References

NHESS

Natural Hazards and Earth System Sciences

NHESS

Nat. Hazards Earth Syst. Sci.

1684-9981

Copernicus Publications

Göttingen, Germany

10.5194/nhess-13-2053-2013

Insuring catastrophes and the role of governments

Boyer

M. M.

¹ Nyce

C. M.

HEC Montréal, Université de Montréal, 3000 chemin de la Côte-Ste-Catherine, Montréal, Québec, QC H3T 2A7, Canada

Florida Catastrophic Storm Risk Management Center, College of Business, Florida State University, Tallahassee, Florida, FL 32306-1110, USA

16 08 2013

13 8 2053 2063

2013

This work is licensed under the Creative Commons Attribution 3.0 Unported License. To view a copy of this licence, visit https://creativecommons.org/licenses/by/3.0/

This article is available from https://nhess.copernicus.org/articles/13/2053/2013/nhess-13-2053-2013.html

The full text article is available as a PDF file from https://nhess.copernicus.org/articles/13/2053/2013/nhess-13-2053-2013.pdf

In this paper we model the cost of providing insurance coverage against natural and man-made hazards. We propose an insurance market model that explains (1) the use of reinsurance to help finance the cost of catastrophic events and (2) the implicit (or explicit) presence of government entities acting as (re)insurers of last resort. Using an economic model, we show how insurance programmes should be designed to cover the losses due to a possible catastrophic natural hazard. Our results show that the optimal structure of a reinsurance programme minimizes the cost of offering insurance protection. We also show how government intervention can reduce the cost of insurance against natural catastrophes and increase policyholders' welfare. Our paper therefore offers public policy implications as to the role and presence of government as an insurer of last resort and the minimum insurance premium necessary to cover the cost of catastrophic events.

References 1

AIR Worldwide: The Coastline at Risk: 2008 Update to the Estimated Insured Value of US Coastal Properties, Boston, Massachusetts, available at: <a href="http://www.air-worldwide.com/_public/images/pdf/AIR2008_Coastline_at_Risk.pdf">http://www.air-worldwide.com/_public/images/pdf/AIR2008_Coastline_at_Risk.pdf</a>, 2008.

Albertini, L. and Barrieu, P.: The Handbook of Insurance-Linked Securities, John Wiley & Sons, New York, 398 pp., 2009.

Berger, L. A., Cummins, J. D., and Tennyson, S.: Reinsurance and the Liability Crisis, J. Risk Uncertainty, 5, 253–272, <a href="http://dx.doi.org/10.1007/BF00057882">https://doi.org/10.1007/BF00057882</a>, 1992.

Borch, K.: Equilibrium in a Reinsurance Market, Econometrica, 30, 424–444, 1962.

Borst, D., Jung, D., Murshed, S. M., and Werner, U.: Development of a methodology to assess man-made risks in Germany, Nat. Hazards Earth Syst. Sci., 6, 779–802, <a href="http://dx.doi.org/10.5194/nhess-6-779-2006">https://doi.org/10.5194/nhess-6-779-2006</a>, 2006.

Boyer, M. M. and Dupont-Courtade, T.: The Market for Reinsurance, Mimeo HEC Montréal and Cirano, Scientific Series, Working Paper 2013-s06, 2013.

Cole, C. R., MacPherson, D. A., Maroney, P. F., McCullough, K. A., Newman, J. W.,, and Nyce, C.: The Use of Post-Loss Financing of Catastrophic Risk, Risk Management and Insurance Review, 14, 265–298, 2011.

Cummins, J. D. and Trainar, P.: Securitization, Insurance, and Reinsurance, J. Risk Insur., 76, 463–492, <a href="http://dx.doi.org/10.1111/j.1539-6975.2009.01319.x">https://doi.org/10.1111/j.1539-6975.2009.01319.x</a>, 2009.

Cummins, J. D., Doherty, N. A., and Lo, A.: Can insurers pay for the "big one"? Measuring the capacity of the insurance market to respond to catastrophic losses, J. Bank. Financ., 26, 557–583, <a href="http://dx.doi.org/10.1016/S0378-4266(01)00234-5">https://doi.org/10.1016/S0378-4266(01)00234-5</a>, 2002.

de Lourdes Centeno, M. and Simoes, O.: Optimal reinsurance, Revista de la Real Academia de Ciencias Exactas, Fisicas y Naturales: Serie A-Matematicas, 103, 387–405, https://doi.org/10.1007/BF03191914, 2009.

Elsner, J., Kossin, J. P., and Jagger, T. H.: The Increasing Intensity for the Strongest Tropical Cyclones, Nature, 455, 92–95, <a href="http://dx.doi.org/10.1038/nature07234">https://doi.org/10.1038/nature07234</a>, 2008.

Emanuel, K.: Environmental Factors Affecting Tropical Cyclone Power Dissipation, J. Climate, 20, 5497–5509, <a href="http://dx.doi.org/10.1175/2007JCLI1571.1">https://doi.org/10.1175/2007JCLI1571.1</a>, 2007.

