Uninsurable Risk Research Articles

The international risk sharing puzzle is at business cycle and lower frequency

Abstract We decompose the correlation between relative consumption and the real exchange rate in its dynamic components at different frequencies. Using multivariate spectral analysis techniques, we show that, at odds with a high degree of risk sharing, in most OECD countries the dynamic correlation tends to be quite negative, and significantly so, at frequencies lower than two years – the appropriate frequencies for assessing the performance of international business cycle models. Theoretically, we show that the dynamic correlation over different frequencies predicted by standard open economy models is the sum of two terms: a term constant across frequencies, which can be negative when uninsurable risk is large; a term variable across frequencies, which in bond economies is necessarily positive, reflecting the insurance intertemporal trade provides against forecastable contingencies. Numerical analysis suggests that leading mechanisms proposed by the literature to account for the puzzle are consistent with the evidence across the spectrum.

Consumption versus asset smoothing: testing the implications of poverty trap theory in Burkina Faso

Despite solid theoretical foundations for the notion that poor, borrowing-constrained households will intertemporally manage assets to smooth consumption, the consumption-smoothing hypothesis has not always withstood empirical scrutiny. This paper reassesses the intertemporal asset management problem with a poverty trap model and shows that we would expect to see asset smoothing, not consumption smoothing, in the neighborhood of critical asset levels at which optimal accumulation behavior bifurcates. We then employ threshold estimation techniques to empirically confirm the co-existence of consumption and asset smoothing regimes using a household panel data set from West Africa. Households above the estimated threshold almost completely insulate their consumption from weather shocks, whereas those below the threshold do not. These results not only indirectly provide evidence of the existence of poverty traps but also speak to the level and incidence of the costs of uninsured risk.

Insurances for human capital risk management in SMEs

Purpose – The purpose of this paper is to analyse how insurances can be used in the management of human capital risks. The issue is highlighted in the context of small and medium‐sized enterprises (SMEs).Design/methodology/approach – Building on literature on intellectual liabilities, the paper provides a comprehensive picture of human capital related risks, emphasising their effects on SMEs. The issue is analysed empirically through a qualitative case study of an insurance company.Findings – The paper divides the identified human capital risks into insurable and uninsurable risks, determining a specific insurance solution for each insurable risk. Based on the results, pension, accident, health, life, liability and crime insurances are the most useful types of insurances for the management of human capital risks.Research limitations/implications – The generalisability of the findings is limited by the methodological choice. As the study is conducted from the viewpoint of an insurance provider, it does not...

The Impact of Weather Insurance on Consumption, Investment, and Welfare

Weather variations crucially affect the wellbeing of farmers in developing countries. I develop and estimate a dynamic stochastic optimization model to assess the impact of weather insurance on the consumption, investment, and welfare for farmers in developing countries. The parameters of the model are pinned down with a combination of calibration and structural estimation using data from Malawi. Contrary to some past work, I find that weather insurance has the potential to provide substantial welfare gains equivalent to almost a 17% permanent increase in consumption. These gains can be magnified especially for the poorest households by contemporaneously extending credit to finance the additional desired investment. In an extension of the model I also show that weather insurance can allow for the adoption of riskier but more-productive improved seeds, further boosting farmers' welfare. Finally, I explore the extent to which the interplay with other uninsured risks, the presence of basis risk, and a loading factor on the insurance premium may lower the welfare gains from weather insurance, and lead to low take-up as is often observed empirically.

Agricultural Decisions after Relaxing Credit and Risk Constraints

The investment decisions of small‐scale farmers in developing countries are conditioned by their financial environment. Binding credit market constraints and incomplete insurance can reduce investment in activities with high expected profits. We conducted several experiments in northern Ghana in which farmers were randomly assigned to receive cash grants, grants of or opportunities to purchase rainfall index insurance, or a combination of the two. Demand for index insurance is strong, and insurance leads to significantly larger agricultural investment and riskier production choices in agriculture. The binding constraint to farmer investment is uninsured risk: when provided with insurance against the primary catastrophic risk they face, farmers are able to find resources to increase expenditure on their farms. Demand for insurance in subsequent years is strongly increasing with farmer’s own receipt of insurance payouts, with the receipt of payouts by others in the farmer’s social network, as well as with recent poor rain in their village. Both investment patterns and the demand for index insurance are consistent with the presence of important basis risk associated with the index insurance, with imperfect trust that promised payouts will be delivered, as well as with overweighting recent events.

