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Abstract:
High correlations between risks can increase required insurer capital and/or reduce the availability of insurance. For such insurance lines, securitization is rapidly emerging as an alternative form of risk transfer. The ultimate success of securitization in replacing or complementing traditional insurance and reinsurance products depends on the ability of securitization to facilitate and/or be facilitated by insurance contracts. The authors consider how insured losses might be decomposed into separate components, one of which is a type of 'systemic risk' that is highly correlated among insureds. Such a correlated component might conceivably be hedged directly by individuals but is more likely to be hedged by the insurer. The authors examine how insurance contracts may be designed to allow the insured a mechanism to retain all or part of the systemic component. Examples are provided that illustrate this methodology in several types of insurance markets subject to systemic risk.

Abstract:
High correlations between risks can increase required insurer capital and/or reduce the availability of insurance. For such insurance lines, securitization is rapidly emerging as an alternative form of risk transfer. The ultimate success of securitization in replacing or complementing traditional insurance and reinsurance products depends on the ability of securitization to facilitate and/or be facilitated by insurance contracts. We consider how insured losses might be decomposed into separate components, one of which is a type of "systemic risk" that is highly correlated amongst insureds. Such a correlated component might conceivably be hedged directly by individuals, but is more likely to be hedged by the insurer. We examine how insurance contracts may be designed to allow the insured a mechanism to retain all or part of the systemic component. Examples are provided, which illustrate our methodology in several types of insurance markets subject to systemic risk.

Abstract:
The paper proposes an explanation for why a rating agency chooses to pool different credit risks in one rating class, and analyzes how information disclosure depends on the value of information to the market. We show that an optimal disclosure policy of a monopoly rating agency is to pool companies or issuers in multiple rating classes and to have partial market coverage. It provides an opportunity for market entry. We then describe the potential market and the strategy of the entrant. We find that entry of an identical rating agency results in asymmetric rating scales. It justifies why some companies obtain multiple ratings and suggests that similar ratings from different agencies may mean different credit risks. We use Standard and Poor's entry in to the market for insurance ratings - a market that was previously covered by the monopolist agency the A.M. Best Company - to empirically test the qualitative predictions of the model regarding the impact of competition on the information content of ratings.

rating agency, entry, competition, precision and disclosure of information, insurance

Abstract:
There has been a net propensity over the last decade for the dominant rating agency of the U.S. insurance industry, A.M. Best, to downgrade property-liability insurers. This could reflect a general deteriorating credit worthiness of the industry or an increase in the performance thresholds Best's has deemed necessary to achieve a given rating class. Consistent with a recent study of corporate bond ratings, we find evidence there has been an increase in rating stringency. Specifically, we show pressure for insurers to maintain their existing ratings provides a plausible explanation of the dramatic buildup of capital in the industry during the 1990's. In addition, our analysis suggests Best's raised the bar in terms of the capital required to maintain the highest ratings differentially relative to the increase in standards they required for lower rated categories. The actual pattern of capital buildup across firms in different rating categories is consistent with an attempt by high quality firms to defend these ratings.

Insurance; Credit ratings; Financial strength ratings; Capital structure

Abstract:
In this article, we examine the benefits that accrue to policyholders and incumbent insurers from an active secondary market for life insurance policies. We begin by examining the benefits of secondary markets in the home mortgage and catastrophic risk insurance industries as points of comparison for the benefits of the secondary market for life insurance policies. Next, we outline the economic theory of a life insurance market both before and after the introduction of a secondary market. Although competition among insurance companies in the primary market leads to reasonably competitive surrender values given normal health, surrender values based on normal health do not appropriately compensate individuals with impaired life expectancies for the resulting appreciation of their policies. Without an active secondary market, the equilibrium quantity of impaired policies that is surrendered is inefficiently low. Incumbent insurance carriers have no incentive to eliminate this inefficiency because they hold monopsony power over the repurchase of impaired policies. Viatical and life settlement firms erode this monopsony power. Finally, we examine the benefits of an active secondary market for life insurance policies to policyholders and incumbent insurers in the primary market. The magnitude of the benefits is positively correlated to the quantity of coverage sold to life settlement firms and to the improvement in the terms of accelerated death benefits offered by incumbent carriers. The emergence of the secondary market for life insurance policies has been pro-competitive and pro-consumer. Lawmakers should therefore design regulations that encourage, rather than dissuade, participation and investment in this secondary market.

Life insurance, secondary market, life settlement, viatical

Abstract:
This paper attempts to identify moral hazard in the traditional reinsurance market. We build a multi-period principle agent model of the reinsurance transaction from which we derive predictions on premium design, monitoring, loss control and insurer risk retention. We then use panel data on U.S. property liability reinsurance to test the model. The empirical results are consistent with the model's predictions. In particular, we find evidence for the use of loss sensitive premiums when the insurer and reinsurer are not affiliates (i.e., not part of the same financial group), but little or no use of monitoring. In contrast, we find evidence for the use of monitoring when the insurer and reinsurer are affiliates, where monitoring costs are lower, but little use of price controls.

Abstract:
This article analyzes the economic functions of independent insurance intermediaries (brokers and independent agents), focusing on the commercial propertycasualty insurance market. The article investigates the functions performed by intermediaries, the competitiveness of the market, the compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium-based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium-based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer's and the intermediary's interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the "winner's curse" and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection.