Fazzari, S. M., Hubbard, R. G., and Petersen, B. C.:Financing Constraints and Corporate Investment, Brookings Papers in Economics, 1, 141–195, 1988.

Froot, K. A. and O'Connell, P. G. J.: On the pricing of intermediated risks: Theory and application to catastrophe reinsurance, J. Bank. Financ., 32, 69–85, <a href="http://dx.doi.org/10.1016/j.jbankfin.2007.09.008">https://doi.org/10.1016/j.jbankfin.2007.09.008</a>, 2008.

Garven, J. R. and Lamm-Tennant, J.: Optimality of a Stop-Loss Reinsurance in Layers, Insurance and Risk Management, 7, 217–237, 2003.

Hartwig, R. and Wilkerson, R.: Residual Market Property Plans: From Markets of Last Resort to Markets of First Choice, Insurance Information Institute, 2007, 2010, 2012.

Hurlimann, W.: Optimality of a Stop-Loss Reinsurance in Layers, ASTIN Colloquium International Actuarial Association – Brussels, Belgium, 2003.

Ibragimov, R. and Walden, J.: The Limits of Diversification When Losses May Be Large, J. Bank. Financ., 31, 2551–2569, <a href="http://dx.doi.org/10.1016/j.jbankfin.2006.11.014">https://doi.org/10.1016/j.jbankfin.2006.11.014</a>, 2007.

Ibragimov, R., Jaffee, D., and Walden, J.: Nondiversification Traps in Catastrophe Insurance Markets, Rev. Financ. Stud., 22, 959–993, 2009.

Jean-Baptiste, E. L. and Santomero, A. M.: The Design of Private Reinsurance Contracts, J. Financ. Intermed., 9, 274–297, <a href="http://dx.doi.org/10.1006/jfin.2000.0291">https://doi.org/10.1006/jfin.2000.0291</a>, 2000.

Kessler, D.: Insurance market mechanisms and government interventions", J. Bank. Financ., 32, 4–14, 2008.

Kleffner, A. E. and Doherty, N. A.: Costly Risk Bearing and the Supply of Catastrophic Insurance, J. Risk Insur., 63, 657–671, 1996.

Krausmann, E., Cozzani, V., Salzano, E., and Renni, E.: Industrial accidents triggered by natural hazards: an emerging risk issue, Nat. Hazards Earth Syst. Sci., 11, 921–929, <a href="http://dx.doi.org/10.5194/nhess-11-921-2011">https://doi.org/10.5194/nhess-11-921-2011</a>, 2011.

Kunreuther, H. and Michel-Kerjan, E.: At War with the Weather: Managing Large-Scale Risks in a New Era of Catastrophes, MIT Press, 2009.

Ladoucette, S. A. and Teugels, J. L.: Analysis of Risk Measures for Reinsurance Layers, Insurance: Mathematics and Economics, 38, 630–639, <a href="http://dx.doi.org/10.1016/j.insmatheco.2005.12.005">https://doi.org/10.1016/j.insmatheco.2005.12.005</a>, 2006.

Lewis, C. M. and Murdock, K. C.: The Role of Government Contracts in Discretionary Reinsurance Markets for Natural Disasters, J. Risk Insur., 63, 567–597, 1996.

Michaelides, S. C., Savvidou, K., Orphanou, A., Nicolaides, K., and Tymvios, F.: Outcomes of the 10th EGU Plinius Conference on Mediterranean Storms (2008), Nat. Hazards Earth Syst. Sci., 11, 259–265, <a href="http://dx.doi.org/10.5194/nhess-11-259-2011">https://doi.org/10.5194/nhess-11-259-2011</a>, 2011.

Nyce, C. and Maroney, P.: Are Territorial Rating Models Outdated in Residential Property Insurance Markets? Evidence from the Florida Property Insurance Market, Risk Management and Insurance Review, 14, 201–232, <a href="http://dx.doi.org/10.1111/j.1540-6296.2011.01204.x">https://doi.org/10.1111/j.1540-6296.2011.01204.x</a>, 2011.

Plattner, Th.: Modelling public risk evaluation of natural hazards: a conceptual approach, Nat. Hazards Earth Syst. Sci., 5, 357–366, <a href="http://dx.doi.org/10.5194/nhess-5-357-2005">https://doi.org/10.5194/nhess-5-357-2005</a>, 2005.

Plattner, Th., Plapp, T., and Hebel, B.: Integrating public risk perception into formal natural hazard risk assessment, Nat. Hazards Earth Syst. Sci., 6, 471–483, <a href="http://dx.doi.org/10.5194/nhess-6-471-2006">https://doi.org/10.5194/nhess-6-471-2006</a>, 2006.

Powell, L. S. and Sommer, D. W.: Internal Versus External Capital Markets in the Insurance Industry: The Role of Reinsurance, J. Financ. Serv. Res., 31, 173–188.2007.

Zanjani, G.: Pricing and Capital Allocation in Catastrophe Insurance, J. Financ. Econ., 65, 283–305, <a href="http://dx.doi.org/10.1016/S0304-405X(02)00141-1">https://doi.org/10.1016/S0304-405X(02)00141-1</a>, 2002.