NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Insurance

February 28 - March 1, 2014
Liran Einav, Stanford University, and Kenneth Froot, Harvard University, Organizers

Justin Gallagher, Case Western University, and Daniel Hartley, Federal Reserve Bank of Cleveland

Underwater? Household Finance and Migration Decisions after a Flood: The Case of Hurricane Katrina

Hurricane Katrina was the most costly hurricane, in terms of property damage, ever to hit the United States and flooded most of the city of New Orleans. Gallagher and Hartley investigate the impact that flooding from Katrina had on individuals' debt levels and on their propensity to leave the city and metropolitan area. They use individual-level credit and debt data provided by a large credit scoring company.

They find that higher levels of flooding resulted in larger reductions in total debt balances. The reduction in total debt is driven almost exclusively by lower home loan debt (that is, mortgages). Surprisingly, there is only modest evidence that residents used credit card debt to smooth consumption and pay for unexpected costs after the flood. Flooded residents have 90-day delinquency rates that are approximately 10 percent higher relative to non-flooded residents for a year-long period following Katrina. The authors also find evidence that higher levels of flooding led to higher migration rates out of the city.

The reduction in home loan debt is much larger in census tracts with a higher share of mortgages originated by non-local lenders. A homeowner in the most flooded areas of New Orleans is 66 percent less likely to have a home loan after Katrina if he lives in a census tract with a high share of loans initiated by non-local lenders. This result is consistent with media accounts that banks, particularly those without a local presence, pressured homeowners to use flood insurance checks to repay their mortgage loans rather than to rebuild their homes. Flood insurance payout data support this interpretation. Flood insurance payouts are highly correlated with flooding, but are not correlated with whether the home loan was originated by a local bank. One economic explanation is that the success of lenders with a large lending presence in New Orleans is highly dependent on the economic well-being of the city. On the other hand, lenders who have a relatively small share of their business in New Orleans may prefer to protect themselves from the uncertain economic environment of post-Katrina New Orleans by reducing their debt exposure.

The negative welfare consequence for residents who used insurance payouts to reduce debt, rather than to repair their homes, can be large if residents are unable to obtain a new home building loan at the same rate as their mortgage, or if paying off the mortgage disqualifies homeowners for public assistance. Preliminary evidence suggests that there was a tightening of credit after Katrina. Further, New Orleans residents who paid off their home loans did not qualify for the largest available source of public assistance, the Louisiana Road Home program, which awarded grants up to $150,000 to homeowners for rebuilding costs.


Florain Scheuer, Stanford University and NBER, and Kent Smetters, University of Pennsylvania and NBER

Could a Website Really Have Doomed the Health Exchanges? Multiple Equilibria, Initial Conditions and the Construction of the Fine (NBER Working Paper 19835)*

Public attention has focused on how the launch of the national health exchanges could impact the types of risks who initially enroll and thereby affect future premiums and enrollment. Scheuer and Smetters introduce simple dynamics into a standard model of insurance under adverse selection to show that such "initial conditions" can indeed matter. When firms are price-takers, the market can converge to a Pareto-inferior "bad" equilibrium if there are at least three equilibria, which the authors suggest has empirical support. Strategic pricing eliminates Pareto-dominated equilibria but requires common knowledge of preference and risk distributions. Changing the fine on nonparticipants from a fixed amount to a fraction of equilibrium prices increases the range of initial conditions consistent with reaching the "good" equilibrium while reducing the "badness" of the bad equilibrium — all without increasing the fine value in the good equilibrium. Allowing insurers to quickly change prices can encourage them to experiment with strategic pricing if market fundamentals are not perfectly known, increasing the chance of reaching the good equilibrium independently from initial conditions.


