Insurance workshop.

The NBER's Working Group on Insurance, directed by Kenneth A. Froot of the Harvard Business School and Howard C. Kunreuther of the Wharton School, University of Pennsylvania, met in Cambridge on May 8. These topics were discussed:

John Major, Guy Carpenter & Company, Inc., "On a Connection

Discussant: Kenneth A. Froot

Thomas Davidoff, University of California, Berkeley, "Illiquid Housing as Self-Insurance: the Case of Long Term Care"

Discussant: David Moss, Harvard University

Dwight Jaffe, University of California, Berkeley; Howard Kunreuther; and Erwann Michel Kerjan, University of Pennsylvania, "The Development of Long Term Insurance (LTI) To Address Catastrophe Insurance Market Failure"

Discussant: Robert J. Shiller, Yale University and NBER

Neil A. Doherty and Anastasia Kartasheva, University of Pennsylvania, and Richard D. Phillips, Georgia State University, "Competition among Rating Agencies and Information Disclosure"

Discussant: Christopher Lewis, The Hartford Financial Services Group

Martin F. Grace and Robert W. Klein, Georgia State University, "The Perfect Storm: Hurricanes, Insurance and Regulation"

Discussant: Richard Thomas, American International Group

Paul A. Raschky, University of Innsbruck, "Natural Hazards, Growth, and Risk Transfer: An Empirical Comparison between Risk-Transfer Mechanisms in Europe and USA"

Discussant: Jeffrey R. Brown, University of Illinois at Urbana-Champaign and NBER

Christian Laux, Goethe University Frankfurt, and Alex Muermann, Vienna University of Economics and Business Administration, "Financing Risk Transfer under Governance Problems: Mutual versus Stock Insurers"

Discussant: Keith Crocker, Pennsylvania State University

Costly external capital is one of the frictions that violates the premises of the Modigliani and Miller irrelevance theorems. Froot et. al. developed a three-stage model to explain how costly external capital, along with other frictions, provides an opportunity for risk management to create value. Major extends their model to analyze risk management (in particular, reinsurance) in the context of a going concern. He relates the extended Froot model to a 50-year-old stochastic dividend optimization problem, introduced by Bruno de Finetti, which has received growing interest in the recent decade.

Long-term care is one of the few observable triggers for home sale among the elderly, Davidoff notes. Combined with a thin reverse mortgage market, this helps to rationalize the weak demand for long-term care insurance (LTCI). Home equity tapped in the event of long-term care reduces the gain to insurance transfers during healthy periods, in which home equity typically goes unspent. The Health and Retirement Study provides empirical evidence supporting this. Households exposed to large increases in home equity in the recent housing boom were relatively unlikely to add LTCI coverage and relatively likely to drop coverage.

Jaffe and his co-authors propose long-term insurance (LTI) as an alternative to the standard annual policies for homeowners' coverage. They underscore the need for such a contractual arrangement by focusing on the challenges facing homeowners who live in high-risk areas and insurers today, having experienced the significant increase and variability in losses from natural disasters in recent years. Lessons from the mortgage market provide a benchmark for the development of LTI. More specifically, the authors here propose fixed and adjustable rate insurance contracts that have features similar to those in the mortgage market with penalties for canceling a long-term (LT) contract before it expires. For insurers to want to offer LTI, premiums have to reflect the risk including the cost of capital. Consumers are likely to prefer LTI to annual policies if there is considerable uncertainty as to whether their insurance will be cancelled unexpectedly, or if premiums are increased significantly following the next disasters. A two-period model illustrates when an LT contract would be attractive to both insurers and consumers under competitive market conditions. The authors show that insurers will be willing to offer such a policy if they can charge a high enough penalty for cancellation.

Doherty and his co-authors analyze why a rating agency pools different credit risks in one credit grade and how information disclosure depends on the value of information to the market. The authors build a model to analyze the optimal disclosure policy of a monopoly rating agency depending on the value of information to investors; they then describe the potential market and the strategy of the entrant. They find that entry of symmetric rating agencies results in asymmetric rating scales. This justifies why some companies obtain multiple ratings and suggests that similar ratings from different agencies may mean different credit risks. The researchers then empirically test the qualitative predictions of their model. They use Standard and Poor's entry into the insurance market that was previously covered by a monopoly agency, A.M. Best, as a natural experiment to study the impact of competition on the information content of ratings.

The risk and cost of natural disasters, their effects on insurance markets, and associated government policies yield an interesting and important story about the interplay of economics and politics. The intense hurricane seasons of 2004 and 2005 caused considerable instability in property insurance markets in coastal states with the greatest pressure in Florida and the Southeast. Insurers have raised their rates substantially and decreased their exposures. While no severe hurricanes have struck the United States since 2005, market pressures remain strong given the high risk still facing coastal states. These developments have generated considerable concern and some controversy among various groups of stakeholders. Government responses have varied. In Florida, political pressures have prompted a wave of legislation and regulations to expand government underwriting and subsidization of hurricane risk and to constrain insurers' rates and market adjustments. In this context, it is important to understand how property insurance markets have been changing and governments have been responding to increased catastrophe risk. Grace and Klein examine important market developments and evaluate associated government policies. They find interesting similarities and contrasts between Florida and other coastal states. They comment on how government policies are affecting the equilibration of insurance markets and offer opinions on actions that are helpful and those that are likely to have a negative impact on the supply of insurance and to undermine the efficient management of catastrophe risk.

An analysis of the effects of natural hazards on society does not depend solely on a region's topographic or climatic exposure, but rather on the region's institutional resilience to natural processes that ultimately determine whether they will result in a natural hazard or not. Raschky provides an institutional comparison between different societal risk-transfer mechanisms against floods in Europe and the United States. In the short run, a major flood event in a European region reduces the regional GDP by 0.4-0.6 percentage points; an average flood event in the United States reduces personal income by 0.3-0.4 percentage points. In addition, the results for the U.S. sample suggest that counties participating in the NFIP follow a less volatile growth path in subsequent years. Appropriate ex-ante risk-transfer policies can largely mitigate these effects, while ex-post governmental disaster relief tends to even enlarge the negative impact of natural hazards on income. These results provide useful implications for adaptation strategies against the adverse effects of climate change.

Laux and Muermann note that mutual insurance companies and stock insurance companies are different forms of organized risk sharing: policyholders and owners are two distinct groups in a stock insurer, while they are one and the same in a mutual. This distinction is relevant to raising capital and to selling policies under governance problems. In the presence of an owner-manager conflict, capital is costly. Free-rider and commitment problems limit the degree of capitalization that a stock insurer can obtain. The mutual form, by tying sales of policies to the provision of capital, can overcome these problems at the cost of less diversified owners.