Ambiguity and Insurance: Robust Capital Requirements and Premiums

Centre for Climate Change Economics and Policy Working Paper 115

Munich Re Programme Technical Paper 16

Grantham Research Institute on Climate Change and the Environment Working Paper 97

22 Pages Posted: 21 Dec 2012

See all articles by Oliver Walker

Oliver Walker

University of Cambridge - Faculty of Economics and Politics

Simon Dietz

London School of Economics - Grantham Research Institute on Climate Change and the Environment and Department of Geography and Environment

Date Written: November 1, 2012

Abstract

Many insurance and reinsurance contracts are contingent on events such as hurricanes, terrorist attacks or political upheavals whose probabilities are not known with precision. There is a body of experimental evidence showing that higher premiums are charged for these “ambiguous” contracts, which may in turn inhibit (re)insurance transactions, but little research analysing explicitly how and why premiums are loaded in this way. In this paper we model the effect of ambiguity on the capital requirement of a (re)insurer whose objectives are profit maximisation and robustness. The latter objective means that it must hold enough capital to meet a survival constraint across a range of available estimates of the probability of ruin. We provide characterisations of when one book of insurance is more ambiguous than another and formally explore the circumstances in which a more ambiguous book requires at least as large a capital holding. This analysis allows us to derive several explicit formulae for the price of ambiguous insurance contracts, each of which identifies the extra ambiguity load.

Keywords: ambiguity, ambiguity aversion, ambiguity load, capital requirement, catastrophe risk, insolvency, insurance, more ambiguous, reinsurance, robustness, ruin, uncertainty, Solvency II

JEL Classification: D81, G22

Suggested Citation

Walker, Oliver and Dietz, Simon, Ambiguity and Insurance: Robust Capital Requirements and Premiums (November 1, 2012). Centre for Climate Change Economics and Policy Working Paper 115, Munich Re Programme Technical Paper 16, Grantham Research Institute on Climate Change and the Environment Working Paper 97, Available at SSRN: https://ssrn.com/abstract=2191959 or http://dx.doi.org/10.2139/ssrn.2191959

Oliver Walker

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom

Simon Dietz (Contact Author)

London School of Economics - Grantham Research Institute on Climate Change and the Environment and Department of Geography and Environment ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://personal.lse.ac.uk/dietzs

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