Dwight M. Jaffee

English

Research Papers in Economics

Commentary
Dwight M. Jaffee
insurance liabilities and the stochastic processes
generating losses. It is assumed the insurer collects
premiums at the beginning of the period equal to
the expected loss. Capital is therefore required to
cover the actual losses in excess of the expected
value. The computations are basically applications
of the law of large numbers and the central limit
theorem. Cummins assumes a normal distribution,
although he properly states that comparable
results are available for a wider range of distribu-
tions. Cummins shows that, when the risks are
identically and independently distributed (i.i.d.),
the required capital per policy approaches zero
as the number of individual policies approaches
infinity. In contrast, when the risks are correlated,
some amount of capital is required even in the
limit as the number of risks approaches infinity.
Cummins reasonably interprets this as meaning
that catastrophic risks, which sensibly imply
correlated risks, require more capital than do
independent risks.
I think it important to add that fat-tailed dis-
tributions raise an even more distinctive issue,
which may help explain why most catastrophe
insurance lines are generally not offered by private
insurers. A key property of fat-tailed distributions
is that the benefits of diversification may not arise.
For example, let an insurer start with a portfolio
consisting of just one catastrophic risk, say risk
A. Now suppose the insurer decides to diversify
by creating a portfolio with one-half risk A and
one-half risk B. Remarkably, the risk exposure of
the portfolio may actually rise, contrary to the
normal case of diversification benefits. The intu-
AGENDA 
F
irst, the conference planners must be
complemented for their foresight to put
catastrophe insurance on the agenda for
this conference, long before Hurricane Katrina
crashed into New Orleans. As Katrina illustrates,
the problems affecting catastrophe insurance in
the United States are taking on, well, catastrophic
proportions. Major changes are required in how
the government intervenes in each of the major
catastrophic risks—earthquakes, floods, hurri-
canes, and terrorism.
Turning to the task at hand, it is always a
pleasure and enlightening to read a paper by
David Cummins (2006). This one is no exception.
My comments follow the lines of David’s paper,
taking up these topics in turn:
• Why do private markets for catastrophic
risks fail?
• Should the government pick up the slack?
• And, if so, how is this best done?
WHY DO PRIVATE MARKETS FOR
CATASTROPHE INSURANCE FAIL?
Capital Market Imperfections Are a
Key Factor
The paper begins with a cogent discussion of
the key role that capital plays for insuring against
catastrophic risks. Applying his earlier work in
Cummins and Weiss (2000), Cummins computes
the capital an insurer should hold, based on its
Dwight M. Jaffee is a professor of finance and real estate at the Haas School of Business at the University of California, Berkeley.
Federal Reserve Bank of St. Louis Review, July/August 2006, 88(4), pp. 381-85.
© 2006, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in
their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made
only with prior written permission of the Federal Reserve Bank of St. Louis.
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2006 381
      ition is that, with fat tails, each catastrophe is
potentially so large that holding equal shares of
two risks may entail more total risk than holding
one risk only.1 And the same result can extend
over a large number of such risks; see Ibragimov
and Walden (2005) and Ibragimov, Jaffee, and
Walden (2006). Thus, it might not be surprising
that insurers often prefer a corner solution in
which they take on no catastrophe risks at all.
In summary, I believe more work on the role
of fat-tailed distributions might be rewarding in
explaining why private markets for catastrophe
insurance fail so regularly. Still, I surely agree with
the main point of David Cummins’s analysis that
catastrophe insurance market failures arise out
of capital market frictions of one sort or another.
Capital Market Imperfections Are
Necessary But Not Sufficient for
Catastrophe Market Failure
Although capital market imperfections are
likely a necessary condition for the failure of pri-
vate catastrophe insurance markets, they seem not
to be sufficient. For example, only 15 years ago,
the United States had active private markets for
hurricane, earthquake, and terrorism risks. Even
today, the United Kingdom has an active private
market for flood insurance (which is sold in clear
recognition of the possibility that the Thames
could flood London). We also see certain insurers
willing to put their money at risk to insure against
catastrophes. In 1996, for example, Warren Buffett’s
insurance firms pledged several billions of dollars
in capital to reinsure the California Earthquake
Authority. And Lloyds of London stands ready
to provide terrorism insurance (at the right price).
So, other factors must play a role in determining
who will and who will not offer catastrophe
coverage. 
