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The NBER's Working Group on Insurance, directed by Kenneth A. Froot, NBER and Harvard University, and Howard Kunreuther, NBER and University of Pennsylvania, met in Cambridge on February 6 and 7. Insurance, from a theoretical perspective, is a cornerstone of economic theory. It is used often in textbooks as an example of a pure contingent claim (for example, one that pays off upon flood damage to a house, or death from natural causes). It is also used frequently as an example of markets that run into imperfections (such as moral hazard and adverse selection). Even the imperfections are interesting, of course, since they are affected by contractual form (as is true in corporate finance). The NBER's Working Group on Insurance has a broad focus, encompassing theoretical, empirical, and industrial topics, including: insurance customers and investors; insurance producers; equilibrium; and policy questions. Since its inception, it has convened once a year for a 2-day meeting. Participants in the group are predominantly academics from a variety of fields, plus a group of carefully-selected practitioners.

The program for the February meeting was:

Amy Finkelstein, NBER and Harvard University, and Kathleen McGarry, NBER and University of California, Los Angeles, "Private Information and its Effect on Market Equilibrium: New Evidence from Long-Term Care Insurance" (NBER Working Paper No. 9957, described earlier in this issue under "Health Care") Discussant: David M. Cutler, NBER and Harvard University

Martin F. Grace, Robert W. Klein, and Richard D. Phillips, Georgia State University, "Insurance Company Failures: Why Do They Cost So Much?" Discussant: Dwight Jaffe, University of California, Berkeley

Stephan Dieckmann, Carnegie Mellon University, "An Equilibrium Model with Heterogeneous Beliefs about Rare Events" Discussant: Geoffrey Heal, NBER and Columbia University

Michael Braun and Alexander Muermann, University of Pennsylvania, "The Impact of Regret on the Demand for Insurance" Discussant: Richard J. Zeckhauser, NBER and Harvard University

Thomas Russell, Santa Clara University, "Deductible Aversion and the Design of High Cost Insurance Contracts" Discussant: Howard Kunreuther

Jeffrey R. Brown, NBER and University of Illinois at Urbana-Champaign; J. David Cummins, University of Pennsylvania; Christopher M. Lewis, Fitch Risk Management; and Ran Wei, University of Pennsylvania, "An Empirical Analysis of the Economic Impact of Federal Terrorism Reinsurance" Discussant: Joan Lamm-Tennant, General Reinsurance Corporation

George Zanjani, Federal Reserve Bank of New York, "The Rise and Fall of the Fraternal Life Insurer: Law and Finance in U.S. Life Insurance, 1870-1920" Discussant: David Moss, Harvard University

Jeffrey R. Brown and Amy Finkelstein, "The Interaction of Public and Private Insurance: Medicaid and the Long-Term Care Insurance Market" Discussant: Mark Pauly, NBER and University of Pennsylvania

Richard A. Derrig, Automotive Insurers Bureau of Massachusetts, and Herbert I. Weisberg, Correlation Research Inc., "Determinants of Total Compensation for Auto Bodily Injury Liability Under No-Fault: Investigation, Negotiation, and the Suspicion of Fraud" Discussant: Scott Harrington, University of South Carolina

Kenneth A. Froot, "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers" (NBER Working Paper No. 10184) Discussant: Anne Gron, Northwestern University

Gordon Woo, Risk Management Solutions, "A Catastrophe Bond Niche: Multiple Event Risk" Discussant: Neil Doherty, University of Pennsylvania

Historical evidence shows that insurer insolvencies are, on average, three to five times more expensive than those of other financial institutions. Using a unique dataset of insurer insolvencies from 1986 to 1999, Grace, Klein, and Phillips examine the cost of insolvency resolution and the factors driving these costs. They find that firms in relatively better shape before being seized impose lower costs on the insolvency system. Further, they find evidence consistent with non-benevolent behavior by regulators, both before and after the firm fails, which adds significantly to the resulting costs of the insolvency.

