ȱ
ȱ¢ȱȱȬȱȱ
ȱ
ȱǯȱ
ȱ
¢ȱȱȱȱȱȱȱ
¢ȱşǰȱŘŖŖşȱ
ȱȱȱ
ŝȬśŝŖŖȱ
ǯǯȱ
řŚŝŚşȱ
ȱȱȱ
Pr
epared for Members and Committees of Congress
ȱ¢ȱȱȬȱȱȱ
ȱ
¢ȱ
Two important issues before 111th Congress are (1) securing the nation’s capacity to prepare for,
respond to, and recover/rebuild from natural catastrophe events, and (2) determining whether and
how the federal government should intervene in catastrophe insurance markets. Since the
devastating Gulf Coast hurricanes of 2004 and 2005, and a sequence of tornadoes, wildfires,
earthquakes, Hurricanes Ike and Gustav, and the Midwestern floods in 2008, public attention has
focused on: (1) the potential high cost of recovery and financing of natural disaster losses; (2) the
supply and relatively narrow scope of private sector disaster insurance; (3) the extent to which
Americans living in disaster-prone areas may be uninsured or underinsured; and (4) potential
increases in federal outlays for disaster assistance.
After Hurricane Katrina in 2005, the property insurance industry revisited catastrophe exposures
with the help of recalibrated catastrophe models for Atlantic tropical storms. Based on this new
analysis insurers arguably face greater potential losses in severe catastrophe events than was
previously appreciated. This enhanced appreciation of risk has implications for property
insurance capacity, underwriting, and pricing. Many insurers responded to recent hurricanes by
requesting rate increases or refusing to renew hundreds of thousands of policies sold in areas
along the Atlantic and Gulf Coasts. Where insurance became either too expensive or unavailable,
homeowners and small business owners who could not otherwise obtain property insurance in the
private markets turned to state-operated “residual market facilities” that serve as insurers of last
resort in these areas. As a result, many of these facilities have expanded. Nevertheless, there is
evidence to suggest that state-operated facilities may not be fully capable of resolving the
problems of insurance availability or affordability. For example, Florida’s inability to issue debt
(bonding capacity) during the global financial crisis in advance of the 2008 hurricane season
threatened to unravel the state’s property insurance system.
In the wake of financial market turmoil in 2008, one point of view contained in this report
stresses the importance of bringing more transparency to the markets for innovative new risk
transfer financial products. Some of these risk transfer instruments, such as credit default swaps
and other derivative products, are not regulated, and regulators have no valid data upon which to
perform oversight of them in the credit markets. Some economists believe that more transparency
and regulation are important components of credit market reform.
Several Members of Congress have debated mechanisms to ensure adequate capacity and
solvency of the insurance industry to meet customer demand. Many proposals have been
introduced that would improve insurers’ access to capital in the reinsurance, banking, and
securities markets. They include (1) study commissions; (2) tax reform incentives; (3) flood
insurance reform; (4) risk retention group reform; and (5) risk securitization and federal
reinsurance and loans. Congress could also be called upon to decide whether transparency
mechanisms are appropriate for resolving the broader issues presently disrupting all financial
markets.
This report will be updated as events warrant.
ȱȱȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
ȱ
Introduction ..................................................................................................................................... 1
Congressional Interest in Natural Disasters .................................................................................... 2
The Catastrophic Loss Financing Problem...................................................................................... 3
Role of Disaster Relief and Private Insurance .......................................................................... 3
Property Insurance Price and Capacity Problem....................................................................... 4
Economic Factors Contributing to Price and Capacity Crisis................................................... 5
Demand-Side Effects .......................................................................................................... 5
Supply-Side Effects ............................................................................................................ 6
Residual Market Mechanisms for Property Insurance .............................................................. 8
Insurability of Natural Disasters...................................................................................................... 8
Insurer Claims-Paying Capacity................................................................................................ 9
Uncertainty in Measuring and Pricing Catastrophe Exposures............................................... 12
Insurance Market Imperfections.............................................................................................. 13
Alternative Risk Transfer Mechanisms ......................................................................................... 13
Financial Market Turmoil in 2008................................................................................................. 14
Impact of Credit Market Illiquidity on Catastrophic Risk Financing...................................... 16
Opaque Capital Markets ................................................................................................... 17
Illuminating Opaque Credit Markets ................................................................................ 17
Transparency and Regulation.................................................................................................. 19
Federal Intervention in the Catastrophe Insurance Market ........................................................... 20
Arguments For Intervention .................................................................................................... 21
Arguments Against Intervention ............................................................................................. 21
Potential Points of Agreement................................................................................................. 22
Legislative Options........................................................................................................................ 22
Concluding Remarks ..................................................................................................................... 24
ȱ
Table 1. Ten Most Costly Insured Catastrophes in the United States, 1989-2008........................... 6
Table 2. Property-Casualty Insurance Industry Income, 2003-2007 ............................................... 9
Table 3. Estimated Insured Hurricane and Earthquake Losses for 10 States for the 1-in-
100-Year, 1-in-250-Year and 1-in-500-Year Catastrophes ..........................................................11
ȱ
Author Contact Information .......................................................................................................... 25
ȱȱȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
ȱ
Ever since eight costly hurricanes struck the East and Gulf Coasts in 2004 and 2005, large
national property and casualty insurers have significantly scaled back their willingness to
underwrite property insurance for homes located on or near coastlines. Hurricanes Ike and Gustav
were the major storms of 2008, and they renewed fears about the economic effects of the
destruction of thousands of homes, businesses, and infrastructure. Public attention is now focused
on issues such as the cost of disaster relief and reconstruction in the wake of financial market
turmoil and growing fiscal deficits, whether and where gaps in private insurance (and
reinsurance) coverage currently exist, why insurance coverage might become expensive and
unavailable, and whether new forms of private-public risk-transfer partnerships are needed to
manage the financial impact of large-scale natural disasters.
Natural disasters in the U.S. have the potential to cause economic losses in the tens or even
hundreds of billions of dollars. The federal government has played a large financial role in
responding to (uninsured) natural disasters. During the 20-year period from FY1989 to FY2008,
Congress appropriated $250 billion dollars for disaster assistance.1
Given the increasing frequency and severity of East and Gulf Coast hurricanes and growing
disaster relief expenditures, there is an urgency in Congress to ensure the effective financing of
catastrophic risks coupled with fair and efficient resolution of policyholder claims. Property value
in key U.S. earthquake and hurricane zones has doubling every 10 years. Meanwhile, global
insurance and reinsurance capital allocated to covering hurricane and earthquake perils is not
keeping pace. Economists have observed that this fundamental shortfall between risk and capital
growth represents a major public policy challenge for Congress.
In addition to federal outlays, private sector expenditures have been considerable; according to
data from the Insurance Services Office’s Property Claims Unit, private insurers paid $261.9
billion in insured catastrophe losses from 1980 through 2007. Insurance companies play a key
role in managing risks of catastrophic events.2 Individuals and businesses usually insure against
catastrophes in order to reduce financial volatility and avoid potential ruin. Insurers, in turn, will
transfer a portion of that risk to a reinsurer, thereby spreading globally the burden of catastrophic
risks. However, some have contended that the capacity of the traditional international reinsurance
market to finance a mega-catastrophic event remains inadequate.3
New forms of innovative risk financing instruments have developed to help insurers and
reinsurers increase their capacity to manage their peak catastrophic risk. Two main categories of
alternative risk transfer (ART) solutions are insurance-linked securities (ILS), which are direct
risk transfer instruments that provide funds to offset catastrophe losses, and contingent debt
1 See CRS Report RL33226, Emergency Supplemental Appropriations Legislation for Disaster Assistance: Summary
Data, by Justin Murray and Bruce R. Lindsay.
2 Insurers have three major tools at their disposal to manage an increase in risk: (1) raise equity capital by selling
company stock; (2) transfer risk to the reinsurance market; and (3) limit risk through the underwriting and asset
management process.
3 J. David Cummins and Mary A. Weiss, “The Global Market for Reinsurance: Consolidation, Capacity, and
Efficiency,” Brookings-Wharton Papers on Financial Services, 2000.
ȱȱȱ
ŗȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
agreements (e.g., contingent surplus notes and equity puts), which can replenish policyholders’
surplus (i.e., an insurer’s capital) after catastrophe losses. ART mechanisms complement
traditional reinsurance by transferring risk directly to capital market participants such as hedge
funds and institutional investors.
