COMPARISON OF ALTERNATIVENATIONAL RISK TRANFER SYSTEMS:

A “fundamental” view

JOANNEUM RESEARCH – Graz Institute of Technology and Regional Policy (InTeReg)

Joint Seminar of the University of Innsbruck and alpSFinancial Risks of Natural Hazards: Markets and the Role of the State

INNSBRUCK, July 5-6, 2007

Franz Prettenthaler & Nadja Vetters

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Designing national risk transfer mechanisms is a matter of dynamic mechanism design

• Mechanisms implement social choice functionsThe „Fundamentals“ of RTMs therefore are to be found in Dynamic Social Choice theory under risk

• Harsanyi (1955) shows that VNM axioms imply utilitarianism• Myerson (1981) shows the problem of dynamic inconsistencies

in egalitarian social choice• Mongin (1995) generalises Harsanyis results for SWFL• Prettenthaler (2002) shows the coherence of Myerson‘s and

Mongin‘s resultsFacing natural catastrophies, egalitarianism is a popular viewAre egalitarian RTMs necessarily dynamically inconsistent and therefore inefficient?

Motivation

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Setting the „fundamental“ scene for RTMs• Mechanism Design based on Social Choice Theory• VNM axioms and Social Choice Theory• Dynamic Consistency & Utilitarianism vs. Egalitarianism

Numeric Example• To expose the problem• To set up the comparative framework

Some national RTMs

A „fundamental“ comparison

Overview

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Theory behind: a numerical example (1)

Two individuals A, B

3 periods

Period 1 & 3: society decides

Period 2: nature decides

The result after period 3 is evaluated from an ethical perspective

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nF x’ (4,4)

y' (0,10)

x' (4,4)x F

y' (12,2)

x' (4,4)nF

yy' (2,10)

x' (4,4)

F y' (10,0)

Period 1 Period 2 Period 3Potential flood

disaster

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2 Social Welfare Functions

Utilitarian: Wu(UA,UB) = UA+UB

Egalitarian: We(UA,UB) = min {UA,UB}

Evaluation of results

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nF x’ (4,4)

y' (0,10)

x' (4,4)x F

y' (12,2)

x' (4,4)nF

yy' (2,10)

x' (4,4)

F y' (10,0)

contingent policy plans: e.g. (x; y‘,y‘)

Period 1 Period 2 Period 3

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Evaluation of the EXPECTED result (1)

E.g. ex ante approach

Utilitarian: Wu(EUA,EUB)

Egalitarian:We(EUA,EUB)

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511(6,5)(y;y',y')310(3,7)(y;y',x')29(7,2)(y;x',y')48(4,4)(y;x','x')612(6,6)(x;y',y')29(2,7)(x;y',x')311(8,3)(x;x',y')48(4,4)(x;x',x')

We(EUA,EUB)Wu(EUA,EUB)(EUA,EUB)Policy Plan

Max :

Therefore choose :

Evaluation of the EXPECTED result (2)

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nF x’ (4,4)

y' (0,10)

x' (4,4)x F

y' (12,2)

x' (4,4)nF

yy' (2,10)

x' (4,4)

F y' (10,0)

We(4,4) = 4

We(4,4) = 4

We(12,2) = 2

We(0,10)= 0

Period 1 Period 2 Period 3

While:

But:

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nF x’ (4,4)

y' (0,10)

x' (4,4)x F

y' (12,2)

x' (4,4)nF

yy' (2,10)

x' (4,4)

F y' (10,0)

Wu(4,4) = 8

Wu(4,4) = 8

Wu(12,2) = 14

Wu(0,10)= 10

Period 1 Period 2 Period 3

Whereas:

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Egalitarianism seems to be in conflict with dynamic consistency

Up to now the ex ante approach was chosen

Ex post approach would mean:• First, the social welfare is calculated from the final

result• Secondly the expected value thereof is maximized

Oberservation

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111(y;y',y')310(y;y',x')29(y;x',y')48(y;x','x')212(x;y',y')29(x;y',x')311(x;x',y')48(x;x',x')

EVe(UA,UB)EVu(UA,UB)Policy Plan

Ex post evaluation

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Observation

Egalitarianism is not in conflict with dynamic consistency but

• Ex ante ex post equivalence

Under the ex post approach, egalitarians can choose dynamically consistent

• Price to pay: ex ante preferences of individuals cannot be fully respected

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Switzerland

Cantonal Property Insurance• mandatory (automatic) extension of coverage to

include natural hazards• Obligation to contract (monopoly position)• Unlimited coverage, low premiums• Reinsurance plus insurance pool (IRV, IRG)• Important role in prevention and spatial planning

