Explaining the Failure to Insure Catastrophic Risks

Carolyn Kousky and Roger Cooke
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Carolyn Kousky: Resources for the Future, 1616 P Street NW, Washington DC 20036, U.S.A. E-mails: kousky@rff.org; cooke@rff.org

The Geneva Papers on Risk and Insurance - Issues and Practice, 2012, vol. 37, issue 2, 206-227

Abstract: It has often been observed that homeowners fail to purchase disaster insurance. Explanations have ranged from behavioural biases to information search costs. We show that the decision to forego disaster insurance may be quite rational. Solvency-constrained insurers are required to have access to enough capital to cover a particular percentile of their aggregate loss distribution. When insuring risks with loss distributions characterised by fat tails, micro-correlations or tail dependence, insurers need to charge a price that is many times the expected loss in order to meet their solvency constraint. Homeowners, facing a budget constraint and a constraint that their utility with insurance exceeds that without it, may find the required loadings too high to make insurance purchase an optimal decision.

Date: 2012
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