This report provides an analysis of the challenges facing property and casualty insurance and
reinsurance companies in financing large-scale natural disasters, particularly during financial
market turmoil. The report begins with a discussion of congressional interest in financing
recovery from natural disasters, and the role and limitations of federal disaster assistance and
private insurance. This is followed by an assessment of the problem of financing catastrophic risk
(i.e., issues of availability and affordability of residential property insurance coverage in coastal
areas), and a discussion of insurability of natural disasters given insurers’ claims-paying capacity.
In the final three sections, the paper examines ART mechanisms, such as ILS and contingent debt
securities that complement traditional reinsurance, the effects of the financial crisis on unraveling
capital structures that underlie some state property insurance systems, and possible roles for the
federal government in the market for catastrophe insurance coverage as it considers policy
options for resolving the broader financial market crisis.
ȱ ȱȱȱȱ
The U.S. has always been exposed to risks of natural disaster. Large-scale natural disasters, such
as wildfires, windstorms (i.e., hurricanes, tornadoes, and other wind damage), floods, and
earthquakes, however, have become increasingly frequent and costly. In 2005, private insurers
paid a record $62.3 billion in insured catastrophe losses.4 At the same time, uninsured losses from
Hurricanes Katrina, Rita, Wilma and Dennis caused an unprecedented $130 billion in federal
outlays for emergency disaster relief. Insured catastrophe losses for 2008 totaled an estimated
$25.2 billion, the fourth most costliest in a decade. Consequently, policymakers are aware that
although there is a well-functioning international catastrophe insurance and reinsurance market,
the federal government has increasingly been called upon to exercise its considerable authority
and significant means to reallocate resources throughout the economy to compensate disaster
victims.
The financial volatility of natural disasters and the resulting burden for society and the economy
are important issues for Congress because of its responsibility to promote national economic
growth. A mega-catastrophic event striking some region of the U.S. could impede interstate and
foreign commerce and cause widespread distress and hardship adversely affecting the general
welfare. Uncertainty about how often catastrophic events will occur (frequency) and the
magnitude of catastrophic events (severity) continue to pose a catastrophic risk financing
challenge both to society as a whole and to the federal government.
In 1995, President Clinton’s National Economic Council Working Group on Disaster Insurance
formulated a set of broad principles and objectives for a federal insurance program to reduce
losses and cover catastrophic risks. In the aftermath of Hurricane Katrina in 2005 and Ike and
4 This figure comes from the Insurance Services Office’s Property Claims Unit.
ȱȱȱ
Řȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
Gustav in 2008, these principles and objectives could set the policy framework to guide
policymakers in coping with natural disasters.
The Working Group concluded that a federal insurance program should:
• reduce total societal costs of catastrophic natural disasters;
• reduce total long-term federal costs of dealing with such events;
• increase personal security in the aftermath of a disaster; and
• increase the extent to which costs of disasters are maintained in the private sector
to create incentives to moderate losses from disasters.
A key question for Congress going forward is whether to proactively address the issue of
managing catastrophic risks through insurance and other risk transfer mechanisms. One option is
to establish an explicit public-private risk transfer partnership that would allow the federal
government to leverage public funds through the use of insurance, reinsurance, and capital market
instruments to accomplish the above-stated public policy objectives. This report analyzes issues
and information related to building a different relationship between insurers, reinsurers, the
capital markets and the federal government.
ȱȱȱȱȱ
At least two complementary approaches exist to manage the risk of large-scale natural
catastrophes: (1) pre-disaster risk avoidance and mitigation that reduces physical and
environmental vulnerabilities but still requires post-event funding; (2) risk transfer mechanisms
that involve disaster relief, insurance, reinsurance and capital market instruments designed to
compensate disaster victims and reduce exposure to financial losses. Generally, the federal natural
catastrophe risk management strategy seeks to mitigate the extent of damages through land-use
regulations, strengthening risk assessment and enforcing structural mitigation and vulnerability
reduction measures, such as zoning and building code compliance. Remaining residual risk is
then largely absorbed through a combination of federal disaster relief assistance, commercial
insurance, self-insurance and tax deductions.
ȱȱȱȱȱȱ ȱ
Private insurance and federal disaster relief have been relied upon for decades as complementary
mechanisms to compensate disaster victims and provide for recovery after a natural disaster. Risk
management theory, however, suggests at least three reasons why insurance is the more efficient
mechanism of the two for allocating the risk of large catastrophic events.
