In an earlier post entitled "Kerry Up, Markets Down? A Regression Analysis", I reported the results of the following regression equation:
(1) rS&P500,t =
where r
Kerry Regression Statistics R2 0.0508 Observations 69 Coefficients Standard Error t Stat P-value a 0.00081 0.0099 0.9921 b -0.03789 0.02001 -1.8938 0.0626
Bush Regression Statistics | | | | |
R2 | 0.1007 | | | |
Observations | 69 | | | |
| | | | |
| Coefficients | Standard Error | t Stat | P-value |
a | 0.00079 | -0.0598 | 0.9525 | |
b | 0.06997 | 0.0255 | 2.7390 | 0.0079 |
As promised, here is today's Austin American Statesman article entitled "Baylor football a bear market".
With the entire furor over the so-called "double deductible" problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.
Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the "option to default" conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.
I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.
In a statistical sense, the probability that the same property is damaged by multiple hurricanes is surely a rare event. However, this is a situation which many property owners in Florida now face. The print media is filled these days with examples of policyholders whose properties have sustained separate damages from Hurricanes Charlie and Frances who will likely have to pay two deductibles. Hopefully this won't become an n deductible problem; obviously whether n will be greater than or equal to two will depend upon how the rest of the hurricane season plays out.
While one cannot help but be sympathetic toward people who face such financial hardships, it is also important to think through this issue in a logical fashion. Under most property insurance contracts, claims and deductible payments are related to a specific insured event. The insurance policy promises to make the property owner whole after an insured event occurs (where being made whole is defined as paying the difference between the property damage related to the insured event and the deductible). Even if a policyholder suffers the misfortune of multiple (e.g., 2, 3, ..., n) different hurricanes affecting the same property, contractually these represent multiple insured events, not one. Consequently, n deductibles apply. Similarly, a person who has the misfortune of being involved in multiple car accidents is not afforded the option of treating multiple accidents as one event; in fact, these are multiple events and each event has its own claim settlement process.
A useful way to think about the double deductible problem is to relate it conceptually to the World Trade Center controversy. In that case, there was one insured event; specifically, a coordinated strike by terrorists on the two buildings. Although it could be (and certainly was) argued that were two insured events, the court's decision to treat it as one event appropriately came down to a question of policy language, which is why the "one event" position eventually prevailed in that case. In the case of Florida homeowners insurance, multiple deductibles follow as a logical consequence of (state regulated) homeowners insurance policy forms which require separate claims and deductibles for damage on separately named storms. From a contractual standpoint, Hurricanes Charles and Frances were clearly two different insured events, so two deductibles (or three if Ivan also ends up hitting the same property) would seem appropriate and consistent with standard policy form contract language and legal principles of insurance.
In all likelihood, the state of Florida will end up considering various regulatory reforms once this hurricane season is over. Even Florida governor Jeb Bush has weighed in on this issue, suggesting that the double deductible is something that might need to be changed because of the financial hardship that this creates for many property owners. In my view, a constructive approach would involve giving consumers the option to choose between a policy based upon the current policy form, and an alternative policy that would enable consumers to insure against aggregate losses. Contractually, the latter policy type would closely resemble a typical health insurance contract which has a "stop loss" provision built in for aggregate losses. Since the alternative policy would provide consumers with the opportunity of insuring against paying multiple deductibles, consumers could expect to pay more for the alternative policy than for the current policy. Besides offering consumers greater choice, such a policy reform would improve market efficiency. So long as these contracts are fairly priced, chances are that the worse-than-average risks would tend to gravitate toward the stop loss policy, whereas the better-than-average risks would tend to gravitate toward the current policy form.
For your information, I have changed the due date for problem set 1 from Thursday, September 9 to Tuesday, September 14. On Thursday, I plan to cover the lecture note which was originally intended for today.
Regarding problem sets - there are two ways to submit them to me: 1) electronically (via email sent to problemsets@rmi.baylor.edu) or 2) hard copy (at the beginning of the class period when the problem set is due). If you opt for the electronic alternative, please use your Baylor email address and not a Yahoo, AOL, MSN, or Hotmail address. Email which comes from a Baylor email address is always delivered, whereas email coming from Yahoo, AOL, MSN, and Hotmail is often (falsely) identified as spam by the anti-spam filtering software which I use. Whenever this occurs, the email is automatically deleted; consequently, email sent to me from these types of accounts will often never be delivered. For that matter, if you ever send me email, try to use your baylor email address so as to avoid this problem.
An important public policy aspect of catastrophes such as hurricanes, floods, earthquakes and terrorist actions is the effect of public disaster relief on the incentives of private firms and individuals to make prudent risk management decisions. Typically, economists are most worried by the possibility that public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select economically efficient levels of private insurance and loss mitigation.
A useful way to think about this problem is to consider what optimal risk management and insurance decisions might look like in a world without public disaster relief, and compare these decisions with the decisions that are likely to be made in a world with public disaster relief. Since consumers fully internalize the costs and benefits of risk management and insurance decisions in the former case, but do not in the latter, the prospect of public disaster relief reduces consumers' demand for private insurance and incentivizes consumers to underinvest in loss mitigation. This is a classic example of the so-called "moral hazard" problem. Moral hazard refers to the tendency for insured consumers to change their behavior in ways that increase the probability and/or size of claims. It is an important issue whenever risk sharing occurs and the price at which risk is transferred is distorted in some fashion; e.g., in the form of subsidized insurance provided after the fact by public entities such as FEMA.
