Corporate Demand for Insurance: New Evidence From the U.S. Terrorism and Property Markets

• Author: Paul Raschky,Erwann Michel‐Kerjan,Howard Kunreuther
• Date: 01 September 2015
• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/jori.12031

CORPORATE DEMAND FOR INSURANCE:NEW EVIDENCE

FROM THE U.S. TERRORISM AND PROPERTY MARKETS

Erwann Michel-Kerjan

Paul Raschky

Howard Kunreuther

ABSTRACT

Since the passage of the Terrorism Risk Insurance Act of 2002, corporate

terrorism insurance is sold as a separate policy from commercial property

coverage. In this article, we determine whether companies differ in their

demand for property and terrorism insurance. Using a unique data set of

insurance policies purchased by large U.S. firms, combined with financial

informationof the corporate clients and of theinsurance provider,we apply a

two-stage least squares approach to obtain consistent estimates of premium

elasticity of corporate demand for property and terrorism coverage. Our

findings suggest that both are rather price inelastic and that corporate demand

for terrorism insurance is significantly more price inelastic than demand for

property insurance. We further find a negative relationbetween the solvency

ratios of both property and terrorism risk coverage, with a stronger effect on

the latter, indicating that companies use their ability to self-insure as a

Erwann Michel-Kerjan is at the Center for Risk Management and Decision Processes at the

Wharton School of the University of Pennsylvania, Philadelphia, PA. Michel-Kerjan can be

contacted via e-mail: erwannmk@wharton.upenn.edu. Paul Raschky is at the Department of

Economics at Monash University, Australia. Raschky can be contacted via e-mail: paul.

raschky@monash.edu. Howard Kunreuther is at the Center for Risk Management and Decision

Processes at the Wharton School of the University of Pennsylvania, Philadelphia, PA.

Kunreuther can be contacted via e-mail: kunreuther@wharton.upenn.edu. Partial financial

support for this research was provided by Wharton’s Managing and Financing Extreme Events

project, DHS’s Center of Excellence CREATE at the University of Southern California, and

Monash University. We thank George Akerlof, Neil Doherty, Marty Feldstein, Scott

Harrington, John Karikari, Greg Nini, William Nordhaus, Jesse Shapiro, Terri Vaughan, and

seminar participants at the American Economic Association Annual Meeting, National Bureau

of Economic Research (NBER) Insurance Group, NBER Economics of National Security Group,

University of Pennsylvania, University of Innsbruck, and the OECD high-level international

conference on terrorism risk insurance markets for their comments and insightful discussions

on an earlier version of this paper [Correction added on 28 August 2015, after first online

publication: John Karikari has been added to the Acknowledgement section.]. We appreciate

Marsh & McLennan sharing with us the data that were used for our analysis and are indebted to

John Rand (formerly at Marsh) for many fruitful discussions on preliminary results. The two

journal referees and the editor provided excellent feedback on previous versions of the paper.

© 2014 The Journal of Risk and Insurance. 82, No. 3, 505–530 (2015).

DOI: 10.1111/jori.12031

505

substitute for market insurance. Our results are robust to the application of

alternative estimators as well as changes in the econometric specifications.

INTRODUCTION

In the past 30 years, we have witnessed a dramatic increase in the economic costs of

natural and man-made disasters around the world, from $528 billion (1981–1990) to

more than $1.2 trillion over the period 2001–2010. The years 2011 and 2012 triggered

another $580 billion in losses (Munich Re, 2013). In the United States, recent

catastrophes have included terrorism (e.g., the 1993 World Trade Center bombing,

the September 11, 2001 attacks), wildfires, hurricanes, flooding (e.g., Hurricane

Katrina in 2005, Ike in 2008, Irene in 2011, Sandy in 2012), and technological accidents

(e.g., the 2003 blackout, the 2010 BP oil spill).

Individuals typically transfer the financial risks associated with such hazards either to

primary insurers by purchasing coverage prior to a disaster and/or de facto to

taxpayers if they receive postdisaster government relief as many have in recent years.

Firms have a variety of financial risk-transfer tools available to protect themselves

against the economic consequences of negative outcomes (i.e., left-tail exposure).

Doherty (2000) and Hau (2006) posit that firms’ principal risk associated with

property damage is a lack of liquidity, which forces them to sell their most liquid

assets at a lower than desired price. Catastrophes can also trigger significant business

interruptions and prevent firms from fulfilling their contractual commitments. If the

firm is unable to raise enough short-term capital to repair the damage, it faces the risk

of bankruptcy.

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There are a number of potential sources of short-term capital that firms can access to

replace damaged property and cover business interruptions. They can use cash

reserves or increase debt by borrowing money at the market rate (self-insurance).

Alternatively, they can obtain property insurance ex ante that covers potential

damages (market insurance).

Corporate risk management aims at reducing the probability of such untoward events

(Stulz, 1996) and cash-flow variability when they occur (Froot, Scharfstein, and

Stein, 1993). The literature has typically focused on the use of corporate derivatives as

a hedge against negative outcomes. Leland (1998) shows theoretically that the use of

derivatives could have a direct effect on cash flow and an indirect effect on negative

(left-tail) outcomes. Smith and Stulz (1985) discuss the firm’s use of a hedging strategy

with off-balance-sheet instruments such as options and futures. Empirical work (e.g.,

Nance, Smith, and Smithson, 1993; Colquitt and Hoyt, 1997; Gezcy, Minton, and

Schrand, 1997; Graham and Rogers, 2002) further suggests that derivatives are widely

used by firms.

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This is part of a larger discussion in recent years about the value of good corporate risk

management and enterprise-wide risk management. For instance, Hoyt and Liebenberg (2011)

find a positive relation between firm value (measured by its Tobin’s Q) and the adoption of

enterprise risk management (with a 20 percent premium).

506 THE JOURNAL OF RISK AND INSURANCE