The Economics of Catastrophe Risk Insurance


   In the United States, insurance is provided through a variety of private and public entities. Insurance companies owned by investors or policyholders sell insurance in the private sector. State-sponsored insurance pools have characteristics of both private and public entities. They are typically owned by a group of private insurers, but they are governed under charters that grant them special rights and impose responsibilities not required of private insurers. Finally, the Federal Government operates at least 135 different programs that provide insurance-like benefits to individuals and businesses.

   To understand how insurance works, imagine a large group of homeowners scattered throughout the country, each of whom faces a risk of property damage from a variety of identified hazards such as fire or severe weather. The likelihood that any particular member of the group will experience a loss is low, but the economic costs to that individual, should a loss occur, are significant. Each member of the group can reduce uncertainty about future economic losses by agreeing to pool risk with other members. One way of accomplishing this is through a mutual insurance agreement. At the beginning of the year, each member agrees to make a payment, called an insurance premium, into the pool. In exchange for their premiums, members are allowed to file claims with the pool should their houses incur damage from a covered hazard. Even if the insurance pool has no other resources, as long as the total value of premiums paid into the pool is at least as large as the value of insured losses over the year, all property damage will be fully covered. In this way, members of the pool gain security through diversification. Because any member's losses are paid for with premiums collected by all members, no member faces uncertainty about how much he will have to pay to cover property damage in the coming year.

   The process of evaluating a risk exposure, determining whether or not to insure it, and setting terms and conditions for any insurance provided is called underwriting. Through underwriting, insurance providers seek to tie the premiums charged for insurance policies to the risks those policies cover. Effective underwriting serves an important social function, because when insurance prices accurately reflect underlying economic costs they can encourage a more efficient allocation of scarce resources. For example, suppose a member of a coastal community must decide where to build a new home. She may prefer to live as close to the ocean as possible, but a home located nearer the ocean may be exposed to a higher risk of damage from windstorms and flooding. If homeowners insurance premiums are appropriately risk sensitive, then she will need to determine whether the benefits of living closer to the ocean are worth the cost of higher insurance premiums.

   Underwriting is critical to the efficient functioning of insurance markets. In general, insurance markets function best under the following conditions:

   1. Either all members of a pool face similar risks, or differences in risks can be observed and incorporated in insurance premiums.

   2. Insurance does not dissuade those who are insured from avoiding risks.

   3. The total value of insured losses for a pool can be forecast with precision.

   In many insurance markets, one or both of the first two conditions may not hold. Violations of the third condition are a particular feature of catastrophe-risk insurance markets. Through effective underwriting, insurers can reduce, though perhaps not eliminate, problems that arise when these conditions fail to hold.

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