Disaster Plan for Insurance Industry

Hurricanes, earthquakes, volcanoes. The list of natural disasters that have befallen Americans in the last decade is remarkable. Damages total $75 billion, one-third more than all losses combined in the previous 40 years. Payouts in the wake of Hurricane Andrew and the Northridge earthquake alone caused the failure of nine insurance companies and triggered a need for new forms of reinsurance that will shore up the financially exhausted insurance system.
Not surprisingly, insurers have called for federal assistance. But politicians and economists alike believe a government safety net would be a mistake over the long haul, says Assistant Professor of Strategic Management Kevin Murdock, who has taken a close look at the U.S. insurance system. A government bailout program would likely leave taxpayers footing the bill for poorly managed insurance companies.
Murdock began digging into this problem with government economist Christopher Lewis while he was on staff at the Council of Economic Advisors three years ago. They believe the insurance fix is a job primarily for the private sector to handle, with government playing only a supporting role. To that end, Murdock and Lewis have devised a model for risk management and distribution that would help insurers shoulder their burden when the next cluster of calamities hits. Their unique proposal, parts of which are now under consideration by Congress, recommends a hybrid form of private reinsurance. Interestingly, it borrows from current models for covering risk in the worlds of both insurance and investment.
Murdock and Lewis take into account three key problems confronting insurers.
First, there has been an avalanche of housing development in relatively unsafe areas. "Think of development patterns 30 years ago and what they are today," says Murdock. "We've increased building on the Florida coast and near the San Andreas fault." There has been a 69 percent increase just in insured coastal property values, to $3.1 trillion, since 1988. That has created new social risks--and costs. The building boom over the last few decades coincided with a period of relatively low incidence of natural disasters. Following the recent string of calamities, however, the cost of building with poor construction or in risky locations is just now being realized.
Second, the current solution for handling the fallout from natural disasters does not create incentives to reduce costs. For example, the government's compassionate policy allows uninsured homeowners to receive low-cost loans or grants to rebuild. Insured homeowners get nothing.
Third, the current market for disaster insurance has not worked well because it doesn't fit into either of two standard mechanisms for handling risk: an insurance model or a market model. In insurance risk management, a large pool of similar homes are typically covered for fire. A large portfolio of premiums covers losses. By contrast, the stock market model uses good information, such as accounting statements, to manage diverse, idiosyncratic risks through a varied portfolio. "The insurance industry is built around the pooling model, so it's not designed to handle these big, infrequent risks," says Murdock.
Murdock's hybrid model creates reinsurance contracts--financial instruments that can be traded in open markets, much like contracts for oil and grain futures. The government would kick-start the market by initially underwriting a quarter of all contracts and then slowly phasing out its participation. Uncle Sam's role would guarantee the initial availability of these contracts so that large insurers and reinsurers develop the systems to manage natural disaster risks using these contracts. Then private investors, such as investment banks, could carve a lucrative market out of the new financial vehicles, eventually eliminating the need for government participation.
Murdock and Lewis envision the reinsurance contracts laying off risk for insurers only after very large disasters, where damage exceeds $25 billion. For example, an investment house like Goldman Sachs might underwrite a reinsurance contract for a large insurer or reinsurance company. In most years the investor will simply collect a large premium. How-ever, if a disaster of more than $25 billion occurs, Gold-man Sachs would pay the insurer $1 million for every $1 billion of damage between $25 billion and $50 billion. In this way, the model caps insurers' liabilities after the largest disasters. It also makes use of the private sector's ability to raise capital, since only $25 million in capital would be required to write a contract.
Murdock expects his proposal would make insurance more available to homeowners, many of whom were scrambling for coverage when some insurers recently stopped writing policies. While better risk management would surely help spread the load when the Big One hits, the real challenge is to convince people to build homes in safer places or to build safer homes in high-risk areas. by Barbara Buell

"The Role of Government Contracts in Discretionary
Reinsurance Markets for Natural Disasters," Christopher Lewis and Kevin C. Murdock, The Journal of Risk and
Insurance, Vol. 63, No. 4, 1996

Illustration by Tim Hussey

There has been an avalanche of housing development in relatively unsafe areas.