Insurance Derivatives, Tax Policy, and the Future of the Insurance Industry

By Harrington, Scott E. | Journal of Risk and Insurance, December 1997 | Go to article overview

Insurance Derivatives, Tax Policy, and the Future of the Insurance Industry


Harrington, Scott E., Journal of Risk and Insurance


The future of the insurance industry will be affected greatly by any developments that significantly reduce underwriting, distribution, or capital costs. Given the theme of this conference and recent concern with the supply of catastrophe insurance and reinsurance, my brief remarks focus on possible reductions in the costs of providing catastrophe coverage through securitization of catastrophe risk and changes in tax policy.

CAPACITY PROBLEMS AND CAPITAL COSTS

In recent years, markets for catastrophe reinsurance and primary insurance have experienced episodes of sharp price increases and/or limits on available coverage following major catastrophe losses. Theory suggests that these short-run effects of large catastrophe losses can be explained by upward revisions in catastrophe loss forecasts for new and renewal policies and, perhaps more important, by temporary reductions in capital below desired levels (e.g., Winter, 1994, and Cummins and Danzon, 1997, in the context of the 1980s liability insurance crisis; also see Berger, Cummins, and Tennyson, 1992). The cost of raising capital immediately following large catastrophe losses will generally be high due to uncertainty and asymmetric information concerning the magnitude of past claim costs and the fact that raising new capital increases the economic value of liabilities for old claims.

Absent regulatory restrictions on catastrophe insurance rate changes or the adoption or expansion of state-mandated insurance plans that might discourage voluntary supply of coverage by insurers, these capacity problems should diminish fairly quickly over time. However, the popular and trade press, many insurers, and a number of state legislatures suggest a chronic capacity shortage for catastrophe reinsurance, which is alleged to have major adverse effects on the primary market. In the long run, and apart from the possible adverse effects of regulation that could discourage additional capacity, limited capacity for catastrophe insurance and reinsurance must reflect the underlying costs of providing capacity in conjunction with the willingness of consumers to pay for catastrophe coverage.

Insurers have two main motives to hold capital: (1) to achieve higher premiums by making their promise to pay claims credible to policyholders, and (2) to avoid loss of franchise value that could occur if the insurer is financially threatened from a catastrophe.(1) But total capital costs for writing catastrophe coverage are high because of the large amounts of capital that are necessary to achieve these goals. While most catastrophe risk might be diversifiable by insurance company investors, tax and agency costs for large pools of capital held by insurers can have a large effect on the price of catastrophe coverage.

Regarding tax costs, in addition to the usual tax disadvantages of equity finance, basic theory of insurance pricing suggests that prices must increase due to the double taxation of returns on insurer financial capital compared to the tax treatment of mutual funds that would have comparable portfolios (Myers and Cohn, 1986). The key point is that issuing insurance policies to obtain additional funds exposes returns on insurer capital invested in financial assets to the corporate income tax. The magnitude of this cost depends on the corporate tax rate and the extent to which the effective personal tax rate for insurer shareholders is lower than would be the case if shareholders held claims to an identical portfolio of assets in a mutual fund.(2)

Agency and tax costs of capital affect all types of insurance. The effect on catastrophe coverage is especially large due to the large capital requirements for providing such coverage. Income tax rules also can produce relatively high costs for catastrophe coverage for another reason. Because the distribution of catastrophe losses is highly skewed, possible loss or deferral of tax write-offs for claims in the event of a large catastrophe probably increases expected taxes on underwriting income compared to other lines of business and further increases the price needed to offer catastrophe coverage.

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