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Catastrophe Insurance, Capital Markets and Uninsurable Risks

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Author Info
Dwight M. Jaffee
Thomas Russell

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Abstract

This paper examines the causes of the failure of the private market for catastrophe insurance and examines some public solutions. Although the standard explanations of insurance market failure (adverse selection and moral hazard, large imprecise risks) are present, we argue that the primary explanation for the failure of this market lies in the inability of insurance companies to arrange for the level of capital necessary to settle a large loss. We examine four reasons for this: a) accounting provisions which preclude the setting up of reserves against losses anticipated but not yet incurred, b) the absence of tax incentives to reserve, c) management fear of loss of control associated with takeovers of companies with large stocks of free cash, and d) reluctance of regulators to raise the rates of firms with large holdings of cash. We examine new capital instruments (catastrophe options, contingency bonds) but find that these new instruments at present fail to provide adequate quantities of capital to meet a large loss. We then examine public schemes in California, Florida, and Hawaii, and argue that if the accounting, tax and regulatory advantages enjoyed by these schemes were made available to the private sector, private corporations would be likely to reenter this market.

This paper was presented at the Financial Institutions Center's May 1996 conference on "

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-12.

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Date of creation: May 1996
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Handle: RePEc:wop:pennin:96-12

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May. [Downloadable!] (restricted)
  2. Dwight Jaffee & Thomas Russell, 1995. "The Causes and Consequences of Rate Regulation in the Auto Insurance Industry," NBER Working Papers 5245, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Patricia Born & William M. Gentry & W. Kip Viscusi & Richard J. Zeckhauser, 1995. "Organizational Form and Insurance Company Performance: Stocks versus Mutuals," NBER Working Papers 5246, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Blanchard, Olivier Jean & Lopez-de-Silanes, Florencio & Shleifer, Andrei, 1994. "What do firms do with cash windfalls?," Journal of Financial Economics, Elsevier, vol. 36(3), pages 337-360, December. [Downloadable!] (restricted)
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  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Erwann Michel-Kerjan, 2004. "Terrorisme à grande échelle : partage de risques et politiques publiques," Working Papers hal-00242918_v1, HAL. [Downloadable!]
  2. Mario Jametti & Thomas von Ungern-Sternberg, 2004. "Disaster Insurance or a Disastrous Insturance - Natural Disaster Insurance in France," Department of Economics Working Papers 2004-13, McMaster University. [Downloadable!]
    Other versions:
  3. Meuwissen, Miranda P.M. & Huirne, Ruud B.M., 1998. "Feasibility Of Income Insurance In European Agriculture," 1998 Annual meeting, August 2-5, Salt Lake City, UT 20947, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association). [Downloadable!]
  4. Mario Jametti & Thomas von Ungern-Sternberg, 2006. "Risk Selection in Natural Disaster Insurance - the Case of France," Working Papers 2006_1, York University, Department of Economics. [Downloadable!]
    Other versions:
  5. Robert W. Klein & Paul R. Kleindorfer, 1999. "The Supply of Catastrophe Insurance Under Regulatory Constraints," Center for Financial Institutions Working Papers 99-25, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  6. James F. Moore, 1999. "Tail Estimation and Catastrophe Security Pricing: Can We Tell What Target We Hit if We Are Shooting in the Dark?," Center for Financial Institutions Working Papers 99-14, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  7. Thomann, Christian & Schulenburg, J.-Matthias, 2006. "Supply and Demand for Terrorism Insurance: Lessons from Germany," Diskussionspapiere der Wirtschaftswissenschaftlichen Fakultät der Universität Hannover dp-340, Universität Hannover, Wirtschaftswissenschaftliche Fakultät. [Downloadable!]
  8. Hao, Jianqiang & Skees, Jerry, 2003. "Structuring Institutions To Share Local Weather Risk Globally," 2003 Annual meeting, July 27-30, Montreal, Canada 21973, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association). [Downloadable!]
  9. Brock, Philip L., 1998. "Financial safety nets and incentive structures in Latin America," Policy Research Working Paper Series 1993, The World Bank. [Downloadable!]
  10. P. Nowak, 1999. "Analysis of Applications of Some Ex-Ante Instruments for the Transfer of Catastrophic Risks," Working Papers ir99075, International Institute for Applied Systems Analysis. [Downloadable!]
  11. J. David Cummins & David Lalonde & Richard D. Phillips, 2000. "The Basis Risk of Catastrophic-Loss Index Securities," Center for Financial Institutions Working Papers 00-22, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
    Other versions:
  12. Dowlatabadi, Hadi & Cook, Christina, 2007. "Climate Risk Management and Institutional Learning," Discussion Papers dp-07-19, Resources For the Future. [Downloadable!]
  13. Martin Nell & Andreas Richter, 2000. "Catastrophe Index-Linked Securities and Reinsurance as Substituties," Working Paper Series: Finance and Accounting 56, Department of Finance, Goethe University Frankfurt am Main. [Downloadable!]
  14. Tse-Ling Teh & Alan Martina, 2008. "Developing Countries Spreading Covariant Risk Into International Risk Markets: Subsidised Catastrophe Bonds Or Reinsurance, Or Disaster Assistance?," ANUCBE School of Economics Working Papers 2008-492, Australian National University, College of Business and Economics, School of Economics. [Downloadable!]
  15. Jeffrey R. Brown & J. David Cummins & Christopher M. Lewis & Ran Wei, 2004. "An Empirical Analysis of the Economic Impact of Federal Terrorism Reinsurance," NBER Working Papers 10388, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  16. Enjolras, Geoffroy & Kast, Robert, 2007. "Using participating and financial contracts to insure catastrophe risk: Implications for crop risk management," 101st Seminar, July 5-6, 2007, Berlin Germany 9268, European Association of Agricultural Economists. [Downloadable!]
  17. Kenneth A. Froot, 1999. "The Market for Catastrophe Risk: A Clinical Examination," NBER Working Papers 7286, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  18. Anonymous & Roe, Terry L., 1999. "Policy Reform, Market Stability, And Food Security; Proceedings Of A Conference Of The International Agricultural Trade Research Consortium," Policy Reform, Market Stability, and Food Security Conference, June 26-27, 1998, Alexandria Virginia 14538, International Agricultural Trade Research Consortium. [Downloadable!]
  19. Kenneth A. Froot & Paul G. J. O'Connell, 1997. "On The Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance," NBER Working Papers 6011, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  20. Nathalie De Marcelis-Warin & Erwann Michel-Kerjan, 2003. "Catastrophe risk sharing and public-private partnerships : From natural disasters to terrorism," Working Papers hal-00242981_v1, HAL. [Downloadable!]
  21. Geoffroy Enjolras & Robert Kast, 2008. "Using participating and financial contracts to insure catastrophe risk: Implications for crop risk management," Working Papers 08-01, LAMETA, Universtiy of Montpellier, revised Jan 2008. [Downloadable!]
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