Dieckmann solves an equilibrium model in which agents have different beliefs about the frequency of rare events. (In this context, a rare event can be understood as a significant, negative jump in economic fundamentals caused by a severe catastrophe like earthquakes, windstorms, or even a terrorist attack.) He poses the question of how the risk of a rare event, in addition to small diffusive risk, is shared among agents in a capital market equilibrium. In a complete market economy, the agent who anticipates less frequent jumps is willing to provide insurance against rare events for the agent anticipating a higher frequency. In the incomplete market economy without insurance, the equity premium of the stock market decreases, because risk sharing solely through the stock is less than optimal. In this case, the agent who anticipates less frequent jumps is leveraging the portfolio optimally, while the agent anticipating a higher frequency reduces stock holdings, compared to the complete market case. The difference in portfolio holdings between the complete and incomplete market looks like a synthetic put option on the stock; the agent who is leveraging the portfolio serves as the seller of the put option. Over time, agents learn about the true frequency of rare events in a Bayesian fashion. As a result, insurance premiums increase significantly as agents update their beliefs after observing a rare event and decline slowly thereafter, a behavior frequently observed in the reinsurance market. Dieckmann compares the long-run wealth effects of the complete and incomplete market and finds a variety of possible scenarios depending on the degree of heterogeneity. Finally, he shows an application of the model to the catastrophe bond market. In a marginal comparison, a reinsurance company would issue a catastrophe bond at a significantly higher yield in the incomplete market. Therefore, these findings help to explain the high yields and insurance premiums observed in the small reinsurance market for rare events.

Braun and Muermann examine optimal insurance purchase decisions of individuals whose behavior is consistent with Regret Theory. Their model incorporates a utility function that assigns a disutility to outcomes that are ex-post suboptimal, and predicts that individuals with regret-theoretical preferences adjust away from the extremes of full insurance and no insurance coverage. This prediction holds for both coinsurance and deductible contracts, and can explain the frequently observed preferences for low deductibles in markets for personal insurance.

Insurance contracts frequently contain deductible arrangements very different from those suggested by standard welfare economics. Russell tries to explain this by examining two non-standard utility models of insurance demand: rank-dependent expected utility and regret theory. He shows that these two models make opposite predictions regarding deductible demand when loadings are small. He suggests an alternative, context-based model of deductible demand and discusses its implications for the design of high cost policies, such as the Medicare Drug Plan and the California Earthquake Authority.

Brown, Cummins, Lewis, and Wei examine the role of the federal government in the market for terrorism risk, beginning with a discussion of the possible sources of market failure, with particular attention to whether terrorism risk differs from other large-scale natural catastrophes. The authors then show how the markets perceived the Terrorism Risk Insurance Act of 2002, which resulted in unprecedented federal intervention in the market for terrorism insurance in the United States. They examine the stock price response of affected industries to a sequence of 13 events, beginning with the initial proposals for a federal reinsurance role in October 2001 and culminating in the signing of the Act into law on November 26, 2002. They find that, in those industries most likely to be affected by TRIA--banking, construction, insurance, real estate investment trusts (REITs), transportation, and public utilities--the stock price effect was primarily negative. They argue that the Act was at best value-neutral for property-casualty insurers for several reasons, including its elimination of the option not to offer terrorism insurance. The negative response of the other industries may be attributable to the Act's impeding the development of more efficient private market solutions and reducing market estimates of expected federal assistance following future terrorist attacks.

Zanjani studies the rise and fall of fraternal life insurance in the decades surrounding 1900. He shows that the rise of the fraternal life insurer took place while it was exempt from the solvency regulations that governed other insurance companies, and its fade into obscurity followed soon after this exemption ended. Enactment of fraternal regulation at the state level was associated with large drops in fraternal insurer formations. The evidence challenges the notion that claimant protection laws "enabled" insurance organizations to succeed by enhancing public confidence in their operations, suggesting instead that they were a burden on industry.

