Catastrophe Insurance, Capital Markets and Uninsurable Risks
by
Dwight M. Jaffee
Thomas Russell
1. Introduction
Catastrophes, according to Zeckhauser [1995], “provide a principal justification for insurance.One pays premiums to secure financial protection against low-probability high-consequence,events — what we normally label catastrophes.”
Principal justification or not, it is clear that private insurance markets are currently having a difficult time providing coverage for catastrophe risk. In California, for example, where earthquake coverage must be offered as an option on homeowner’s policies, companies representing 93% of the homeowner’s insurance market either stopped writing homeowner’s insurance or imposed strict limits on the policies they were willing to sell after the Northridge earthquake in 1994. [California: Dept. of Insurance Survey May 1, 1995].
In Florida, insurance company withdrawal from the state has been prevented only by a legal moratorium on exit. In many states (e.g. California, Florida, Texas, Hawaii), public officials now take it for granted that if catastrophe insurance is to be available at all, it must be provided by a public agency either State or Federal.
Catastrophes have thus become what insurance textbook writers call an ‘uninsurable risk’.The purpose of this paper is to examine what it is about catastrophe risk which makes it uninsurable. The paper argues that there is nothing in the nature of catastrophe risk as such which prevents the operation of a private market in insurance. In particular, large as the damage from a catastrophe event may be, it is infrequent, local, and unlikely to be correlated with the price of a global market index, so it is certainly diversifiable.
For example, even if every 20 years (on average) a $50 billion earthquake occurs somewhereon one of California’s many fault lines, ex ante we do not know where this event will occur. If we assume that say 5 million households are at risk from this event, it is sufficient for the insurance industry to collect an annual premium of $500/household/year to break even. (Assuming for simplicity no allowance for administrative costs or time value of money). Taking the long view, risk sharing seems eminently possible in this case.
What then prevents the operation of a private market? We will argue that to be viable a private insurance market must solve not a ‘point in time’ risk spreading problem, but rather an intertemporal problem of how to match a smooth flow of annual premium receipts to a highly non-smooth flow of annual loss payments. This is a capital market problem, not an insurance market problem, and we will argue that current institutional arrangements are not conducive to its solution. This, however, does not preclude a private market based on different institutional arrangements, and we examine some proposals which could allow private markets profitably to re-enter the catastrophe line.