The International Risk-Sharing Puzzle is at Business-Cycle and Lower Frequency

We decompose the correlation between relative consumption and the real exchange rate into its dynamic components at different frequencies. Using multivariate spectral analysis techniques we show that, at odds with a high degree of risk-sharing, in most OECD countries the dynamic correlation tends to be quite negative, and significantly so, at frequencies lower than two years - the appropriate frequencies for assessing the performance of international business cycle models. Theoretically, we show that the dynamic correlation over different frequencies predicted by standard open-economy models is the sum of two terms: a term constant across frequencies, which can be negative when uninsurable risk is large; and a term variable across frequencies, which in bond economies is necessarily positive, reflecting the insurance that intertemporal trade provides against forecastable contingencies. Numerical analysis suggests that leading mechanisms proposed by the literature to account for the puzzle are consistent with the evidence across the spectrum.

Agricultural Decisions after Relaxing Credit and Risk Constraints

The investment decisions of small-scale farmers in developing countries are conditioned by their financial environment. Binding credit market constraints and incomplete insurance can reduce investment in activities with high expected profits. We conducted several experiments in northern Ghana in which farmers were randomly assigned to receive cash grants, grants of or opportunities to purchase rainfall index insurance, or a combination of the two. Demand for index insurance is strong, and insurance leads to significantly larger agricultural investment and riskier production choices in agriculture. The salient constraint to farmer investment is uninsured risk: when provided with insurance against the primary catastrophic risk they face, farmers are able to find resources to increase expenditure on their farms. Demand for insurance in subsequent years is strongly increasing in a farmer’s own receipt of insurance payouts, and with the receipt of payouts by others in the farmer’s social network. Both investment patterns and the demand for index insurance are consistent with the presence of important basis risk associated with the index insurance, and with imperfect trust that promised payouts will be delivered.

Managing climate risk: extreme weather events and the future of insurance in a climate-changed world

Recent extreme weather events in eastern Australia have again raised questions in the public sphere about the nature of links between anthropogenic climate change and extreme weather events. Demonstrating that anthropogenic climate change was wholly responsible for any extreme weather event may never be possible in a system as complex as the Earth's. Yet the extent to which anthropogenic climate change increased the likelihood of some specific extreme weather events occurring can be quantified. However, this article argues that unmitigated climate change threatens not just measurable, increased likelihoods of extreme events, but over time, wholly unpredictable frequencies for extreme weather events. This article asks what the prospects might be for continued provision of insurance in a climate-changed world, for the insurance sector as well as the societies dependent on insurance as a primary tool to manage financial risks. The article argues that ultimately, the only viable way to insure against climate risks will be through effective mitigation of climate change: deep and rapid cuts in emissions now as a ‘premium’ to avoid uninsurable climate risks in the future.

Savings and Default

In the presence of uninsurable idiosyncratic risk, the optimal credit contract allows for the possibility of default. In addition, the optimal contract incorporates a precautionary savings motive over and above what agents would otherwise save. When default is sufficiently high, credit markets may collapse. A regulatory requirement on the level of savings can increase risk-sharing and improve welfare by increasing the gains to trade in credit exchange. Under the appropriate verifiability condition on the level of savings, an appropriate market structure, agents voluntarily increase their level of storage such that trade and welfare improve.

Uninsurable risk and financial market puzzles

We compare the empirical performances of three risk-sharing arrangements involving idiosyncratic skill shocks: (a) where individuals are unable to directly insure their consumption against individual-specific shocks, (b) where agents strike long-term insurance contract with financial intermediaries involving a truth revelation constraint as in Kocherlakota and Pistaferri (2009), (c) full risk sharing. Based on the widely accepted assumption of cross-sectional log-normality of individual consumption levels, we work out closed form expressions of the pricing kernels for (a) and (b). We put these three models to test four financial market anomalies, namely the equity premium, currency premium, risk-free rate, and consumption-real exchange rate puzzles simultaneously in an integrated framework. We find that the pricing kernel associated with (a) outperforms the other two models in terms of the produced estimates of the agent’s preference parameters and the model ability to predict the equity and currency premia, the risk-free rate, and the log growth in the exchange rate. However, the predictive ability is still far from satisfactory for all three models under scrutiny.

