Premium
Equity Risk, Conversion Risk, and the Demand for Insurance
Author(s) -
Garratt Rod,
Marshall John M.
Publication year - 2003
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/1539-6975.t01-1-00059
Subject(s) - equity (law) , randomness , actuarial science , property insurance , risk pool , economics , business , property (philosophy) , insurance policy , key person insurance , casualty insurance , mathematics , statistics , philosophy , epistemology , political science , law
Existing insurance theory fails when applied to real property because it does not account for variations in the economic environment. The article studies optimal property insurance in the presence of two sources of variation: equity risk and conversion risk. Equity risk is randomness of the value of a property. It tends to raise demand for conventional insurance. In contrast, conversion risk is randomness in the value the property would have if, after severe damage, it were converted to the highest‐valued use. It is distinct from equity risk because the highest‐valued use is typically not the current one. Under independent conversion risk, the optimum upper limit is a compromise among underlying conversion thresholds. Absent independence, the optimum can be quite different. Conversion risk can raise or lower the demand for property insurance. Insurance contracts that fail to address conversion tend to undermine the orderly disposition of obligations and reduce the gains from reallocation of risks through insurance.