Firms Fight Risk

To increase efforts to dealt with catastrophic risks, shift responsibility from individuals to firms:

Corporate demand for catastrophe coverage is actually more price inelastic than the demand for non-catastrophe coverage. … A 10% increase in price will reduce quantity of terrorism coverage by only 2.42% whereas it will reduce the quantity of property coverage by 2.91%. This result is in contrast to the findings with respect to individual insurance choices in laboratory experiments and empirical studies on homeowners insurance. …

The majority of homeowners do not purchase catastrophic coverage voluntarily and those cases that do obtain some coverage, exhibit a very elastic demand. … Typically, individuals either ignore those low-probability risks (optimism) or over-estimate them by focusing on possible outcomes without paying much attention to the likelihood of them happening (availability bias). Such bimodal distributions of behavior were also shown experimentally … analyzing actual long-term care insurance decisions by individuals. … Individuals tend to largely neglect risks with a very low probability. However, once a low-probability event takes place, the risk is back in their attention and individuals tend to overinsure against this risk. …

Even when the cost of insurance is subsidized, many people located in high risk areas
still do not purchase coverage. … Even those homeowners who purchased insurance against catastrophe risks (hurricane) exhibited a more price elastic demand for catastrophic risks than for non-catastrophe risks (fire). A related finding is that many individuals are willing to pay significantly more for non-catastrophe insurance than for catastrophe insurance. (more)

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  • Of course, shifting this responsibility to corporations only works for local catastrophic risks (where capitalism still functions afterwards). Global catastrophic/existential risks still need to be addressed by the government.

  • Doug

    The study should do a follow up looking at corporate risk aversion based on capital structure and holding concentration.

    On the first point, a lot of corporate risk aversion comes from strict bond covenants that they have to comply with. My guess would be that highly levered companies purchase much more insurance than mostly equity funded firms.

    On the second point, it makes sense that firms pay more for catastrophic insurance. If shareholders hold diversified insurance they shouldn’t care about idiosyncratic risk. It makes no sense to sacrifice return on equity in the form of insurance premiums (except in the case of firm-specific distress costs). Catastophic risk on the other hand probably maps more closely to market wide factor risks, which diversified investors still care about.

  • Albert Ling

    If a person is reasonably wealthy, it is generally the cases that ONLY catastrophe insurance is a good purchase, in the sense that on the aggragate, the insurance buyer loses in terms of expected value (otherwise insurers would go broke) and the only rational reason to buy insurance is protection from losses that are catastrophic.

    It makes much more sense to buy house insurance than car insurance. Buying laptop insurance for instance is ridiculous (except if are a few standard deviations above the norm in terms of recklessness and the insurance covers it even if you drop it). I don’t have the data buy I’d bet that many electronics retailers and car rental companies derive a significant part of their income from insurance, because their margins are so high.

    I’ve just seen the movie “Contagion”, which is about epidemics, and the idea came to mind that drug companies can fund their research by selling the optionality of buying not-yet approved drugs when they do get approved, so you pay a small insurance premium to guarantee that you are first in line if there is a shortage of medicine of some kind. In other words, a good way to fund the protection of tail risks is to take money from people who worry about tail-risks and not have to convince people who ignore them that they should be worried and pay.

  • dave

    People don’t get fired for small loses, but they do get fired for big losses.