A Disaster Under-(Re)Insurance Puzzle: Home Bias in Disaster Risk-Bearing

International sharing of the risk of disasters through insurance markets lies on a spectrum defined by two ideal types: full risk sharing and autarky. The full risk sharing case features 100 percent insurance coverage for losses within a country and a high degree of international reinsurance to spread the risks globally. Domestic full insurance abstracts from moral hazard, adverse selection, disaster myopia and other frictions that lead to non-participation, deductibles, co-pays and other departures from full insurance. Internationally, reinsurance spreads risk evenly to leave domestic investors holding only the share of their own disaster risk that corresponds to their share of global wealth. In theory, disaster insurance improves welfare if it is priced not too much above the actuarily expected loss. In autarky, no reinsurance leaves each country to bear all of its own disaster risk and none of the rest of the world’s risk.

A new journal article in the IMF Economic Review from Hiro Ito and Robert N. McCauley examines disaster reinsurance from the perspective of international risk-sharing. The authors find that losses from disasters are shared internationally to a generally very limited extent, unlike what the theory of international risk-sharing suggests. They propose a new dataset of cross-border reinsurance payments for 93 disasters of 44 economies in 1982-2017. Combining these balance of payments data with industry data, the authors find that the lack of disaster risk-sharing through international reinsurance results from low participation in primary insurance as well as limited use of reinsurance. Regression analysis finds that countries with higher levels of economic or financial development tend to insure a larger share of disaster losses while proxies for disaster myopia are associated with less insurance. Regarding the share of insured losses that is internationally reinsured, small size and de facto financial integration tend to raise the reinsurance share, while high levels of external wealth and low foreign firm presence in insurance are associated with less reinsurance. Advanced economies with little fiscal space that provide ex-post government disaster insurance without international reinsurance could experience disaster risk morphing into financial risk.

Looking forward, global warming may be raising the losses associated with flood and storm hazards while leaving those of earthquakes unchanged. The cost of both underpriced explicit government insurance, for instance against US floods, and implicit insurance looks set to rise. At the same time, the potential benefit of using prices to provide incentives to mitigate risks could also be rising. While this study finds limited international sharing of disaster risk, Ito and McCauley argue public policy would be ill-advised to neglect markets and prices in responding to the challenge of climate change.