Making Sense of China’s Excessive Foreign Reserves

Large uninsured risk, severe borrowing constraints, and rapid income growth can imply excessively high household saving rates. Therefore, the global saving glut and massive foreign reserves accumulated by emerging economies are not necessarily the intended outcome of any government policies or undervalued home currency, but instead a natural consequence of the ine¢ cient nancial system (or lack of timely nancial reform) in these countries. Since nancial development is a much more complicated task and harder goal to achieve than GDP growth, even if the Chinese government appreciate RMB dramatically, trade imbalances between China and the United States will remain, as was the case between Japan and the U.S. in the last century. Worse still, without a well developed domestic nancial market, the RMB may signi cantly depreciate, instead of appreciate, once the government in China abandons the linked exchange rate and the massive amount of precautionary savings of Chinese households unleashed toward the world nancial markets in seeking for better returns. In other words, the gigantic asset demand caused by precautionary savings may completely dominate the Balassa-Samuelson e¤ect on the exchange rate. Keywords: Exchange Rate Determination, Borrowing Constraints, Bu¤er Stock Saving, Global Imbalance, Foreign Reserves, Trade De cit, Incomplete Markets, Uninsured Risk.

Climate costs and benefits: new challenges for corporate accounting and management

0959-6526/$ e see front matter doi:10.1016/j.jclepro.2010.12.016 Given the growing evidence and scientific consensus about globalwarming, companies are challenged byamultitude of climate change related costs, risks, benefits, and opportunities which require measures and assessments. Climate change-related risks such as uninsurable risks fromunpredictableweather conditions, as well as newgovernmental regulations, like the EU Emission Trading System, carbon taxes, new building codes and energy efficiency standards can substantially influence competitiveness. Climate

Does Tort Law Reform Help or Hurt Consumers?*

Legal limits on insurance damage claims have been introduced in Australia, the United States and other jurisdictions. In this article, I construct a simple competitive model to analyse the effect of tort law reforms on consumers. The model shows that reforms to limit non‐economic losses make consumers unambiguously worse off ex ante. Although insurance premiums fall and these reductions are passed on to consumers in full, this gain is more than offset by the increased risk that consumers are forced to bear. In contrast, reforms for income‐related (i.e. economic) losses lead to ambiguous outcomes. The potential benefits from limits to economic loss arise due to the inability of insurers to price discriminate on the basis of income or expected loss. Because of this, there is an implicit cross subsidy from low‐ to high‐income consumers that is embedded in the insurance premium and relevant product price. Tort law reforms partially unwind this cross subsidy. The results presented in this article show that tort law reforms may achieve their stated goal, such as lowering monetary prices, but can still make consumers worse off by introducing an uninsurable risk. There is also an important difference between reforms that limit claims for economic and non‐economic losses. Insurance for economic loss will generally include an implicit cross subsidy and, as a consequence, reforms can alter the ex ante utility for different groups of consumers in different ways.

Limited Asset Market Participation and the Variation of Real Risk Premia

This paper studies the contribution of limited asset market participation to the variability of real interest rates in the UK. Using a quadratic term structure model of real interest rates in an economy with endogenously segmented asset markets, I estimate the contribution of money and real shocks to the volatility of interest rates. The estimates suggest that the consumption of households participating in the asset market has time-varying conditional variances and varies more in response to money shocks when inflation is close to its unconditional mean. Asset market segmentation is an uninsurable risk which varies more at lower levels of inflation because more households are ready to participate at low levels than at high levels of inflation. Consequently, participating households bear a larger portion of aggregate consumption variability. The endogenous asset market segmentation generates the rejection of the expectations hypothesis in real interest rates.

