Market Expectations Following Catastrophes: An Examination of Insurance Broker Returns

• DOI: http://doi.org/10.1111/jori.12069
• Date: 01 December 2016
• Author: Martin Halek,Marc A. Ragin
• Published date: 01 December 2016

©2015 The Journal of Risk and Insurance. Vol.83, No. 4, 849–876 (2016).

DOI: 10.1111/jori.12069

Market Expectations Following Catastrophes: An

Examination of Insurance Broker Returns

Marc A. Ragin

Martin Halek

Abstract

We investigate the effect major catastrophes are expected to have on equi-

librium price and quantity in the insurance market. In particular, we exam-

ine whether investors expect total industry revenue to increase following a

disaster’s shock to insurers’ financial capital. Rather than examine insurers

directly, we study insurance brokers, who earn commissions on premium

revenue but do not pay losses following a disaster. We conduct an event

study on insurance broker stock returns surrounding the 43 largest insured-

loss catastrophes since 1970. We find that brokers earn positive abnormal

returns on the day of the event, and that these returns are sustained follow-

ing the top 20 largest events. We then investigate factors influencing these

returns and find that returns are positively related to the size of the loss

and negatively related to existing insurer capital. From this, we conclude

that catastrophe shocks are expected to increase net industry revenue, ben-

efiting brokers most immediately. This investor response is consistent with

economic theories of a negative relationship between capital and insurance

prices and price-inelastic demand for commercial insurance.

Introduction

The commercial insurance industry reliesheavily on financial capital to maintain equi-

librium. Large disasters reduceavailable capital, creating uncertainty in the market. To

recoup lost capital, insurers may raise external funds, increase prices, and/or restrict

coverage, but they also must consider how policyholders, competitors, investors, and

regulators may react. Insurance buyers may face rate increases, impaired insurers,

Marc A. Ragin is in the Department of Risk, Insurance, and Healthcare Management in the Fox

School of Business at TempleUniversity.Ragin can be contacted via e-mail: mragin@temple.edu.

Martin Halek is in the Department of Actuarial Science, Risk Management, and Insurance in the

Wisconsin School of Business at the University of Wisconsin–Madison.Halek can be contacted

via e-mail: mhalek@bus.wisc.edu. Wewould like to thank the two anonymous referees for their

insights and suggestions. Thanks also are due to Joan Schmit, Jed Frees, Mark Browne, Justin

Sydnor,Morris Davis, and seminar participants at the American Risk and Insurance Association

and WesternRisk and Insurance Association annual meetings, Florida State University, Temple

University,and the Federal Reserve Bank of Chicago.

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and existing losses as they make decisions regarding future insurance purchases.

Considering all these factors, how is the commercial insurance market equilibrium

expected to change following a major disaster?

Many existing theories suggest that insurance supply will contract after a capital

shock, but few explicitly consider the response of commercial demand. Following

seminal work by Winter (1994) and Gron(1994), Cagle and Harrington (1995) develop

a model of insurer profits, ultimately showing that a shock’s effect on price depends

on the elasticity of demand relative to the elasticity of supply. The authors note

that insurance guaranty funds, compulsory insurance requirements, and the lack

of substitutes for insurance make it likely that demand is less elastic than supply,

concluding that prices will increase following a capital shock.1The measurement

of corporate insurance demand elasticities has not been widely studied—the only

empirical article estimating corporate insurance demand elasticities that we are

aware of is a study by Michel-Kerjan, Raschky, and Kunreuther (Forthcoming). The

researchers use proprietary purchasingdata to estimate the price elasticity of demand

for corporate property and terrorism insurance and find that firms were relatively

price inelastic for both types of coverage.2

The objective of our article is to contribute to this nascent literature by examining the

expected effect of a major disaster on commercial insurance market equilibrium. Our

approach is innovative in several ways. First, we use an event study methodology to

examine stock returns, which isolates the effect of a catastrophefrom other factors that

may impact the insurance market. In other words, rather than examining the realized

revenue changes in the quarter following the disaster (which would be influenced by

interest rates, investment returns, inflation, and other losses), we study the stock mar-

ket’s immediate reaction in the days following the 43 largest insured-loss catastrophes

since 1970. This captures any new expected change in insurance premium revenue as

a direct result of the disaster.

Second, rather than examining stock returns for insurers, we examine returns for

insurance brokers. Net increases in premium revenue benefit insurers, but that benefit

may be offset by claim payments following a disaster. Prior catastropheevent studies

focusing on insurers find that insurersgenerally experience negative abnormal returns

as a result of their expected loss payments (Lamb, 1995; Cummins and Lewis, 2003;

Doherty, Lamm-Tennant, and Starks, 2003). Insurance brokers, on the other hand,

derive a substantial portion of their revenues from commissions on premiumspaid, so

broker revenues may serve as a proxy for insurer revenues.Unlike insurers, however,

insurance brokers have little (if any) exposure to policyholder claims. Hence, expected

1Cummins and Danzon (1997) develop a similar model, which specifically allows for potential

price decreases following capital shocks under certain conditions that may affect elasticity of

demand.

2Our use of the term “elastic” versus “inelastic” is somewhat arbitrary. We generally describe

an elasticity absolute value less than 0.5 as “inelastic” and greater than 1.0 as “elastic.” This

is intended to capture the effect of these elasticities on total revenue, as a demand elasticity

greater than 1.0 indicates a price increase would cause total revenue to decrease.