Jon Meacham, best-selling author of Franklin and Winston: An Intimate Portrait of an Epic Friendship, will present the third Ferguson-Clark Author Lecture benefiting the Baylor University Libraries.
Meacham will speak on "Franklin and Winston: Leadership Issues for Today" at 7:30 p.m. Oct. 26 in the Mayborn Museum Complex. Baylor alumnus Collen A. Clark established the lecture series endowment in honor of his mother, Carla Sue Ferguson Garrett, a Baylor alumna and member of the libraries' Board of Advisors. Ernest Gaines and David McCullough presented the first two lectures.
Managing Editor of Newsweek
Born and raised in Chattanooga, Tenn., Meacham graduated cum laude from the University of the South and went to work as a reporter for The Chattanooga Times. He soon became an editor of The Washington Monthly and two years later was hired by Newsweek as a national affairs writer. As managing editor at 34, he oversees Newsweek's coverage of politics, international affairs and breaking news. The New York Times has called him "one of the most influential editors in the news magazine business."
Important, Insightful Book
Tom Brokaw, author of The Greatest Generation wrote: "This is at once an important, insightful, and highly entertaining portrait of two men at the peak of their powers who, through their genius, common will, and uncommon friendship, saved the world. Jon Meaham's Franklin and Winston takes its place in the front ranks of all that has been written about these two great men."
Meacham's new sources - including unpublished letters of FDR's secret love, the papers of Pamela Churchill Harriman, and interviews with the few surviving people who were in FDR and Churchill's joint company - shed new light on the characters of both men. Meacham calls the book "a portrait of what I believe to be the "most fascinating friendship of modern times."
An eloquent speaker and a skilled raconteur, Meacham understands important issues and events in all of their complexity and how they impact our lives.
More information on the event may be obtained by calling Mary Goolsby, 254-710-6735.
Today's Wall Street Journal features a page 1 story entitled, "After Storms, Florida Wakes Up to a New Insurance Reality". This article provides a very compelling analysis of the economics of catastrophe risk, focusing specifically upon the "special case" of Florida windstorms since Hurricane Andrew in 1992.
After blogging earlier this evening about the financial implications of hurricanes, I was blown away by the National Hurricane Center's forecasted paths for Frances and Ivan. Also, it is hard to beat NASA's picture of Frances, circa September 5, 2004.
Fortunately, the severity of damage from Hurricane Frances will likely be much less severe than what was anticipated in the later part of last week. Then, forecasters were bandying about Andrew/911 level estimates; e.g., $20-$50 billion. The three most prominent insurance risk management companies, AIR Worldwide, Risk Management Solutions and EQECAT, now estimate that insured losses from the storm will likely range from $2 billion to $10 billion, which still aren't exactly "chump change". Combined with Charley's insured losses of $7 billion, this is turning out to be a rather expensive hurricane season for the insurance industry.
The worst hurricane (in terms of total property damage and insured losses) was Hurricane Andrew, a Category 4 hurricane which hit Florida in August 1992. Andrew caused $20.3 billion in losses for insurers (in today's dollars) and caused a dozen insurance carriers to go bankrupt. Andrew set in motion fundamental changes in the way that the insurance business is conducted in Florida. Consider the following examples of private sector innovation:
Furthermore, other mechanisms have been put in place which causes consumers and the state government to share more of the catastrophe risk. Consider the following:
It will be interesting to see how this hurricane season plays out. To date, the damages have been very manageable for the insurance industry. However, if we have many more storms like Charley and Frances, this may have significant pricing and coverage implications for property insurance markets throughout the United States. Historically, the capital shocks from major catastrophes such as Andrew and 911 caused insurance rates and reinsurance rates to rise and coverage levels to fall. This is to be expected, since capital shocks result in capacity constraints in these markets, which in turn result in higher rates and lower coverage.
Tomorrow (on Tuesday, 9/7) we will be completing the Statistics Tutorial and moving on to the lecture note entitled Decision Making under Risk and Uncertainty, part 1. You'll probably want to download and print these lecture notes because I made a few minor changes (corrections and improvements) to them today. While you're at it, you might also want to download and print the lecture note for Thursday's class, entitled Decision Making under Risk and Uncertainty, part 2, since I also made some minor modifications that that document as well and I expect this to be the "final" version for the time being. Also, Thursday, 9/9 is the due date for the first problem set for this course.
Besides reading the book chapter entitled Risk and Utility: Economic Concepts and Decision Rules, you should also read Supply of Insurance and Measuring Morals: Researchers ask if Americans are cheating more often -- and what can be done about it for tomorrow, and Avoiding Decision Traps for Thursday.
The Wall Street Journal asks a series of questions to a number of Nobel Laureates in economics. On one question, whether the global income distribution will be more equal 50 years from now, several of them say "yes," because they are optimistic about China and India. This article is definitely worth reading!
In case if you missed its airing on Saturday Night Live, I highly recommend the video entitled "Straight Talk about Today's Markets"!