Abstract:
This article attempts to identify moral hazard in the traditional reinsurance market. We build a multiperiod principal-agent model of the reinsurance transaction from which we derive predictions on premium design, monitoring, loss control, and insurer risk retention. We then use panel data on U.S. property liability reinsurance to test the model. The empirical results are consistent with the model's predictions. In particular, we find evidence for the use of loss-sensitive premiums when the insurer and reinsurer are not affiliates (i.e., not part of the same financial group), but little or no use of monitoring. In contrast, we find evidence for the extensive use of monitoring when the insurer and reinsurer are affiliates, where monitoring costs are lower.

Abstract:
This article addresses the trade-off between moral hazard and basis risk. A decision maker, e.g., a primary insurer, is considered who can purchase an index hedge and a (re)insurance contract that covers the gap between actual losses and the index-linked payout, or part of this gap. The results suggest that combining insurance with an index hedge may extend the possibility set and by that means lead to efficiency gains. Naturally, the results depend heavily on the transaction costs associated with both instruments. In particular, the authors show that if the index product is without transaction costs, at least some index-linked coverage is always purchased, so long as there is positive correlation between the index and the actual losses. So under these circumstances, there is in any case a benefit from the availability of index products. Furthermore, it is shown that the index hedge would always be supplemented by a positive amount of gap insurance.

Abstract:
How do markets spread risk when events are unknown or unknowable and where not anticipated in an insurance contract? While the policyholder can "hold up" the insurer for extra contractual payments, the continuing gains from trade on a single contract are often too small to yield useful coverage. By acting as a repository of the reputations of the parties, we show the brokers provide a coordinating mechanism to leverage the collective hold up power of policyholders. This extends both the degree of implicit and explicit coverage. The role is reflected in the terms of broker engagement, specifically in the ownership by the broker of the renewal rights. Finally, we argue that brokers can be motivated to play this role when they receive commissions that are contingent on insurer profits. This last feature questions a recent, well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer.

Incomplete Insurance Contracts, Brokerage, Contingent Commissions, Reputation

Abstract:
There has been a net propensity over the last decade for the dominant rating agency of the U.S. insurance industry, A.M. Best, to downgrade property-liability insurers. This could reflect a general deteriorating credit worthiness of the industry or an increase in the performance thresholds Best's has deemed necessary to achieve a given rating class. Consistent with a recent study of corporate bond ratings, we find evidence there has been an increase in rating stringency. Specifically, we show pressure for insurers to maintain their existing ratings provides a plausible explanation of the dramatic buildup of capital in the industry during the 1990s. In addition, our analysis suggests Best's raised the bar in terms of the capital required to maintain the highest ratings differentially relative to the increase in standards they required for lower rated categories. The actual pattern of capital buildup across firms in different rating categories is consistent with an attempt by high quality firms to defend these ratings.

Insurance, credit ratings, financial strength ratings, capital structure

Abstract:
The 1990s witnessed an unprecedented decline in leverage ratios in the United States property-liability insurance industry. The premiums-to-surplus ratio, the most commonly used leverage ratio in the industry, fell from its historical average of 2.0 to less than 1.0 by the end of 2000; and the industry-wide capital-to-asset ratio increased from an historical average of about 25% to 35%. The international reinsurance industry also experienced significant capital increases and leverage declines during the 1990s (Cummins and Weiss, 2000) These unusual trends raised widespread concerns that the property-liability insurance industry had become over-capitalized (The Economist, 1999; Bowers, 2001; Seifert, 2001). To investigate the growth in capitalization and its potential causes, the Conference on Capitalization in the Property-Liability Insurance Industry was held at the Wharton School in September 2000 under the joint sponsorship of the Wharton Financial Institutions Center and AON. Selected papers from the conference comprise this issue of the Journal of Financial Services Research (JFSR).

Capital structure, property-liability insurance, organizational form, insolvency risk, financial ratings, efficiency

Abstract:
Insurance profits exhibit cyclical behavior that has been attributed to capital market constraints. We show that changes in interest rates simultaneously affect the insurer's capital structure and the equilibrium underwriting profit. Depending upon asset and liability maturity structure, capital market access, and reinsurance availability, insurers will be differently affected by changing interest rates. We find that the average market response to changing interest rates roughly tracks market clearing prices. These "cyclical" effects are enhanced for firms with mismatched assets and liabilities and more costly access to new capital and reinsurance. This evidence supports the capacity constraint hypothesis.

Abstract:
This article shows how the introduction of severity risk into a simple model of insurance markets affects the optimal level of insurance. Also examined is how severity risk affects the equilibrium for an insurance market exhibiting adverse selection in the frequency risk. Individuals are assumed to possess identical loss severity distributions, but differ in their privately-known probabilities of having a loss. In particular, the effects of severity risk on the Nash equilibrium of Rothschild and Stiglitz (1976), on the anticipatory equilibrium of Wilson (1977), and on Miyazaki's (1977) extension of Wilson's equilibrium are analyzed. Severity risk is shown to affect the type of equilibrium contracts (pooling vs. separating), equilibrium levels of coverage, and overall societal welfare.

Abstract:
Efficient contracts for sharing risk will allocate risk according to comparative advantage. This article considers insurance markets for earthquake risk and how comparative advantage in risk bearing can explain the amount of business individual insurers write. The respective abilities of insurers to write this risk depend on the characteristics of their entire portfolio as well as on financial features that influence the costs of risk bearing. Several recent contributions have shown why risk is costly to corporations such as insurers. The costs of risk arise from tax convexity, principal agent relationships within the firm, and the costs of financial distress. We will show how these types of features jointly determine the capacity of insurers to write earthquake insurance. We derive and estimate a cross-sectional model of earthquake insurance, and the results support the hypothesis that firms with a higher imputed cost of risk bearing assume less earthquake risk.