Insurance Project
Participants in the NBER's Insurance Project met in Cambridge on February 25 and 26. Project Director Kenneth A. Froot, NBER and Harvard University, and Howard C. Kunreuther, NBER and University of Pennsylvania, organized this program:
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Jaffee and Russell use the example of the California Earthquake Authority (CEA), the quasi-state agency organized in 1996 to replace the private market for earthquake insurance in California, and its customers to study a catastrophe insurance market. They describe three features of the CEA: 1) the values reflected in CEA premiums are higher than what many consumers feel is the probability of a major future earthquake and the expected losses from such a quake; 2) the CEA offers only partial insurance, because claims cannot be paid in full for events with insurable losses that exceed about $7.2 billion; 3) the CEA contract initially provided only a high 15 percent deductible, while a "buydown" option to a 10 percent deductible was introduced in late 1999. The authors focus on how a welfare maximizing public agency such as the CEA should set premiums and coverage limits when its views of the probabilities and expected losses from earthquakes diverge from the views of its customers. Jaffee and Russell also analyze the preferences of consumers for insurance contracts, with or without deductible limits, when the payment of claims may be limited by financial constraints.
Cummins and Mahul develop a theoretical model of optimal contracting for financing large, infrequent events in which the payoffs are subject to both default risk and basis risk. Full insurance above a deductible is optimal when both parties have the same perception of the seller's default risk. When this perception differs, the optimal insurance design depends on behavioral concepts that are standard in the literature of insurance economics, such as risk tolerance, and on concepts from actuarial science, such as hazard rates. Under some specific behavioral and actuarial assumptions, the first-best indemnity schedule should increase and be concave with losses. This could in part explain why the proportion of the loss reinsured decreases with the size of the loss in real-world reinsurance markets. The optimal hedging strategies in the reinsurance market and in the financial market can be derived from this first-best solution.
Grace, Klein, and Kleindorfer find that price variation across states in homeowners insurance is significant and not explained completely by expected losses. Nearly every feature of homeowners policies and company characteristics is associated with premium levels and prices, they find. At the zip code level, there is some sensitivity between the supply of insurance and price -- that is, as price increases, insurers are willing to supply a greater quantity of insurance. The authors also find some initial evidence that regulatory constraints on territorial rates reduce the supply of insurance, at least for homes with low value. For homes with high value, the effect of price regulation on the supply of insurance is less clear.
Many individuals one would expect to have insurance (for example, subsidized flood insurance) do not have coverage, while others who appear not to need protection against certain events actually have purchased a policy (for example, flight insurance). Furthermore, certain types of insurance policies that one might expect (or hope) to be marketed by insurers are not (for example, guaranteed renewability insurance for small group health insurance), while other policies that one would not expect to be marketed successfully exist on a large scale (for example, coverage with low or no deductible). Kunreuther and Pauly seek to explain these apparent contradictions. They first develop theories of the demand for insurance and the supply of coverage in a world of perfect information and no transaction costs between parties. They then develop a broader theory of the demand and supply of insurance that introduces other factors not usually considered, including information imperfections, effort and attention costs, multiattribute preferences, and insolvency concerns. They conclude that there may be a role in which government can increase economic welfare in some of these situations.
Brown, Mitchell, and Poterba explore four issues concerning annuitization options that retirees might use in the decumulation phase of an "individual accounts" retirement saving system. First, they investigate the operation of both real and nominal individual annuity markets in the United Kingdom. The widespread availability of real annuities in the United Kingdom dispels the argument that private insurance markets could not, or would not, provide real annuities to retirees. Second, the authors consider the current structure of two inflation-linked insurance products available in the United States, only one of which proves to be a real annuity. Third, they evaluate the potential of assets, such as stocks, bonds, and bills, to provide retiree protection from inflation. Finally, the authors use a simulation model to assess the potential willingness of retirees to pay for real, nominal, and variable payout equity-linked annuities. They find that a representative retiree with a relative risk aversion coefficient of two would need 1.5 times as much wealth to achieve a given lifetime utility level without access to an actuarially fair nominal annuity market as someone with such a market. These findings are germane to concerns raised in connection with Social Security reform plans that include individual accounts.
