Insurance Companies and the Propagation of Liquidity Shocks to the Real Economy

Abstract

We study the role of insurance companies in propagating liquidity shocks to the real economy. We
use natural disasters as our instrument to identify exogenous shifts in capital‐market liquidity, and
study whether capital‐market liquidity affects regional‐level fiscal conditions and output. Aggregate
disaster‐driven sales of disaster‐unaffected municipal bonds by exposed insurers cause low GDP
growth and high unemployment. In micro data, natural disasters trigger large, unexpected redemptions of property‐insurance contracts, causing: fire sales of municipal bonds; increased
borrowing costs in primary markets; decreased muni issuance; lower investment in muni‐reliant
sectors. Therefore, insurance companies do propagate liquidity shocks to the real economy.

Keywords: insurance companies, market liquidity, natural disasters, fire sales, reinsurance, public and private investment

JEL Classification: G22, G14, G32, G31, E22