The Geneva Papers on Risk and Insurance Theory, 20:185-187 (1995) �9 1996 The Geneva Association

Insurance and Catastrophes: Comment

HENRI LOUBERGI~ University of Geneva, Department of Economics, 102, Blvd. Carl gogt, CH-1211 Geneva 4, Switzerland

The title of Richard Zeckhauser's lecture--' 'Insurance and Catastrophes"-- leads one to ex- p e a an essay on the insurability of natural or human-made catastrophes. But the term catas- trophe may refer to quite different events depending on the point of view that is adopted:

�9 At the micro level of the firm, the sudden death of the entrepreneur and the bankruptcy of a major customer are catastrophes;

�9 At the regional level, a flood, an earthquake, an oil spill, and the delocalization of a dominant job supplier represent catastrophes;

�9 At the macro (or national) level, a deep economic slump, a generalized social conflict, an extended period of snowfalls, and a collapse in the price of a major export product are catastrophes;

�9 Finally, at the global level, events like a world war, the breakdown of a major economic power, and a climate change are catastrophic events.

The definition of a catastrophe changes depending on the point of view that is adopted because the notion of catastrophe is strongly linked to the notion of insurability within bounds: a catastrophe is an event that cannot be insured (by insured, I mean diversified) within the confines of the reference area, even if information problems such as adverse selection and moral hazard do not arise or are ignored.

If we take the point of view of an insurance firm, catastrophes do not necessarily arise on the liability side of the activities. As financial intermediaries, insurers are at least as much affected by events like a collapse of the housing market, or a sudden drop in bond prices, as by large claims. Indeed, considering the experience over the past two decades, it might be argued that the main catastrophe potential for an insurer arises on the assets side of the balance sheet.

In his lecture, Professor Zeckhauser adopts the point of view of the global insurance business. From this stance, it is clear from what precedes that catastrophes are events that exceed the diversification potential at the global level. Since the Arrow-Debreu general equilibrium model, and more particularly since Borch's mutuality theorem, it is well known to economists that nondiversifiable risks are those affecting social wealth and that those risks cannot merely be transferred to reinsurance pool: once such transfer has occurred, the residual (systematic) risk must be spread across the community of risk-averse individuals using some sharing rule. Even when individuals or insurers are risk neutral, recent research has shown that nonlinearities in the pricing schedule arising from, say, an asymmetric tax schedule lead to an optimal role for social risk sharing.

Commentary on presentation by Richard Zeckhauser, "Insurance and Catastrophes;' Geneva Lecture, Pads, France, May 12, 1995.

186 rmNRI LOUBERGI~

For this reason, I cannot completely subscribe to Richard Zeckhauser's proposition that insurance payofl~ should be larger when an aggregate catastrophe occurs. If the risk is really an aggregate risk, Pareto-optimality implies that is has to be spread over individuals and nobody can get complete insurance in equil~rium. It is only in the case where the catastrophe is insurable at a larger level, and where moral hazard is present, that his proposition holds.

One of the important messages in the lecture points to the fact that there are different kinds of catastrophes and that the "liability revolution" is a catastrophe for the insurance industry. In terms of the economic model of risk transfers, this so-called revolution may be interpreted as an ex post change in the risk-sharing rules. Such a change represents a catastrophe for this segment of the economy, which is in charge of risk spreading. It is all the more important that liability risk is not a social risk in the economic sense (it does not affect aggregate wealth). The litigation explosion in the United States results in wealth transfers among different groups in the economy, according to rules that are differ- ent from those that were initially agreed upon. It has no economic justification. The prob- lem belongs essentially to the realm of power conflicts between different pressure groups: in this instance, consumers representing the victims on one hand and the insurance business on the other hand. Such power conflicts are more likely to arise if the insurance business does not invest enough in information and education to improve public knowledge about the economic role of insurance institutions.

Concerning the third theme in the lecture--the distribution distortion hazard--I would first like to remark that it is not an unknown theme in the insurance economics literature. It has been known since Ehrlich and Becker in 1972 that optimal behavior in the presence of market insurance affects not only the effort to reduce the probability of a loss (self- protection) but also the effort to mitigate the amount of loss (self-insurance). Clearly, self- insurance and market insurance are substitutes. As such, if the insurance premium cannot be adapted to take actual behavior into account, a moral hazard problem arises. However, and this is my second remark, such a distribution distortion is not necessarily detrimental if one adopts a larger viewpoint. By allowing individuals to transfer some of their risks, insurance, of course, increases the aggregate level of risk in the economy, but it also in- creases the well-being of society if increased risk taking is rewarded by superior perfor- mance on average. To take famous examples, the traders of the late Middle Age would not have taken the maritime risks that they took if they had not found the forerunners of the modern insurers to guarantee the value of their cargoes; similarly, the modern industrial society could not have developed without the availability of insurance policies of many kinds. Of course, this has increased aggregate risk, but this has not occurred to the detri- ment of insurance. This was not a catastrophe for insurance and not a catastrophe for society, although some people might object to the latter opinion.

A final remark concerning catastrophes and the prediction of losses. Professor Zeckhauser argues that the size of the loss experienced in a catastrophic event

(e.g., the number of deaths) is not necessarily a useful statistic for the prediction of future losses. In his view, "the losses associated with catastrophic experiences do not predict future losses as strongly as equivalent ordinary losses would" and "in pricing for the future, we should count strongly that a catastrophe occurred, but the precise number of people killed may not tell us much"

INSURANCE AND CATASTROPHES: COMMENT 187

This is probably true for relatively frequent catastrophes such as air crashes or terrorist attacks. However, this is not true for fortunately less frequent catastrophes such as a nuclear accident or an earthquake in a densely populated area. It seems that catastrophes like Three Mile Island, the Chernobyl accident, or the Kobe earthquake provided useful information to reinsurers, and public-risk managers about the severity of losses to expect from such events and about the efficiency of loss prevemion measures and contingency plans in such situations.

When a dreadful event occurs very infrequently, or when it has not yet occurred, there is uncertainty about the range of losses associated to this event. I used elsewhere the ex- pression "ambiguity in the domain of consequences" to def'me this situation, by analogy with the ambiguity concept used by Hogarth and Kunreuther to refer to the lack of infor- mation about the probability of an event.

For catastrophes of this kind, I thinkthat Richard Zeckhauser's argument should be quali- fied: the loss experience may provide useful information for consideration of future losses.