• Disaster relief assistance is assumed to have negative incentives for risk
mitigation because benefits are paid whether or not recipients have taken steps to
reduce their loss exposures. The inefficiency results in higher social and federal
costs of disasters, and is commonly referred to as “moral hazard.”
• From a welfare economics or resource allocation perspective, disaster relief is
inequitable because it is funded through general tax revenue and the costs of
disasters are borne by people or businesses regardless of their location in
ȱȱȱ
řȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
hazardous areas—i.e., residents and taxpayers in high-risk areas are subsidized
by those in low-risk areas.
• Disaster relief is inefficient and inclined to misjudgment because property
owners oftentimes do not fully understand the risks they face, make risk
management decisions based on inaccurate information, and intentionally rely on
disaster relief for compensation. Insurance is considered a more efficient
mechanism to deal with natural catastrophes; it establishes a price on the hazard,
based on actuarial information, and creates economic incentives to mitigate
losses.
Insurance manages risk pooling; insurers are uniquely exposed to a variety of risks arising from
their risk-bearing (underwriting) function. Insurers typically will hedge the risk they assume by
directly transferring some portion of that risk to a reinsurance company or indirectly to a special
purpose reinsurer set up to transfer the risk to investors in the capital markets through indemnity-
based or index-based insurance-linked securities (i.e., derivative transactions).5
There are inherent limitations to using insurance or reinsurance as a risk transfer tool because
insurance protection against a mega-catastrophic event is not always available through private
sources. Also, plans, policies, and structures intended to mitigate the effects of such losses might
not always fully anticipate the destructive aspects of hurricanes, earthquakes and other natural
disasters.
¢ȱ ȱȱȱ¢ȱȱ
At the core of the problem of the availability and affordability of homeowners’ insurance in
hurricane-prone coastal areas is the way insurers internally raise capital, the cost of capital
required to underwrite exposures in disaster-prone areas, and how insurers react to situations
where their earnings or solvency are threatened. Insurers must have adequate capital to support
the risks assumed and generally meet capitalization requirements. This can usually be achieved in
four ways:
• earn a net profit, thereby increasing policyholders’ surplus;
• sell insurance policies, which increases long-term debt capital;
• account for the value in the assets and liabilities not reported on their balance
sheets (realized and unrealized capital gains); and
• reduce the amount of capital required by reducing exposure to risk.
Insurers generally limit the capital committed to underwrite property insurance in coastal disaster-
prone areas largely because regulatory constraints have led to what some insurers believe are
inadequate returns to attract sufficient capital. Insurers usually seek a rate of return commensurate
with the risk they assume, expecting higher return from capital allocated to catastrophic risk than
5 Indemnity-based transactions involve settlement that is directly related to the loss experience of the company issuing
the securities (e.g., catastrophe bonds and contingent capital facilities such as surplus notes). Index-based transactions
involve settlements that are triggered or derived from the value of an independent index.
ȱȱȱ
Śȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
from, say, a stable book of automobile insurance policies where losses do not fluctuate widely
from year to year. In contrast, losses from catastrophic perils are more volatile and potentially
much larger. An insurer must hold significantly more equity to underwrite catastrophe exposures
than it needs to underwrite non-catastrophe exposure. To remain viable, the insurer must be able
to pass on its cost of capital to policyholders.
Shortages of insurance induced by capital shortages led two states, California (earthquake) and
Florida (hurricanes), to establish state catastrophe funds that offer certain advantages over private
sources of capital. State catastrophe funds that receive tax-exempt status can accumulate funds
free of federal insurance tax and use their government authority to issue debt to pay losses,
supported by future assessments against residents in the state. The states are therefore able to
diversify (spread) risk over time through the debt financing mechanism within their limited
jurisdictions.
ȱȱȱȱȱȱ¢ȱȱ
Property coverage became expensive and difficult to obtain following the 2004-2005 hurricane
seasons. After the storms, insurers felt compelled to revise their underwriting and pricing
assumptions to reduce their risk exposure and the amount of capital they needed to maintain
profitability and comply with regulatory requirements. As a result, insurance coverage for
residential properties in hurricane-prone coastal areas became more expensive and scarce for the
average resident.
Higher residential property insurance prices and reduced availability of coverage occurred not
because of a financial capacity shortage but rather because of changed industry assumptions
about the frequency and intensity of North Atlantic hurricanes and uncertainty about the models,
methodologies and data used for estimating natural hazard risk and losses from hurricane events.