Agency Problems for Catastrophe
Insurers
Basic finance theory suggests that capital
markets face no special problem with taking on
catastrophic risks. First, catastrophes mainly
reflect idiosyncratic risks, which implies that
capital markets should not even require much in
the way of a risk premium. Second, the special
problems created by fat-tailed distributions could
be solved by allocating the risk among a large num-
ber of equity investors in each insurance firm, with
each such investor holding a well-diversified
portfolio. Thus, the financial structure of insurance
firms should diversify risks even if diversification
is not achieved within each insurer’s portfolio.
But insurance firm managers strongly disagree.
The following quote from Edward Liddy, president
of Allstate, in the Wall Street Journal, September 6,
2005, illustrates their position: 
The insurance industry is designed for those
things that happen with great frequency and
don’t cost that much money when they do. It’s
the infrequent thing that costs a large amount of
money to the country when it occurs—I think
that’s the role of the federal government.
(Francis, p. c.1)
This has the ring of a classic agency problem. An
insurance firm manager is certainly at special
risk—to lose his job and ruin his reputation—
were he to be the one who bankrupted his firm by
taking on a catastrophic risk that went bad. It is
also intriguing that those insurers that do appear
willing to take on catastrophic risks, for example,
Warren Buffett and Lloyds of London, also appear
to have special structures that eliminate the tradi-
tional manager-shareholder agency problem. 
Zealous Regulators and Daffy Consumers
Insurance regulators compound the problem
by restricting the degree to which primary insurers
can use reinsurance and similar risk-sharing
instruments. One issue is that regulators often
do not allow primary insurers to include the full
costs of reinsurance in their premiums. Another
issue is that offshore reinsurance is often dis-
counted as a means through which a primary
insurer can meet its capital requirements. To be
fair, regulators may have a basis for questioning
the premiums charged by reinsurers and for dis-
counting the credit worthiness of certain offshore
insurers. Nevertheless, reducing or eliminating
Jaffee
382 JULY/AUGUST 2006 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
1 This may seem to conflict with Paul Samuelson’s famous (1967)
paper, in which he showed that diversification generally pays.
Samuelson, however, carefully ruled out fat-tailed distributions
that do not have finite moments.such frictions certainly would help persuade
private insurers to offer coverage against cata-
strophic risks. 
Consumers, furthermore, are also not always
rational in evaluating the contracts offered by
insurers, which is another likely reason that catas-
trophe insurance markets fail to operate. The
fundamental issue is that policyholders often con-
sider the likelihood of a future catastrophe to be
much lower than do the insurers. The result is
that consumers often feel the premiums charged
by the insurers are far too high. This is not a
comfortable position for an insurer that has an
otherwise profitable business writing auto and
homeowner insurance for these same customers.
An easy solution is just not to offer the catastrophe
coverage.
Other Issues Seem Less Fundamental
Still other explanations are often offered for
why insurers are reluctant to cover catastrophic
risks, but these appear to me to be less funda-
mental than the capital market imperfections,
fat-tailed risk distributions, agency problems,
regulator problems, and daffy consumers already
discussed. Here, I offer brief comments on two of
these other issues.
Quantifying the Risk Parameters. It is often
pointed out that, because of the infrequency of
catastrophic events, it is difficult to obtain reliable
estimates of their statistical frequency. It should
be recognized, however, that estimation problems
arise for all risks, whatever their frequency. For
example, “parameter uncertainty” for the capital
asset pricing model was studied long ago, with
the conclusion that it created no fundamental
problem. More recently, Froot and Posner (2002)
have carried out a parallel analysis focusing on
catastrophic risk estimates, reaching an equally
sanguine conclusion. Furthermore, as a specific
counterexample, telecommunications satellites
were “insurable” from their very first launch,
confirming that a long-established historical
record is not an essential basis for firms to offer
insurance coverage. 
Time Diversification Versus Cross-Section
Diversification. It is also sometimes suggested
that catastrophic risks are more difficult to diver-
sify because the risk-sharing occurs across time
more than across individual risks. To be sure,
large catastrophic risks may have to be diversified
across time, but capital market imperfections aside
(discussed above), time-series diversification does
not appear intrinsically more difficult. Indeed,
asymmetric information, in which the insured
party knows more than the insuring firm, is less
likely to inhibit risk-sharing for catastrophic risks
