Today, we are pleased to present a guest contribution written Hiro Ito (Portland State University) and Robert N. McCauley (formerly Bank for International Settlements). The views presented represent those of the authors, and not necessarily those of the institutions the authors are affilliated with.
One basic role of international financial markets is to share risks across economies. For instance, investors swap the equity of firms at home for those abroad in order to diversify away from sources of loss that are unique to the domestic economy. In an ideal world of complete risk-sharing, domestic investors would bear such a loss only to the extent of their share of world wealth (“CAPM”).
Thus, a small economy would lay off on the rest of the world almost all risk that is unique to it. Natural disasters pose such a risk. In theory, financial markets might spread their risk around the world to approach the ideal.
However, the reality is different.
The losses from the 2011 earthquakes in Japan remained in Japan, while reinsurance spread the losses from that year’s New Zealand earthquake to the rest of the world. Furthermore, the losses remaining in Japan are much larger than the CAPM theory suggests. Even the losses that New Zealand shared through reinsurance fell well-short of the nearly 100% the theory suggests.
Our recent paper (Ito and McCauley, 2019) finds that losses from natural disasters are shared internationally to a generally very limited extent. We find the mean portion of economic losses received offset by reinsurance is less than 5%. On a value-weighted basis, the degree of international risk-sharing is still only 7.5%. These findings are far below a textbook norm of full international risk-sharing. This finding of home bias in disaster risk-bearing poses a puzzle of international risk-sharing (Figure 1).
Figure 1: Shortfall of reinsurance coverage of disaster losses relative to a CAPM-type ideal distribution of risk
In this paper, we use data compiled by Munich Re, a major reinsurer, on the largest natural catastrophes. These give us estimates on the monetary value of the direct losses and the fraction covered by insurance. We then search balance of payments data to identify related receipts of reinsurance payments from the rest of the world. This method identifies for the first time the cross-border flow of reinsurance payments to 88 economies that experienced insured disasters in the 1985–2017 period. Using the data, we decompose international risk-sharing into the portion of losses insured and the portion of insurance that is internationally re-insured.
We find that the failure of international risk-sharing begins at home with low participation in insurance. That is, the lack of insurance coverage is the overwhelming factor in the shortfall of reinsured loss from the textbook level (Figure 2). The contrast of international risk-sharing of the losses from the 2011 earthquakes in Japan and New Zealand arises mostly from the coverage of insurance.
Figure 2: Decomposition of the shortfall into insurance cover and reinsurance. Sources: NatCatSERVICE data; IMF balance of payments data; authors’ calculations.
Regression analysis points to economic development and institutional/legal quality as important determinants of insurance participation. The reinsurance share is related to small size, as theory would suggest, while higher levels of international reserves holding are also found to be positive contributors. As a form of international financial integration, the international reinsurance share is also positively related to overall de facto international financial integration (as measured by the ratio of international assets and liabilities to GDP). In addition, we also find that more internationally wealthy economies reinsure less, suggesting that net foreign assets substitute for international sharing of disaster risk.
The lack of international risk-sharing against the background of low insurance coverage poses profound questions about the role of government. The practical alternative to ex ante insurance, however organised, seems to be demand for government spending to serve as ex post insurance. Indeed, the trend in both Japan and the United States looks to be toward greater spending in relation to disaster losses over time.
The difficulty is the empirical observation that those advanced economies which enjoy less international risk-sharing also enjoy less fiscal space. Thus, the realization of a disaster risks ratcheting up already high public debt levels. In this manner, disaster risk can morph into financial risk. Bond holders should insist that the government should implement policies to identify and better-share disaster risks. Large-scale natural disasters, including those which are increasingly affected by climate change, tend to require the central government to provide an implicit backstop for insurers or local governments and to function essentially as ex post de facto insurer.
This post written by Hiro Ito and Robert McCauley .