Insurance for Financial Crisis?
Michael Faure and Klaus Heine
METRO, Maastricht University
PO Box 616, 6200 MD Maastricht,
The Netherlands
RILE, Erasmus University Rotterdam
PO Box 1738, 3000 DR Rotterdam,
The Netherlands
Structure
1 Introduction
2 The Problem
3 Insurance for Catastrophes
4 Export Insurance
5 Proposal
6 Concluding Remarks
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1. Introduction
• After financial crisis: bail-out of
financial institutions
• Debated by economists because
perverse incentives
• Financial intervention by government
not new (Natcats, export insurance)
• Example for financial crisis?
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2. The Problem
2.1 Bail-out flawed
• Bailing-out ex post
• Ad hoc
• Random compensation
• Moral hazard: wrong incentives etc.
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2. The Problem
2.2 … but intervention unavoidable?
• Financial crises are systemic risks
• Some government intervention
unavoidable
• Why not better solutions
• Like insurance?
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2. The Problem
2.3 Why not insurance for financial crisis?
• Theoretically insurance could protect
(financial) institutions
• Insurance not only taken for risk aversion,
but also reduction of transaction costs
• Potential problems:
• Predictability of risk (reliable statistics
lacking etc.)
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2. The Problem
• Endogenously: business failure really
due to crisis? Business risk
uninsurable!
• Moral hazard
• Adverse selection (enterprise risk
caused by financial crisis or by
mismanagement?)
• Damage uninsurable; lacking capacity
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2. The Problem
2.4 A conditional support
• Problems serious, but not incurable
• Today, many interdependencies between
insurance and financial markets
• Predictability: lacking statistics, not
necessarily uninsurable: adding risk
premium
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2. The Problem
• Moral hazard curable through
adequate information: risk
differentiation and classification
• Enterprise risk is now also insurable
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2. The Problem
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2. The Problem
• Capacity problem: government as
reinsurer of last resort? Examples
exist!
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3. Insurance for Catastrophes
3.1 Theory
• Insurance solutions favoured (Kunreuther
1968)
• Reinsurance by state necessary to support
development of insurance coverage
(Schwarze/Wagner 2004)
• Government capacity to diversify risks over
population and over generations
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3. Insurance for Catastrophes
• Government better placed to reduce
risks?
3.2 Examples
• Many! E.g.
• CCR (France) for Natcats
• NHT (Netherlands) for terrorism etc.
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3. Insurance for Catastrophes
3.3 Lessons
• Of course, Natcats/terrorism vs.
financial crisis different (economic
impact, interrelatedness of banks,
predictability etc.) but:
• Also in case of Natcats charity hazard
(Weck Hanneman)
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3. Insurance for Catastrophes
• Also preference for structural solutions
vs. ad hoc-ism
• Also preference for multi-layered
approach (using insurance to full
extent; government only in last
resort)
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4. Export Insurance
4.1 Theory
• Political risk in export difficult to insure
• Government better able to bundle
claims and recover obligations
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4. Export Insurance
4.2 Example
• Euler Hermes KreditversicherungsAG
• Only coverage for political risk; not
commercial risk
• Exists in many countries
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4. Export Insurance
4.3 Lesson
• State considered better insurer of
political risks
• Distinction between commercial and
political risks possible
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5. Proposal
• Ex ante structural approach instead of
ad hoc and ex post solutions
• Idea: Establishing private insurance
markets to deal (at least partly) with
financial crises
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5. Proposal
• Advantages:
1. Employing market incentives to
evaluate financial risks correctly;
2. Sharing the burden of compensation
between the private and the public
sector;
3. Triggering a pre-emptive effect
against crises
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5. Proposal
5.1 Multi-layered insurance approach
• Lesson learned from natcats:
Self-insurance by victims (1st layer);
Private insurance and reinsurance
(2nd layer);
Public as reinsurer of last resort (3rd
layer)
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Self-insurance by victims (1. layer)
• Incentive for firms to not engage in
moral hazard (taking too high financial
risks)
• May also help to overcome adverse
selection. Firms may hold higher rates
of equity for self-insurance. Reliable
signal for insurers that a firm strives
for a proper management
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Private insurance and reinsurance (2.
layer)
• Risk adjusted insurance premiums for
covering (at least a part of) the risk of
becoming illiquid (market prices)
• Insurers will undertake risk
evaluations of firms on a regular base
(due diligence, stress tests).
