Why can’t we insure for the Big One?

Examining insurance company’s inability to insure.

Disasters are why we need insurance, but the truly catastrophic events—earthquakes, hurricanes, and floods—remain stubbornly difficult to insure. (This despite the fact that the modern insurance industry itself was born out of catastrophe: the Great Fire of London in 1666, which destroyed a quarter of England’s GDP.) Why? The problem, notes SCU Associate Professor of Economics Thomas Russell, lies in the capital markets, not in the insurance markets.

Thomas Russell
Thomas Russell
Photo: Courtesy Thomas Russell

Just over a decade ago, Russell and UC Berkeley Professor Dwight Jaffee co-authored a paper examining why insurance companies are reluctant to insure catastrophic risks. And this fall, because of that paper, “Catastrophe Insurance, Capital Markets, and Uninsurable Risks,” the pair was honored with the American Risk and Insurance Association’s Robert I. Mehr Award. The lag time is intentional; the award is presented to a journal article that stands the test of time. After all, with insurance, one needs to take the long view.

With auto insurance, premiums collected in any one year suffice when it comes to paying out that year’s claims. “With catastrophes, however,” note Russell and Jaffee in a more recent paper, “when the ‘big one’ hits, current premiums will not suffice.” Instead, large pools of capital are needed to cover potential catastrophes. And those pools are not available for a number of reasons, including accounting requirements that prohibit companies from irrevocably earmarking surplus funds toward payment of a catastrophic risk; lack of tax incentives for companies to save for a rainy day; and, as the authors put it, “myopic behavior of stock market investors.”

The devastation wrought by Hurricane Katrina renewed concern over making catastrophe insurance available. (Another factor became evident in the aftermath of Katrina: Despite the subsidized National Flood Insurance Program run by FEMA, the program hasn’t helped the many people along the Gulf Coast who didn’t buy this protection.) Russell and Jaffee call for government involvement as a solution, along the model of the Federal Reserve, with the guiding principle of having a public scheme mimic how the markets would govern—if only the markets would do what they should. —AKG and SBS

post-image Homewrecker: Hurricane Katrina's aftermath Photo: iStockPhoto
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