(where Mother Nature is the source) than for con-
sumer lines such as auto insurance (where the
propensity of individual drivers is important).
WHEN PRIVATE MARKETS FAIL,
IS GOVERNMENT INSURANCE
THE ANSWER?
Insurance, by sharing individual risks across
a large number of agents, creates immense social
benefits. Risk-sharing, by its very nature, is also
arguably the most social of economic activities
(self-insurance being interpreted as no insurance
at all). It is thus not surprising that when private
catastrophe markets fail, citizens dependably
call on their government to fix the failure. And it
is no more surprising that governments typically
respond. So the question regarding government
intervention is not so much “if” as it is “how”
and “how long.” Before turning to some possible
answers to these questions, it is useful to have a
quick look at how government insurance is actu-
ally working in the United States across the four
major catastrophe lines.
National Flood Insurance Program 
Flood insurance is the longest standing of
the government interventions in catastrophe
insurance markets in the United States, dating
from the 1960s. It is a federal program, initiated,
expanded, and revised by Congress. Congress has
required that the premiums be set on an actuarial
basis, but at the same time it has required deep
subsidies for homes that existed at the time each
community entered the program. The effect is
that expected losses on grandfathered properties
are five times those on newly built homes, with
an average annual grandfather subsidy of $610
Jaffee
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2006 383(compared with a total premium of $310 on newly
constructed homes) (see Government Accounting
Office, 1999). It has reached the point that the
National Flood Insurance Program (NFIP) is now
considering a proposal to buy the grandfathered
homes to save the high cost of future claims! At
this writing, it is expected the NFIP losses from
Katrina are likely to be about $20 billion, virtually
all of which will have to be provided as a one-time
transfer from the U.S. Treasury.
In contrast, the United Kingdom appears to
have a well functioning private market for flood
risks. The plan operates as a private/public part-
nership, in which the government “guarantees”
levees and requires good upstream practices,
but the insurance rates and risks are all handled
entirely within the private markets (for further
details, see the Association of British Insurers;
www.abi.org.uk/flooding).
Terrorism Risk Insurance Act
Following the terrorist attack of 9/11, Congress
passed the Terrorism Risk Insurance Act, which
provides reinsurance at the upper risk levels for
qualifying terrorism insurance offered by the
primary insurers. Premium setting is left fully in
the hands of the insurance firms, but the govern-
ment reinsurance is offered without charge.
Assuming the subsidy is passed through to the
policy holders, it creates an incentive against miti-
gation and induces new properties to continue
to be built in risky locations. The Terrorism Risk
Insurance Act was just renewed at year-end 2005,
following, not surprisingly, the major endorsement
of key parts of the real estate and insurance
industries.
California Earthquake Authority
Although the government interventions in
flood and terrorism risks are federal, the California
Earthquake Authority (CEA) is a state program.
This program was created by the California legis-
lature in the aftermath of the Northridge earth-
quake of 1994. Although state funds are not
committed to the CEA, it operates under rules set
by the legislature and it is a good guess that state
funds would be made available to support the
program if that became necessary. The enabling
legislation requires that the premiums be “actu-
arially based,” but scientists disagree substan-
tially over what the correct numbers are. This
allows for substantial differences of opinion
between the insurers and their customers. Indeed,
less than 14 percent of applicable homeowners
are currently purchasing CEA coverage. There is
also consternation over the standard 15 percent
deductible, although few consumers opted for a
new 10 percent deductible (presumably because
the premium is still higher).
In this context, David Cummins has raised the
possibility that earthquake insurance be made
mandatory on all homeowners, as a means to
increase the participation rate. I have to disagree,
certainly as long as the proper premiums are a
matter of dispute. In addition, a government
requirement would imply government backing
for a potentially bankrupt plan, create the need
for an “assigned risk pool” for those homeowners
excluded from the regular program, and create
pressure for further rate subsidies. It is also
enlightening that mortgage lenders in California
do not require earthquake coverage as the basis
for a home loan, no doubt because earthquakes
rarely create serious damage to wood-framed,
detached homes.
Florida Hurricane Funds
The state of Florida created a complex of
insurance structures following Hurricane Andrew
in 1992, including an assigned risk pool for home-
owners who could not otherwise obtain coverage