Gaston Palmucci, University of Wisconsin-Madison, and Laura Dague, Texas A&M University

The Welfare Effects of Banning Risk-Rated Pricing in Health Insurance Markets: Evidence from Chile*

Palmucci and Dague study the welfare consequences of a switch from risk-rated premiums to communityrated premiums using a two stage model of health insurance demand and detailed claims data from Chilean health insurers. Their results suggest that if insurers are not allowed to scale premiums based on age and sex (in accordance with a recent court ruling), a significant fraction of young, healthy individuals will opt out of the private insurance market, raising the average cost of insuring those who remain. Chilean consumers in aggregate are likely to be worse off under community-rated premiums, with declines in total surplus of 9%.

Daniel Bauer, Georgia State University; Jochen Russ, Institute for Financial and Actuarial Science; and Nan Zhu, Illinois State University

Adverse Selection in Secondary Insurance Markets: Evidence from the Life Settlement Market

Bauer, Russ, and Zhu use data from a large U.S. life expectancy provider to test for asymmetric information in the secondary life insurance, or life settlement, market. They compare the average difference between realized lifetimes and estimated life expectancies for a subsample of settled policies relative to the entire sample. They find a significant positive difference indicating private information on mortality prospects. Using nonparametric estimates for the excess mortality and survival regressions, the authors show that the informational advantage is temporary and wears off over five to six years. They argue this is in line with adverse selection on an individual's condition, which has important economic consequences for the life settlement market and beyond.


Thomas Davidoff and Jake Wetzel, University of British Columbia

Do Reverse Mortgage Borrowers Use Credit Ruthlessly

Home Equity Conversion Mortgage (HECM) rules concerning repayment, limited liability, and credit line growth provide older homeowners with put options that are "in the money" when available credit exceeds mortgaged homes' resale value. Federal Housing Administration (FHA) mortgage insurance pricing and credit rules do not reflect geographic or cyclical risk, and HECMs were disproportionately originated near the home price cycle peak in markets with large subsequent busts. Federal reverse mortgage insurance has thus lost money, contrary to legislative goals. Was selection on geography and timing adverse because borrowers consciously exploited unpriced information? Davidoff and Wetzel find that this appears unlikely because borrowers have not used credit "ruthlessly." Borrowers whose loans have terminated with credit limits greater than property value have not been likelier to exhaust credit lines than similar borrowers with put options "out of the money."


John Kiff, International Monetary Fund, and Michael Kisser, Norwegian School of Economics

Longevity Risk Transfer Markets: Market Structure, Growth Drivers and Impediments, and Potential Risks

Kiff and Kisser investigate the relation between life expectancy assumptions and pension liabilities for a large sample of U.S. corporate defined benefit pension plans. They show that longevity assumptions are systematically related to the lagged funding status of a pension plan: underfunded plans make lower life expectancy assumptions. Cross-sectional analysis further reveals that each year of life expectancy increases pension liabilities by around 4 to 5 percent. The economic magnitude is substantial: a one-year shock to longevity would more than double the degree of aggregate pension underfunding. Forecasts of future life expectancy typically underestimate realized improvements, thereby increasing chances of lumpy adjustments to pension liabilities.


Ralph Koijen, London Business School, and Motohiro Yogo, Federal Reserve Bank of Minneapolis

Shadow Insurance (NBER Working Paper 19568)

Liabilities ceded by life insurers to shadow reinsurers (that is, affiliated and less regulated off-balance-sheet entities) grew from $11 billion in 2002 to $364 billion in 2012. Companies using shadow insurance, which capture half of the market share, ceded 25 cents of every dollar insured to shadow reinsurers in 2012, up from 2 cents in 2002. The authors' adjustment for shadow insurance reduces risk-based capital by 53 percentage points (or three rating notches) and raises impairment probabilities by a factor of four. Koijen and Yogo develop a structural model of the life insurance industry to estimate the impact of current policy proposals to curtail shadow insurance. Without shadow insurance, marginal cost would rise by 18 percent, and annual life insurance underwritten would fall by 23 percent.

* This paper was a part of a joint session with the Healthcare Program Meeting


 
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