Insurers were essentially reacting to the perception, not necessarily based on historical and
actuarial data, that more properties were at risk than previously thought. Residents in areas
exposed to these catastrophic perils have experienced wide fluctuations in the price and
availability of insurance, especially after a major disaster. Uncertainty about the probability of
losses caused by natural catastrophes and concern about insolvency triggered by a series of
disasters are the key reasons for fluctuations in the price and availability of property insurance in
disaster-prone areas.
Increased prices for and reduced availability of insurance have been attributed to both demand
and supply side factors. The next two sections examine demand and supply side effects that
contributed to a scarcity of private-sector disaster insurance following the 2004 and 2005
hurricane seasons.
Ȭȱȱ
The demand for insurance coverage is a function of the growth in population and property values
along the Gulf and Atlantic coasts and the perception of increased catastrophic risks. This
increased demand has contributed to disruptions in the coastal wind insurance market. When
demand exceeds supply, prices tend to rise.
ȱȱȱ
śȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
¢Ȭȱȱ
Four factors were key in the development of the current scarcity of residential property insurance:
(1) historic levels of insured catastrophe claims payments; (2) limited supply of catastrophe
reinsurance, particularly after the devastating 2004 and 2005 hurricane losses; (3) higher capital
adequacy requirements imposed on insurers by credit rating agencies; and (4) litigation
surrounding wind versus flood insurance coverage disputes after Hurricane Katrina. These factors
are discussed below.
First, insurers had to make historically unprecedented levels of payments to policyholders in
2004 and 2005; this has altered their view of what constitutes an “infrequent” mega-catastrophe.
Consequently, the structure of reinsurance contracts has changed, forcing primary insurers to
retain more risks and pay more for the expanded coverage. Table 1 shows the ten costliest insured
catastrophe loss events in recent years. Six of the 10 largest insured catastrophe losses occurred
over the last five years. Hurricane Katrina alone caused private insurers approximately $45.3
billion in insured losses, surpassing the $23.8 billion from Hurricane Andrew and $22.8 billion
for the 9/11 terrorist attacks.
Table 1. Ten Most Costly Insured Catastrophes in the United States, 1989-2008
(billions of 2008 dollars)
Rank Hurricane
Year
Insured
Losses
1 Hurricane
Katrina
2005
$45.3
2 Hurricane
Andrew
1992
23.8
3
World Trade Center Terrorist Attacks
2001
22.8
4
Northridge, CA earthquake
1994
18.2
5 Hurricane
Wilma
2005
11.4
6 Hurricane
Ikea 2008
10.7
7 Hurricane
Charley
2004
8.5
8 Hurricane
Ivan
2004
8.1
9 Hurricane
Hugo
1989
7.3
10 Hurricane
Rita
2005
6.2
Source: Insurance Services Office’s Property Claims Services Unit; Insurance Information Institute.
a. Estimated.
Faced with the changed marketplace conditions after the 2005 hurricanes, primary insurers sought
to reduce their exposure to catastrophe losses by decreasing the number of policies issued on
properties in coastal areas. Insurers lowered their exposure by not renewing policies (coverage)
for a significant number of their customers, not selling new policies, or exiting the market
altogether. Although individual insurers have sought to reduce their presence in coastal areas, the
property insurance industry as a whole continues to supply insurance to virtually every property
in the United States. In states where the insurance market disruption was most severe (e.g.,
Florida, Louisiana, Mississippi, and Texas), state officials either created state-sponsored residual
mechanisms or expanded existing ones to provide insurance to all those who could not purchase
coverage in the voluntary market.
ȱȱȱ
Ŝȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
The second factor that arguably contributes to the current problem is the limited supply of
catastrophe reinsurance after the devastating 2004 and 2005 hurricane losses. A critical element in
the ability of private insurers to underwrite catastrophe risk is the availability of reinsurance.6
Insurers typically purchase reinsurance to protect themselves from the financial consequences of
a single catastrophic event that causes insured loss to multiple policyholders. Reinsurance
markets, however, are subject to price and availability cycles, often resulting in price increases
and supply restrictions following catastrophic events.7 A significant portion of the insured
catastrophe losses from the 2004 and 2005 hurricanes were paid by reinsurance proceeds, and, as
reinsurers’ capital reserves were depleted, reinsurers needed to rebuild capacity.8 The limited
supply of residential property catastrophe reinsurance forced many primary insurers to reduce
their exposure to catastrophe losses from hurricanes and to retain more risk than they would
prefer. This has driven up their costs.
