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Can Insurers Pay for the "Big One"? Measuring the Capacity of an Insurance Market to Respond to Catastrophic Losses
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Abstract
This paper presents a theoretical and empirical analysis of the capacity of the U.S. property-liability insurance industry to finance major catastrophic property losses. The topic is important because catastrophic events such as the Northridge earthquake and Hurricane Andrew have raised questions about the ability of the insurance industry to respond to the "Big One," usually defined as a hurricane or earthquake in the 100billionrange.Atfirstglance,theU.S.property−liabilityinsuranceindustry,withequitycapitalofmorethan300 billion, should be able to sustain a loss of this magnitude. However, the reality could be different; depending on the distribution of damage and the spread of coverage as well as the correlations between insurer losses and industry losses. Thus, the prospect of a mega catastrophe brings the real threat of widespread insurance failures and unpaid insurance claims. Our theoretical analysis takes as its starting point the well-known article by Borch (1962), which shows that the Pareto optimal result in a market characterized by risk averse insurers is for each insurer to hold a proportion of the "market portfolio" of insurance contracts. Each insurer pays a proportion of total industry losses; and the industry behaves as a single firm, paying 100 percent of losses up to the point where industry net premiums and equity are exhausted. Borch's theorem gives rise to a natural definition of industry capacity as the amount of industry resources that are deliverable conditional on an industry loss of a given size. In our theoretical analysis, we show that the necessary condition for industry capacity to be maximized is that all insurers hold a proportionate share of the industry underwriting portfolio. The sufficient condition for capacity maximization, given a level of total resources in the industry, is for all insurers to hold a net of reinsurance underwriting portfolio which is perfectly correlated with aggregate industry losses. Based on these theoretical results, we derive an option-like model of insurer responses to catastrophes, leading to an insurer response-function where the total payout, conditional on total industry losses, is a function of the industry and company expected losses, industry and company standard deviation of losses, company net worth, and the correlation between industry and company losses. The industry response function is obtained by summing the company response functions, giving the capacity of the industry to respond to losses of various magnitudes. We utilize 1997 insurer financial statement data to estimate the capacity of the industry to respond to catastrophic losses. Two samples of insurers are utilized - a national sample, to measure the capacity of the industry as a whole to respond to a national event, and a Florida sample, to measure the capacity of the industry to respond to a Florida hurricane. The empirical analysis estimates the capacity of the industry to bear losses ranging from the expected value of loss up to a loss equal to total company resources. We develop a measure of industry efficiency equal to the difference between the loss that would be paid if the industry acts as a single firm and the actual estimated payment based on our option model. The results indicate that national industry efficiency ranges from about 78 to 85 percent, based on catastrophe losses ranging from zero to 300billion,andfrom70to77percent,basedoncatastrophelossesrangingfrom200 to 300billion.Theindustryhasmorethanadequatecapacitytopayforcatastrophesofmoderatesize.E.g.,basedonboththenationalandFloridasamples,theindustrycouldpayatleast98.6percentofa20 billion catastrophe. For a catastrophe of 100billion,theindustrycouldpayatleast92.8percent.However,evenifmostlosseswouldbepaidforaneventofthismagnitude,asignificantnumberofinsolvencieswouldoccur,disruptingthenormalfunctioningoftheinsurancemarket,notonlyforpropertyinsurancebutalsoforothercoverages.Wealsocomparethecapacityoftheindustrytorespondtocatastrophiclossesbasedon1997capitalizationlevelswithitscapacitybasedon1991capitalizationlevels.ThecomparisonismotivatedbythesharpincreaseincapitalizaitonfollowingHurricaneAndrewandtheNorthridgeearthquake.In1991,theindustryhad.88 in equity capital per dollar of incurred losses, whereas in 1997 this ratio had increased to 1.56.Capacityresultsbasedonourmodelindicateadramaticincreaseincapacitybetween1991and1997.Foracatastropheof100 billion, our lower bound estimate of industry capacity in 1991 is only 79.6 percent, based on the national sample, compared to 92.8 percent in 1997. For the Florida sample, we estimate that insurers could have paid at least 72.2 percent of a $100 billion catastrophe in 1991 and 89.7 percent in 1997. Thus, the industry is clearly much better capitalized now than it was prior to Andrew. The results suggest that the gaps in catastrophic risk financing are presently not sufficient to justify Federal government intervention in private insurance markets in the form of Federally sponsored catastrophe reinsurance. However, even though the industry could adequately fund the "Big One," doing so would disrupt the functioning of insurance markets and cause price increases for all types of property-liability insurance. Thus, it appears that there is still a gap in capacity that provides a role for privately and publicly traded catastrophic loss derivative contracts.