Page 314 - DMGT303_BANKING_AND_INSURANCE

Unit 14: Marine and Motor Insurance

This evolution is a source of concern for the insurance industry, because the wealth elasticity of Notes
insurance demand is empirically larger than one. Thus, rapid increases in exposed wealth mean
that insured losses represent an increasing proportion of total losses. For example, one of the
most severe catastrophes over the past years was the Kobe earthquake in 1995, which caused
losses to an amount of US$82.4 billion, but insured losses remained at a more modest $2.5
billion. This is relatively small compared to the series of losses which were inflicted upon the
insurance industry since 1988. Insurers had to pay $12.5 billion for the Northridge earthquake
(1994) and $16 billion for Hurricane Andrew (1992), more than 40 percent of the combined total
cost for these two events, estimated at $65 billion.
Prior to Andrew, the industry had not anticipated such high damage values. Indeed, the financial
press was saturated with stories of astonishment following Hurricane Hugo in 1989, which cost
the industry over $5 billion. Ever since Hugo however, insured losses in excess of $1 billion
have become the rule rather than the exception.

Catastrophic losses challenge the economic role of insurance as a private wealth redistribution
mechanism. Insurance makes possible the transfer of numerous risks. It is a mechanism whereby
insurers collect funds from many agents exposed to similar risks, to pay for losses that will
randomly affect some of these agents. The reinsurance mechanism complements direct insurance
by allowing a more world-wide diversification of risks. In general, the financial capacity of the
insurance industry has been able to absorb intertemporal deviations of total losses from their
expected value. However, financial capacity has been outpaced by potential losses in the
catastrophe lines. The total capital of the US property-casualty insurance industry is estimated at
$200 billion, of which $20 billion is provided by reinsurers (Kielholz and Durrer, 1997). The
coverage capacity in the catastrophe line of business (direct insurance and reinsurance) is estimated
at $25 billion. This is less than the reference loss, estimated by reinsurers, of $50 billion for a
California earthquake or $45 billion for a single large east-coast storm; and it is well below the
maximum probable losses from these two kinds of events, estimated at $100 billion for California
earthquakes and $85 billion for east-coast storms.
The problem arises because the risk of natural catastrophes is not widely diversifiable in an
insurance context, where insurers supply coverage in well-defined business lines. Natural
catastrophes tend to occur in selected areas of the globe: seismic regions and ocean coasts.
Moreover, only a subset of these regions expresses much demand for insurance coverage. Thus,
reinsurers are not able to disseminate the risk easily across the world, and cross-subsidization
among different lines of business is not feasible in a competitive environment.
Two types of solutions to the insurance capacity gap have been proposed and put into practice.
Mandatory public provision of insurance is one alternative. It relies on the financial and fiscal
ability of the government to spread losses across many citizens, as well as intertemporally. This
was imposed in France, where all insureds pay an additional premium on their property-
liability insurance contracts in exchange for coverage against natural catastrophes, with a
reinsurance guarantee provided by the State.
Risk securitization represents a second alternative. It relies on the huge pool of financial capacity
provided by asset markets. By increasing the capacity provided by reinsurance markets alone,
securitization allows for a higher level of diversification for catastrophic risks (Cummins and
Weiss, 2000). For example, total capitalization of the US financial market amounts to approximately
$20 trillion, with a daily standard deviation of around $130 billion. Thus, typical daily fluctuations
in total US asset market capitalization are able to cover the maximum probable loss from a
California earthquake. Risk securitization is accomplished by issuing specific conditional claims
and selling them directly to financial investors. Options on natural catastrophes (cat spreads)
started trading at the Chicago Board of Trade in 1995, and catastrophe-linked bonds (cat bonds)
have been issued since 1997.

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