and a state-backed reinsurance fund. These plans
have taken substantial losses as a result of the bad
hurricane seasons in recent years. In fact, the
plans are surviving only because they provide
for quite high deductible limits and for ex post
additions to premiums going forward. Florida
does not, however, face a low take-up rate, because
mortgage lenders uniformly require wind-damage
coverage as a requirement for obtaining a mortgage
on a Florida property.
How the Government Should Intervene
In view of the rather dire experience with the
existing government interventions in catastrophe
Jaffee
384 JULY/AUGUST 2006 FEDERAL RESERVE BANK OF ST. LOUIS REVIEWinsurance markets in the United States, I will
suggest a simple proposition: When intervening
in catastrophe risk insurance markets, govern-
ment plans should mimic as closely as possible
what operating private markets would have been
expected to do. (See also Jaffee and Russell,
forthcoming). In particular, based on this principle,
government plans would generally be expected
to do the following:
• Use risk-based premiums in setting the
price charged for each individual risk. Risk-
based premiums, of course, create the
proper incentives for policyholders to take
actions to mitigate the underlying risks. In
the case of location-based real estate risks,
property owners may even decide not to
build in particularly risky locations.
• Do not offer subsidies in setting the pre-
miums on individual risks and certainly do
not subsidize the riskiest locations. To do
otherwise—that is, to provide subsidies—
would be to actively induce people to put
themselves in harm’s way. Such subsidies
would also be sure to crowd out any poten-
tial private market initiatives. Of course, to
follow this advice, the government must
have the will to reject requests to provide
special help to affected industries and/or
regions.
CONCLUSION
In conclusion, David Cummins and I firmly
agree the first best solution is to keep the govern-
ment out of the insurance business entirely, or to
retire the government from active duty as soon
as practical after a major event. To reach this goal,
we also agree that a key step is for the government
to rapidly remove all existing impediments to
catastrophe bonds. And if the government is
willing to go further, a good next step is to create
a facility that auctions off access to these catas-
trophe bonds.
REFERENCES
Cummins, J. David. “Should the Government Provide
Insurance for Catastrophes?” Federal Reserve Bank
of St. Louis Review, July/August 2006, 88(4), pp.
337-79.
Cummins, J. David and Weiss, Mary A. (2000), “The
Global Market for Reinsurance: Consolidation,
Capacity, and Efficiency,” in Robert E. Litan and
Anthony M. Santomero, eds., Papers on Financial
Services. Washington, DC: Brookings Institution
Press, pp. 159-209.
Francis, Theo. “Boss Talk: CEO Says Allstate Adjusts
Storm Plan; Personnel Can’t Reach Heart of Disaster,
So They Start Claims Work at the Fringes.” Wall
Street Journal (Eastern edition), September 6, 2005,
p. c.1.
Froot, Kenneth A. and Posner, Steven. “The Pricing
of Event Risks with Parameter Uncertainty.” Geneva
Papers on Risk and Insurance Theory, December
2002, 27(2), pp. 153-65.
Government Accounting Office. “Flood Insurance:
Information on the Financial Condition of the
National Flood Insurance Program.” Report GAO-
01-992T, 1999.
Ibragimov, Rustam and Walden, Johan. “The Limits
of Diversification When Losses May Be Large.”
Working paper, Harvard University, 2005.
Ibragimov Rustam; Jaffee, Dwight M. and Walden,
Johan. “Non-Diversification Traps in Markets for
Catastrophic Risk.” Presented at the National Bureau
of Economic Research insurance group meetings,
February 2006.
Jaffee, Dwight M. and Russell, Thomas. “Should
Governments Support the Private Terrorism
Insurance Market?” Financier (forthcoming).
Samuelson, Paul. “General Proof that Diversification
Pays.” Journal of Financial and Quantitative
Analysis, March 1967, 2(2), pp. 1-12.
Jaffee
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2006 385386 JULY/AUGUST 2006 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

Boss Talk: CEO Says Allstate Adjusts Storm Plan; Personnel Can’t Reach Heart of Disaster, So They Start Claims Work at the Fringes.” Wall Street Journal

General Proof that Diversification Pays.” Journal of Financial and Quantitative Analysis,

Government Accounting Office. “Flood Insurance: Information on the Financial Condition of the National Flood Insurance

Non-Diversification Traps in Markets for Catastrophic Risk.” Presented at the National Bureau of Economic Research insurance group meetings,

Should the Government Provide Insurance for Catastrophes?” Federal Reserve Bank of St. Louis Review,

The Global Market for Reinsurance: Consolidation, Capacity, and Efficiency,”

The Limits of Diversification When Losses May Be Large.” Working paper,

Commentary on "Should the government provide insurance for catastrophes?"

http://research.stlouisfed.org/publications/review/06/07/Jaffee.pdf

Commentary on "Should the government provide insurance for catastrophes?"

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics