Wednesday, March 16, 2011

Ricardian equivalence in insurance

Ricardian equivalence refers to the argument that consumers internalize the government's borrowings by cutting back on their spending (or increasing their savings) in anticipation of higher taxes in future. Conservative economists have invoked this to argue that government deficit spending cannot stimulate aggregate demand.

The NYT has an article raising the issues concerning insurance industry in the aftermath of the Japanese earthquake and tsunami,

"Moody’s said ratings for all of the major reinsurers were stable, and many reinsurance analysts said they saw one bright spot in the disaster: prices for reinsurance have been declining for several years, and while the earthquake will hurt the results of companies for one quarter, it might spur new demand and higher prices.

Reinsurance contracts are often renewed in April, and Keefe, Bruyette & Woods issued a report on Tuesday suggesting that losses from the earthquakes in Japan and, recently, New Zealand would lead to firmer prices on California earthquake and Florida hurricane insurance."

This is classic rational expectations (or cognitive biases) operating from both ends of the market. Property owners, atleast in earthquake prone and coastal areas, swayed by the availability bias generated by events in Japan, will be more inclined to insure their assets in a more comprehensive manner. Similarly, insurers would increase the actuarial risks associated with such events and price their premiums upwards.

Assuming that the actual risks remain the same (taken on a historic scale), the insurer can therefore hope to claim higher profits in future (though this is partly reduced the higher premiums that re-insurers are themselves likely to charge). To this extent, insurers will be able to recover a large portion of the current payouts from these higher future premiums. This begs the accounting question about what is the real long-term impact of such earthquakes on the insurance industry.

1 comment:

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