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Catastrophic Risks and Insurance: Financial Designs and Market Capacity

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:

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Catastrophic Risks and Insurance: Financial Designs and Market Capacity

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  1. Catastrophic Risks and Insurance: Financial Designs and Market Capacity Mike Orszag March 2005

  2. 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

  3. 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

  4. Life Insurance and Pension Catastrophes

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

  6. Insurability • Available data and information • Locality of risk (geographic?) • Moral hazard: • Preparation • Possibility of human influence on event

  7. 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

  8. Capacity Potential Source: Mechler (IIASA), 2004

  9. 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?

  10. 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

  11. Conceptual Framework Payouts Perfect market Capacity in practice Losses

  12. 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

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

  14. 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)

  15. Comments Better financial markets More demand for security Payouts Perfect market Less friction in reinsurance More competitive markets Capacity in practice Losses

  16. Solutions for more market capacity • Risk sharing designs, in particular with public sector (may need international involvement) • Public benchmark securities

  17. 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

  18. 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

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