Moss presented a draft chapter on Social Security from his book in progress (tentatively titled When All Else Fails) about the government's role as a risk manager. In this chapter, he explores the pivotal risk management logic underlying Franklin D. Roosevelt's landmark social insurance legislation of 1935, which inaugurated the nation's federal-state system of unemployment insurance as well as its purely federal old-age insurance program. Moss finds that although risk management was only one of several explicit goals motivating the enactment of federal old-age insurance (the others being economic stabilization, redistribution, and forced savings), it was nonetheless a very important one. Depression-era policymakers focused on three risks that they believed plagued millions of Americans in their efforts to save for retirement -- longevity risk, work-duration risk, and investment risk. The last of these was viewed with particular alarm, since retirees who had depleted their human capital were thought to be unusually vulnerable to financial volatility. Comprehensive risk management thus emerged as one of the primary objectives (perhaps the primary objective) in the formulation of federal old-age insurance -- a historical fact that takes on added significance given the current debate over Social Security privatization.
Grace and Phillips investigate the incentives that states have to regulate insurance products in an efficient manner. Regulation of the insurance industry in the United States is unique in that it is conducted primarily at the state level while the majority of insurance sales are interstate. States with small domestic insurance markets are less efficient producers of insurance regulation, and they tend to allow states that expend the greatest resources to regulate for them. Furthermore, states with more profitable domestic insurers export greater levels of regulation, suggesting that extraterritorial regulation may erect barriers to entry. Grace and Phillips find increasing economies of scale in the production of insurance regulation after they control for these regulatory externalities. Taken together, their results suggest that aggregating the production of regulation to a multistate or federal level may resolve a number of inefficiencies in the current system.
Myers and Read show how option pricing methods can be used to allocate an insurance company's surplus across different lines of insurance. The first step is to calculate a default value, that is the premium that the company would have to pay in a competitive market for a policy guaranteeing payment of all policyholders' losses if the company defaults. Each line's marginal contribution to the default value would be the same. The resulting allocations are unique and not arbitrary. The surplus allocation of a line depends not just on the degree of uncertainty about the line's losses, but also on the correlations with other lines' losses and with the returns on the company's assets. It also depends on the line-by-line composition of the insurance company's business, but adding new lines should not lead to material changes in surplus allocations for existing lines.
Hendel and Lizzeri focus on the life insurance industry and ask how contracts are designed to deal with classification risk. Their model captures the main features of this industry, and the data are especially suited for a test of their theory, since they include information on the entire profile of future premiums. The authors find that the lack of commitment by consumers shapes contracts in the way that their theory predicts. All types of contracts involve front-loading, which generates a partial lock-in of consumers. Contracts that are more front-loaded have a lower present value of premiums over the period of coverage. This is consistent with the idea that more front-loaded contracts retain better risk pools. The estimates suggest that classification risk is insured almost completely by long-term level-premium contracts.
Reinsurance, the traditional hedging instrument for insurers, encounters potentially serious moral hazard, which is reflected in contract design. New financial instruments have adopted radically different devices for addressing moral hazard, including the use of "instrument variables" that are correlated to the insurer's risk but which the insurer cannot control. Doherty and Smetters attempt to identify moral hazard in the traditional reinsurance market. They build a multiperiod principle agent model of the reinsurance transaction with which they can predict on premium design, monitoring loss control, and insurer risk retention. Then using panel data on U.S. property liability reinsurance, they find evidence for the use of loss sensitive premiums when the insurer and reinsurer are not affiliates (that is, not part of the same financial group). There is little or no use of monitoring, though. In contrast, when the insurer and reinsurer are affiliates -- and where monitoring costs are lower -- there is little use of price controls, but Doherty and Smetters find evidence for the use of monitoring.