Private insurance market (GUSTAVO cantons)• mandatory extension of coverage• Premiums not risk related• Elementary damage pool

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France

The “CAT NAT” insurance scheme• Private insurance carrier but regulated• mandatory extension of coverage to include

“exceptional natural hazards”• risk independent premium surcharge (in %)• Compensation demands governmental decision• Unlimited government reinsurance by CCR (adverse

selection problem stimulated reform)• Sliding scale for deductibles in communities without

risk prevention plans• No extension of coverage for new buildings in risk

zones after the publication of risk prevention plans

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Spain

Consorcio de Compensación de Seguros• Automatic coverage of „extraordinary events“

(compulsory insurance) when underwriting certain insurance contracts

• Monopoly position• Premiums risk independent• Profits and interests paid into a reserve pool• Distributed via private insurance companies, claim

settlement by the Consorcio• Unlimited state guarantee• Not very actively involved in prevention

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USA

National Flood Insurance Program• Optional coverage of flood damage in communities

participating in the Program• Communities have to develop risk management plans• Risk mapping via NFIP• Premiums depending on flood risk and quality of the

risk, partly subsidized• Distribution/claims settlement via licensed agents and

private insurance companies• State guarantee (loan of up to 1,5 billion US$)• Different incentives for communities and individuals

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Turkey

Turkish Catastrophe Insurance Pool• Launched 2000 with assistance from the World Bank• Compulsory insurance coverage for all residential

dwellings• Stand alone insurance policy• Risk related premiums (based on risk zone and type

of building)• Management “outsourced” to reinsurance company• Distribution through private insurance companies,

independent loss adjustors• tax-exempt• Actively involved in prevention and awareness raising

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Austria

private insurance market + public compensation fund

private insurance market:• low insurance penetration• very limited coverage• extended coverage only outside flood risk areas• Premiums are risk independent

catastrophe fund:• tax financed• compensation and prevention• compensation is limited

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Austrian Catastrophe Funds - Reserves

Development of Reserves

-200

-100

0

100

200

300

400

500

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Development of Reserves

-200

-100

0

100

200

300

400

500

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Rerserves without „skimming“

Reserves with „skimming“

Tax receipts

Expenditure

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Cross country comparison of RTM‘s (1)

state guarantee (loan of up to 1,5 billion US$)

-unlimited state guarantee

-Keep monopolies

unlimited state guarantee for CCR

ad hoc reliefRole of the state

NoNoYesYesYesYesYesBundle of natural hazards

YesYesYes(Yes)Yes(Yes)NoObligation to contract

Nocompulsory insurance

compulsory insurance (subsidiary)

mandatory extension of coverage

automatic extension of coverage

mandatory extension of coverage

NoMandatory insurance

NoYesYesNoYesNoNoMonopoly

National Flood Insurance Programme

public corporation

public corporation

Private insurance companies

Cantonal Property Insurance

private insurance companies

private insurance companies

Insurance Carrier

USATurkeySpainCH (Priv.)CH (CPI)FranceGermany

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Cross country comparison of RTM‘s (2)

adverse selection is a big problem

Compati-bilitywith EU legislation

CPI actively involved in prevention

CCR confronted with adverse selection

low insurance penetration

Further issues

state guarantee (loan of up to 1,5 billion US$)

insurance pool, intern. capital markets

reserve fund, unlimited state guarantee

insurance pool plus reinsurance

reinsurance plus insurance pool (IRV, IRG)

reinsurance (optionally with CCR), state guarantee

reinsurance

Coverage against catastro-phiclosses

risk-related, part. subsidized

risk-relateduniform plus risk loadinguniformuniform plus

risk loadinguniformrisk-relatedPremium design

USATurkeySpainCH (Priv.)CH (CPI)FranceGermany

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Classification of RTMs

Adverse selection

Adverse selectionresistant

Adverse selection resistant

Adverse selection

always coherent

always coherent

UT

EG

Ex postEx ante

ex ante ex post coherence

dynamically inconsistent

CHM

TR

USA

CHP

A

D

FUSA D

E

A

Anew

Thank you for your attention!