Long-term care represents one of the largest uninsured financial risks facing the elderly in the United States. Brown and Finkelstein examine the importance of Medicaid, relative to potential private market failures, in limiting private insurance coverage. They develop an analytical framework to compute a risk averse consumer's willingness to pay for a long-term care insurance policy and calibrate the model using state-of-the-art actuarial data on long-term care utilization probabilities, comprehensive market data on insurance policy characteristics and premiums, and common state Medicaid rules. They find that, given the existence of the public Medicaid program as a payer-of-last resort, individuals throughout most of the wealth distribution would not be willing to pay for either the currently available limited insurance contracts or for comprehensive coverage, even if prices were actuarially fair. By contrast, they find that making Medicaid less generous substantially increases the proportion of individuals who are willing to pay for either the currently available, limited policies or for more comprehensive policies, even at existing prices. These findings thus highlight the fundamental role played by Medicaid in limiting demand for private long-term care insurance.

Auto bodily injury liability claim payments are predominantly negotiated settlements, with less than 2 percent the result of complete litigation and jury trials. All settlements consist of a combination of claimed economic loss, called special damages, and a payment for "pain and suffering", called general damages. The dependence of the total compensation on a variety of factors relating to the type and magnitudes of the economic losses, medical and wage loss, and to the type and severity, of injury has been explored by prior researchers; they found medical losses to be the primary determinant of total compensation. They also found that other severity variables play a distinct and significant role in the final settlement values, though. Further research introduced the notion that both the information gathered in the course of investigation and the adjuster's attitude toward the quality of the claim, especially the suspicion of fraud, also played a significant role in the final settlement value. Recently, it has been shown that settlement values for subjective injury claims are systematically lower relative to special damages. This indicates that insurers use their negotiating power to obtain lower settlements on questionable claims as a rational response to the presence of fraud and build up claims. Derrig and Weisberg extend that research by examining additional variables specifically related to the investigation and negotiation processes. They quantify the effect of those variables on the final total compensation. In particular, they find that strain and sprain claims command lower general damages relative to specials, even in the absence of suspicion of fraud and build up. Still, the intensity of suspicion of fraud and build up can reduce overall payments as much as 26 percent. For the first time, the negotiating effect of attorney demands enters the quantitative model in addition to the usual contingency fee. Finally, evidence that insurers are isolating low impact collisions and reducing the compensation through negotiation is explored and quantified.

Froot develops a framework for analyzing the risk allocation, capital budgeting, and capital structure decisions facing insurers and reinsurers. His model incorporates three key features: 1) value-maximizing insurers and reinsurers face product market as well as capital market imperfections that give rise to well-founded concerns with risk management and capital allocation; 2) some, but not all, of the risks they face can be frictionlessly hedged in the capital market; 3) the distribution of their cashflows may be asymmetric, which alters the demand for underwriting and hedging. Froot shows that these features result in a three-factor model that determines the pricing and allocation of risk and the optimal capital structure of the firm. This approach allows him to integrate these features into: 1) the pricing of risky investment, underwriting, reinsurance, and hedging; and 2) the allocation of risk across all of these opportunities, and the optimal amount of surplus capital held by the firm.

The successful securitization of terrorism risk, pioneered in October 2003 through Golden Goal Finance Ltd., suggests that the catastrophe bond market may yet be expanded through innovation, enterprise, and industry on the part of investment bankers, lawyers, and risk analysts. The issuance to investors of $260 million of bonds, exposed principally to terrorism risk, reveals a latent appetite within the capital markets for specialized forms of risk. Woo studies a special class of catastrophe bonds: multiple event instruments which either cannot or are extremely unlikely to default until at least two major events have occurred. He reviews Golden Goal Finance Ltd. and some recent natural peril multiple event transactions, as well as related securitizations, such as Vita Capital for mortality risk.
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Title Annotation:Bureau News; discussion
Publication:NBER Reporter
Geographic Code:1USA
Date:Mar 22, 2004
Previous Article:Economic fluctuations and growth.
Next Article:Industrial organization.

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