The Effect of Costly Risk Bearing on Insurers' Supply Decisions

Efficient contracts for sharing risk will allocate risk according to comparative advantage. When risks meet the typical criteria for insurability, in particular independence, the comparative advantage is straightforward and insurers are able to diversify risk by pooling together many policyholders. But this comparative advantage is established only in the event insureds have a low correlation. Earthquakes do not fit this description. The high correlations between the claims on the insurer's policies will (in the limit) equalize the costs of risk bearing for the insurer and insured. But the insurer's comparative advantage is not necessarily entirely removed, since correlations are not perfect, but there is a limit to the insurers' ability to diversify the risk. This paper 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 collect these arguments together in a simple equilibrium model of insurance. From this we derive and estimate a cross sectional model of earthquake insurance which emphasizes the differing capacity of insurers to write this line of business.