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The Effect Of Costly Risk Bearing On Insurers' Supply Decisions

Listed author(s):
  • Anne E. Kleffner
  • Neil A. Doherty
Registered author(s):

    Efficient contracts for sharing risk will allocate risk according to comparative advantage. When risks meet the typical criteria for insurability, in particular independence, the comparative advantage is straightforward and insurers are able to diversify risk by pooling together many policyholders. But this comparative advantage is established only in the event insureds have a low correlation. Earthquakes do not fit this description. The high correlations between the claims on the insurer's policies will (in the limit) equalize the costs of risk bearing for the insurer and insured. But the insurer's comparative advantage is not necessarily entirely removed, since correlations are not perfect, but there is a limit to the insurers' ability to diversify the risk. This paper considers insurance markets for earthquake risk and how comparative advantage in risk bearing can explain the amount of business individual insurers write. The respective abilities of insurers to write this risk depend on the characteristics of their entire portfolio as well as on financial features that influence the costs of risk bearing. Several recent contributions have shown why risk is costly to corporations such as insurers. The costs of risk arise from tax convexity, principal agent relationships within the firm, and the costs of financial distress. We will show how these types of features jointly determine the capacity of insurers to write earthquake insurance. We collect these arguments together in a simple equilibrium model of insurance. From this we derive and estimate a cross sectional model of earthquake insurance which emphasizes the differing capacity of insurers to write this line of

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    Paper provided by EconWPA in its series Risk and Insurance with number 9407005.

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    Date of creation: 14 Jul 1994
    Handle: RePEc:wpa:wuwpri:9407005
    Note: Postscript (ASCII) KLEFFNER.ABS
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    1. Patricia Munch & Dennis Smallwood, 1981. "Theory of Solvency Regulation in the Property and Casualty Insurance Industry," NBER Chapters, in: Studies in Public Regulation, pages 119-180 National Bureau of Economic Research, Inc.
    2. Joseph E. Stiglitz, 1973. "Incentives and Risk-Sharing in Sharecropping," Cowles Foundation Discussion Papers 353, Cowles Foundation for Research in Economics, Yale University.
    3. Martin, Robert E, 1988. "Franchising and Risk Management," American Economic Review, American Economic Association, vol. 78(5), pages 954-968, December.
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    5. Galai, Dan & Masulis, Ronald W., 1976. "The option pricing model and the risk factor of stock," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 53-81.
    6. Mayers, David & Smith, Clifford W, Jr, 1982. "On the Corporate Demand for Insurance," The Journal of Business, University of Chicago Press, vol. 55(2), pages 281-296, April.
    7. Doherty, Neil A & Dionne, Georges, 1993. "Insurance with Undiversifiable Risk: Contract Structure and Organizational Form of Insurance Firms," Journal of Risk and Uncertainty, Springer, vol. 6(2), pages 187-203, April.
    8. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    9. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    10. Doherty, Neil A., 1987. "Retroactive price regulation and the fair rate of return," Insurance: Mathematics and Economics, Elsevier, vol. 6(2), pages 135-144, April.
    11. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
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