Universal Banking and Equity Risk Premium

Did the unification of commercial and investment banking heighten risk in financial markets due to moral hazard of borrowers? In a simple intertemporal model with moral hazard and uninsured risk, we argue that if financial contracts are properly written, the integration in financial markets could give rise to greater risk sharing arrangement and could eliminate the equity risk premium attributed to informational asymmetry among the lenders and the borrowers.

Risk, Credit Constraints and Financial Efficiency in Peruvian Agriculture

Based on a panel data set, we use a two-stage analysis to evaluate the effects of access to formal credit on financial efficiency of farms in northern Peru. The first stage uses non-parametric data envelope analysis to estimate farm-specific measures of financial efficiency; 28 per cent of farmers are financially inefficient and credit constraints reduce profits of these farmers by an average of between 17 and 27 per cent. The second stage uses Tobit regression to evaluate the determinants of financial inefficiency; the results point to uninsured risk as a key determinant of financial inefficiency and suggest that policies to strengthen agricultural insurance markets would likely pay large dividends in rural Peru.

Intra-Household Labor Supply, Migration, and Subsistence Constraints in a Risky Environment: Evidence from Rural El Salvador

We use panel data from El Salvador to investigate migration and the intra-household allocation of labor as a strategy for coping with uninsured risk. Consistent with a model of a farm household with a binding subsistence constraint, we show that adverse agricultural productivity shocks increased both male migration to the US and the supply of male agricultural labor within the household in El Salvador. In contrast, after damage sustained from the 2001 earthquakes, female migration from El Salvador declined. This is consistent with the earthquakes increasing the demand for home production. Overall, household responses to uninsured risk appear to be consistent with a simple framework in which household members are allocated to sectors according to their comparative advantage. Finally, we show no evidence that the labor market in El Salvador is capable of helping rural Salvadoran households to buffer the effects of adverse shocks.

Growth and Capital Flows with Risky Entrepreneurship

This paper shows that the behavior of entrepreneurs facing incomplete financial markets and risky investment can explain why growth accelerations in developing countries tend to be associated with current account improvements. The uninsurable risk of losing invested capital forces entrepreneurs to rely on self-financing, so that when business opportunities open up entrepreneurs increase saving to finance the investment that produces growth. The key insight is that saving has to rise more than investment to allow also for the accumulation of precautionary assets. Plausibly calibrated simulations show that this net saving increase can sustain large and persistent net capital outflows.

Growth and Capital Flows with Risky Entrepreneurship

This paper shows that the behavior of entrepreneurs facing incomplete financial markets and risky investment can explain why growth accelerations in developing countries tend to be associated with current account improvements. The uninsurable risk of losing invested capital forces entrepreneurs to rely on self-financing, so that when business opportunities open up entrepreneurs increase saving to finance the investment that produces growth. The key insight is that saving has to rise more than investment to allow also for the accumulation of precautionary assets. Plausibly calibrated simulations show that this net saving increase can sustain large and persistent net capital outflows.

Does Tort Law Reform Help or Hurt Consumers?

Legal limits on insurance damage claims have been introduced in Australia, the United States and other jurisdictions. In this article, I construct a simple competitive model to analyse the effect of tort law reforms on consumers. The model shows that reforms to limit non-economic losses make consumers unambiguously worse off ex ante. Although insurance premiums fall and these reductions are passed on to consumers in full, this gain is more than offset by the increased risk that consumers are forced to bear. In contrast, reforms for income-related (i.e. economic) losses lead to ambiguous outcomes. The potential benefits from limits to economic loss arise due to the inability of insurers to price discriminate on the basis of income or expected loss. Because of this, there is an implicit cross subsidy from low- to high-income consumers that is embedded in the insurance premium and relevant product price. Tort law reforms partially unwind this cross subsidy. The results presented in this article show that tort law reforms may achieve their stated goal, such as lowering monetary prices, but can still make consumers worse off by introducing an uninsurable risk. There is also an important difference between reforms that limit claims for economic and non-economic losses. Insurance for economic loss will generally include an implicit cross subsidy and, as a consequence, reforms can alter the ex ante utility for different groups of consumers in different ways.