Policy Documents

Catastrophe Insurance, Dynamic Premium Strategies, and the Market for Capital

Thomas Russell and Dwight M. Jaffee –
January 1, 1998

The purpose of this paper is to revisit the problem of the non-insurability of catastrophe risk. The paper focuses on questions surrounding the insurability of earthquake risk in the State of California, but the analysis may be applied to problems of insuring any natural disaster risk (for example the risk of hurricanes).

The paper argues that there is nothing in the nature of catastrophe risk as such which prevents the operation of a private market of insurance. To be viable, however, this market must solve the problem of matching a smooth flow of annual premiums to a highly non-smooth flow of annual losses. Current institutional arrangements do not provide incentives to solve this problem, hence the withdrawal of many insurance firms from this market. This does not mean that the difficulty (a capital market problem, not an insurance problem) cannot be overcome, and we offer a few
suggestions.

We believe that framing the problem of catastrophe insurance as a capital market problem rather than a problem in pure insurance may be of value to regulators for two reasons.

1. In prior approval states, regulators are frequently called upon to evaluate requests for premium increases following a natural disaster. By thinking of this request as an attempt to solve a problem of inadequate capital (rather than a problem of increased risk) regulators can evaluate this (often politically sensitive) request with the relevant economic tools.

2. Since there seems to be some consensus that private markets cannot provide catastrophe insurance, regulators in catastrophe-prone states are beginning to design state-run catastrophe insurance schemes. Also regulators are frequently asked to comment on and assist in the design of Federal Catastrophe Insurance legislation. If State and Federal schemes are to avoid the problems faced by the private market, it seems essential to know exactly what these problems are.

The paper will conclude by examining the recently proposed California Earthquake Authority Bill in the light of our discussion of capital market reforms.