decisions relating to resilience during the recovery process. Another is the crude nature of functional relationships that translate property damage into BI. Huyck and Rose propose a framework for improving the estimation of ordinary and contingent BI. Improved data collection on individual facilities within a company, and application of more detailed and realistic resilience adjustments, can improve estimation accuracy. They then illustrate the difference that this can make in a case study example. They also explain how some macroeconomic modeling approaches are best suited to estimating contingent BI because they can model critical aspects such as supply chain and infrastructure interdependence, as well as the ability to estimate the economic decline following a disaster that affects the demand for goods and services.

S. Erik Oppers, Ken Chikada, Patrick A. Imam, and John Kiff, International Monetary Fund, and Michael Kisser, Norwegian School of Economics

The Financial Impact of Longevity Risk

Oppers, Chikada, Imam, Kiff, and Kisser present estimates that suggest that if everyone lives three years longer than now expected—the average underestimation of longevity in the past—the present discounted value of the additional living expenses of everyone during those additional years of life amounts to between 25 and 50 percent of 2010 GDP. On a global scale, that increase amounts to tens of trillions of U.S. dollars, boosting the already recognized costs of aging substantially. Threats to financial stability from longevity risk derive from at least two major sources. One is the threat to fiscal sustainability as a result of large longevity exposures of governments, which, if realized, could push up debt-to-GDP ratios more than 50 percentage points in some countries. A second factor is possible threats to the solvency of private financial and corporate institutions exposed to longevity risk; for example, corporate pension plans in the United States could see their liabilities rise by some 9 percent, a shortfall that would require many multiples of typical yearly contributions to address. Longevity risk threatens to undermine fiscal sustainability in the coming years and decades, complicating the longer-term consolidation efforts in response to the current fiscal difficulties. Much of the risk borne by governments (that is, current and future taxpayers) is through public pension plans, social security schemes, and the threat that private pension plans and individuals will have insufficient resources to provide for unexpectedly lengthy retirements. Most private pension systems in the advanced economies are currently underfunded and longevity risk alongside low interest rates further threatens their financial health. To address longevity risk, certain measures could be taken : 1) acknowledging government exposure to longevity risk and implementing measures to ensure that it does not threaten medium- and long-term fiscal sustainability; 2) risk sharing between governments, private pension providers, and individuals, partly through increased individual financial buffers for retirement, pension system reform, and sustainable old-age safety nets; and 3) transferring longevity risk in capital markets to those that can better bear it. An important part of any reform would be to link retirement ages to advances in longevity.

Thomas R. Berry-Stoelzle, University of Georgia; Greg Nini, University of Pennsylvania; and Sabine Wende, University of Cologne

External Financing in the Life Insurance Industry: Evidence from the Financial Crisis

The financial crisis and subsequent recession generated sizable operating losses for life insurance companies, yet the consequences were far less significant than for other financial intermediaries. The ability to quickly generate new capital through external issuance and dividend reductions let life insurers maintain healthy levels of equity capital. Berry-Stoelzle, Nini, and Wende use this experience to examine the causes and consequences of external capital issuance by U.S. life insurance companies. They show that, in general, new capital is issued both to support the growth of new business and to replace capital depleted by operating losses. This second channel is particularly important during macroeconomic recessions. Notably, they do not find any evidence that insurers had difficulty generating new capital, unlike other financial service providers that required large amounts of public support. For life insurers, what changed following the financial crisis was the demand to raise external capital; but the supply of external capital appears to have remained constant.

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