Community Rating, Cross Subsidies and Underinsurance: Why so many Households in Japan do not Purchase Earthquake Insurance

Abstract

A theoretical framework and empirical evidence are presented to show the connection between community uniform rating and cross-subsidies in earthquake insurance policy in Japan. Cross-subsidies are defined as the difference between a fair actuarial premium and the community uniform rate. The estimation result shows that the uniform community rating may unintentionally cross-subsidize inhabitants in high risk areas at the expense of inhabitants in low risk areas. Our simulation results indicate that replacing the current community rating with the fair actuarial premium would increase the overall subscription rate for earthquake insurance by about 3.7 percentage point, and that the increase is particularly prominent in relatively less risky areas. We propose modifying the Japanese earthquake insurance system by adopting a more refined risk rating system that more closely reflects regional differences in earthquake risk.