Uncovering of a firm’s performance
and financial stability
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Private insurance and reinsurance (2.
layer)
• Permanent monitoring by insurance
companies triggers a pre-emptive
effect against crises
• Availability of data in case of a
financial crisis
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The public as reinsurer of last resort (3.
layer)
• Covering of remaining losses
• Speedy decision making on financial
help based on the information
provided by insurers
• Cross-time diversification of risks to
future tax-payers (not available on
private insurance markets)
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5. Proposal
5.2 Addressing some general problems
1. Proposal applicable to all firms. Here
focus on financial intermediaries
2. When is it a financial crisis? The
government has to declare it
(referring to the information provided
by insurers). See the example of
France for declaring a natural
catastrophe
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5. Proposal
3. State subsidies of the third layer may
trigger severe inefficiencies.
However, state provided reinsurance
must not be costless and can be
designed to reflect actual risk as
close as possible. See the example of
Dutch insurance against terrorism
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5. Proposal
4. Should the private insurance at the
second layer be mandatory or
voluntary? Example of natcats
suggests a mandatory insurance
(behavioral arguments). However, in
case of financial crises the issue is
more complicated… Preventing a
systemic risk may incur a pooling
equilibrium…
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5. Proposal
5.3 Addressing some special problems
1. Implementation of a separating
equilibrium
2. Problem of state intervention
3. Coordination of compensation
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1. Implementation of a separating equilibrium
•
•
•
Differentiation between firms which are a
victim of the crisis and those which are in
trouble anyway
If insurance is voluntary, good risks may
insure, while bad risks will not. An insured
firm will then be monitored by the insurer.
A separating equilibrium can be attained
However, if insurance is voluntary firms
may speculate on a bailing out because of
the need to prevent a systemic crisis
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1. Implementation of a separating equilibrium
•
•
Mandatory insurance may yield enough
money for compensations at the second
layer. However, a pooling equilibrium may
occur, which does not allow for risk
differentiation
Yet, it is not obvious, whether additional
signalling and screening mechanisms will
be sufficient for attaining a separating
equilibrium (small differences of premiums
may be leveraged by decisions of
investors on capital markets, if premium
differences are made public)
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2. Problem of state intervention
•
•
•
•
The state may impinge on insurance
premiums of the second layer. Making
premiums no longer risk adjusted
Firms as well as insurers may have an
interest for state interference (rent
seeking)
Equalization of premiums fosters a pooling
equilibrium
State intervention is a serious problem,
but not exclusive to our proposal
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3. Coordination of compensation
•
•
The proposed model suggests that the
third layer pays, if the second layer
ascertains a loss because of a financial
crisis and if the money of the second layer
is not sufficient
However, the different layers may try to
shift the burden of compensation.
Therefore, strategic behavior has to be
prevented
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3. Coordination of compensation
•
Need of a clear and reliable legal
framework, which comprises two
components:
1) Automatism which triggers the
mechanism;
2) Independent committee which has to
confirm the event of a financial crisis
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6. Concluding Remarks
• The technique and experience of insuring
natcats provide interesting suggestions for
insuring a firm’s risk in the event of a
financial crisis
• General idea: Making use of market
solutions as far as possible
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6. Concluding Remarks
• Proposal: A three layers model of insurance,
comprising
(1) self-insurance,
(2) insurance by insurance companies and
(3) the public as lender of last resort
• The implied problems seem not to be
insurmountable
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