Catastrophic Risks and Insurance: Financial Designs and Market Capacity

Mike Orszag

March 2005

Catastrophic Risks

Richard Posner, Catastrophe: Risk and Response, Oxford, 2004

• Natural disasters:– Asteroid hits the planet– Hurricanes, tornadoes

• Man-made disasters:– Particle accelerate creating a strange particle which crushes

the planet into a ball 100 metres across– Terrorism– Global warming

• Others– Mortality risk

Life Insurance and Pension Catastrophes

• Tremendous uncertainty about future longevity

• Vaupel: life expectancy at 65 may rise without bound

• Olshansky: life expectancy may decrease – no natural limit but no reason for individuals to live a long time

Life Insurance and Pension Catastrophes

0

5

10

15

20

25

Annuity Factor -Constant Interest Rate

Annuity Factor - Real

Denmark

Grosen and Jorgensen, Journal of Pension Economics and Finance, 1(3), 2003

Insurability

• Available data and information

• Locality of risk (geographic?)

• Moral hazard:– Preparation– Possibility of human influence on event

The Capacity Puzzle

• Global equity markets significant in size. If insurance products have high rates of return, capital should flow into insurance sector….

• … yet even products considered insurable limited in quantity

Capacity Potential

Source: Mechler (IIASA), 2004

The Capacity Puzzle

• Are catastrophe products zero beta (Froot/Posner)?

• Auffret (2003) – looked at Caribbean countries – premia 1.5% of GDP 1970-1999 whereas claims average 0.5% of GDP.

• Explanations: catastrophes not zero beta• Explanations: basis risk?• Is there scope for government involvement in

market?

Measuring Capacity

• Cummins, Doherty and Lo, “Can Insurers Pay for the Big One?”, Journal of Banking and Finance (2002)

• Are losses of US$100 bn sustainable?

• Comparisons:– Northridge Earthquake US$10bn– Hurricane Andrew US$19bn

Conceptual Framework

Payouts

Losses

Perfect market

Capacity in practice

Measuring Capacity

• Is capital distributed optimally? Optimal portfolio close to all having share in aggregate losses.

• Reinsurance priced on correlation of individual losses with aggregate losses

• Normally distributed losses

• Pricing assumed competitive

• No transaction costs

Results

Correlation

All US 0.18

Florida 0.13

Industry could cover 90-96% of $100 bn loss

Comments

• Does not get at question: how much can industry afford to write?

• Estimation based on all losses instead of catastrophic losses (less scope for reinsurance)

Comments

Payouts

Losses

Perfect market

Capacity in practice

Better financial markets

More demand for security

Less friction in reinsurance

More competitive markets

Solutions for more market capacity

• Risk sharing designs, in particular with public sector (may need international involvement)

• Public benchmark securities

Issues in non-OECD countries

• Low penetration but some success stories (Turkey earthquake insurance)

• Governments themselves may face significant risks and therefore may want to set up contingent financing or prefund

Summary

• Capacity issues are apparent, even though theory suggests they should not be

• Lack of successful large-scale pure private sector solutions

• Need to consider public-private partnerships both in OECD and non-OECD countries