Policy instruments

Risk layering provides an helpful conceptual framework for thinking about government intervention in risk transfer markets, tte discussion of the market insurance layer described situations in which government packaging or pooling of risk could potentially reduce the transaction costs associated with risk transfer and thus the premiums paid by end users, ttis section explores other possible government interventions, including government facilitation of risk transfer in the market failure layer, the role of government subsidies in risk transfer markets, and potential uses of index insurance instruments to finance government disaster relief and safety net policies.

Government Disaster Option for CATRisk:A Policy for the Market Failure Layer

Cognitive failure and ambiguity loading occur primarily with events in the extreme tail of the loss distribution, the area previously termed the market failure layer. For this reason, and as a substitute for ad hoc disaster relief payments, governments may decide to co-finance risk transfer mechanisms for these events. A government, for example, could design Disaster Option for CAT risk (DOC) index reinsurance contracts for catastrophic risks. Returning to the example in Figure 22.2, a DOC could insure against rainfall less than 500 mm with a payment per tick of say, USS50. Primary insurers could then offer coverage beyond the earlier imposed limit of 500 mm and transfer the catastrophic tail risk to the government using the DOC. Even if primary insurers are selling traditional crop insurance, they could use a DOC to transfer part of the catastrophic tail risk in their portfolio of crop insurance policies (Schade et al. 2002). DOCs could be offered for a variety of strikes and settlement weather stations, as long as the coverage is for catastrophic risk layers and can be offset in international weather risk markets, tte government could even offer other DOC indexes (for example, excess rainfall or wind speed) to reinsure other lines of insurance, such as property and casualty, tte government would reinsure DOCs in international reinsurance or capital markets using any of the three risk transfer strategies described earlier (Skees and Barnett 1999). Since

DOCs would address only extreme catastrophic loss events, reinsurance premium rates would likely contain an ambiguity load. Premiums could be subsidized to offset part of this ambiguity load so that DOC purchasers would pay something closer to a pure premium rate (Skees 2003). DOCs could be tailor-made to individual insurers' needs; for example, DOCs could be based on individual weather stations or written as regional weighted average baskets of weather stations. Strikes should be set so that the DOC covers only infrequent events (for example, events with an expected frequency of once every thirty years or less), ttis is the domain of the probability distribution over which potential insurance purchasers tend to experience cognitive failure and insurance providers engage in ambiguity loading. Primary insurers and ultimately insured parties would pay a premium for this catastrophic protection, but it would be significantly less than what the market would charge, ttose who reinsure DOC contracts will insist on verifying the credibility of the underlying indexes, tte premium required to transfer the risk to international markets would provide a baseline for setting DOC premium rates, tte risk-layering approach proposed here would institutionalize the social role of government in subsidizing extreme risk events at the local level. Premium rates could be subsidized to offset ambiguity loading. Furthermore, by organizing DOC contracts at the local level, victims of isolated severe events that fail to capture national policymakers' attention could still receive some structured assistance, tte following list summarizes the major advantages of offering index-based DOCs:

• DOC contract provisions established ex ante allow for better planning than do ad hoc disaster payments.

• DOCs provide a structure that provides more spatial and temporal equity in government disaster assistance.

• DOCs facilitate commercial insurance product development by providing a means by which catastrophic risk layers can be effectively transferred into international markets.

• DOCs can be subsidized to address the market failure associated with ambiguity loading and cognitive failure.

• Governments can estimate their own DOC subsidy cost exposure based on actuarial estimates of the risk inherent in the index. Reinsurance coverage adds a market check on the credibility of the index and the adequacy ofDOC premium rates.

• While DOCs may be partially subsidized, end users still pay part of the cost to transfer the risk into international markets, ttis reduces the potential for perverse incentives that could encourage excessive risk taking.

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