Risk Overhang and Market Behavior

We show that exposure from past business transactions – risk overhang – can reduce activity in related business lines, sometimes to the point where no new trade occurs. We focus primarily on the role of overhang in nonlife insurance market disruptions. Our model predicts that the relative impact, duration, and character of supply disruptions are related to the extent of overhang. These predictions are consistent with differences between the mid-1980s liability insurance crisis and the early-1990s catastrophe reinsurance crisis. The overhang model predicts attributes of these crises that prior explanations relying on adverse selection do not. We also discuss applications of the overhang model to disruptions in lending and securities markets. JEL Classifications: D45, G20, G22, L10 1Limited capacity has been used more generally to explain the overall pattern called the insurance cycle, of which crises are a part. A typical cycle starts with a crisis, which is followed by a few years of relatively high prices, restricted but no longer declining availability and high profitability. This evolves into a market where prices and profitability are eroding and insurance is relatively abundant. After several years of these declining market conditions for insurers, another crisis repeats the cycle. See Stewart (1984), Winter (1988, 1991) and Gron (1994). 2Liability insurance covers losses from third party claims against the policyholder; the 1980's liability crisis was particularly severe in commercial liability lines such as product liability, professional liability and environmental liability. Reinsurance refers to insurance purchased by insurers as opposed to other firms or households. Catastrophe reinsurance covers significant property losses associated with natural catastrophe events such as a hurricane, windstorm or earthquake. 1