Third, primary insurers and reinsurers who underwrite catastrophe lines of coverage were subject
to higher capital adequacy requirements imposed on them by credit rating agencies like Standard
& Poor’s and A.M. Best Company. This change affected the amount of catastrophe insurance that
insurers were willing to sell. A strong financial rating reduces the insurer’s borrowing costs and,
therefore, increases its competitiveness in the marketplace.
Rating agencies were actually responding to adjustments in catastrophe modeling firms’
assumptions with respect to probabilities of loss based on a presumed up-tick in frequency and
severity of catastrophic events over a more immediate time horizon. The “near-term” higher
expected frequency of hurricanes making landfalls and higher estimates of the amount of
structural damage repair costs—both assumptions based on information provided by catastrophe
modeling firms—led to higher predicted losses and ultimately to higher premiums.
After the back-to-back record-setting hurricane seasons in 2004 and 2005, rating agencies
required insurers and reinsurers to plan for a catastrophic event projected to occur with a
frequency of one in 50 years rather than one in 100 years. Insurers’ balance sheets had to be able
to withstand multiple extreme events rather than just a single event. To maintain their financial
strength ratings, insurers were required to maintain a higher level of capital to demonstrate an
ability to pay claims under these two new standards. The consequence of higher capital adequacy
requirements was the sharp increase in demand for residential property reinsurance, which, in
turn, caused the price of this reinsurance to increase dramatically in 2006 through 2008.9
Fourth, litigation surrounding insurance coverage disputes and litigation over the standard
homeowners’ insurance policy exclusions for wind and water damage created “contract
uncertainty” associated with the judicial interpretation of insurance policy terms and language.10
6 Dwight M. Jaffee and Thomas Russell, “Catastrophe Insurance, Capital Markets, and Uninsurable Risks,” Journal of
Risk and Insurance, 1997, vol. 64, p. 205-230.
7 Kenneth A. Froot and Paul J.G. O’Connell, “The Pricing of U.S. Catastrophe Reinsurance,” in Kenneth Froot, ed.,
The Financing of Catastrophe Risks (Chicago: The University of Chicago Press, 1999).
8 A.M. Best Company, “Credit Crunch Clouds Outlook of Hurricane Insurers, Cat Funds,” 2008 Special Report: U.S.
Hurricane—Catastrophe Review, May 19, 2008, located at http://www3.ambest.com/DisplayBinary/
DisplayBinary.aspx?TY=P&record_code=142243&URatingId=1436841.
9 Ibid.
10 CRS Report RL33892, Post-Katrina Insurance Issues Surrounding Water Damage Exclusions in Homeowners’
(continued...)
ȱȱȱ
ŝȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
The legal dispute concerned which portion of the loss is due to wind (covered by a standard
homeowners policy) and which is from rising water, whether from storm surge or flooding.
Realizing that a court’s action could substantially increase insurers’ risks in hurricane-prone
states, some insurers decided to limit the amount of coverage sold in high-risk coastal areas.
ȱȱȱȱ¢ȱ ȱ
When residential property insurance becomes scarce and unaffordable, individuals and businesses
who cannot otherwise secure private coverage have turned to state-sponsored residual market
mechanisms.11 State residual markets were created to improve the availability and affordability of
property insurance primarily for residents and private businesses in coastal high-risk areas. As
private insurers have withdrawn from high-risk areas, state residual markets have become the first
and only choice for many homeowners. Consequently, the programs have expanded in recent
years. Residual market and state catastrophe funds typically charge a lower risk premium than
private insurers because they generally hold little or no capital reserves against major events.
These facilities will typically impose a tax or assessment after a catastrophe in order to fund
resulting claims obligations.
The 2004 and 2005 hurricane seasons demonstrated the limits of residual market facilities and
catastrophe funds, with losses exceeding the facilities’ claims-paying capacity. Most state residual
markets face financial challenges because of the concentration of property risk underwritten by
the facility, the reliance on post-event assessment and the inadequacy of rates to cover expected
losses over time. There is a growing belief that traditional backstop mechanisms, such as
assessments on insurers that have their own catastrophic losses to fund, are not appropriate
protection against a mega-catastrophic event. Many economists have acknowledged the political
necessity for these facilities but suggest that the lower prices tend to distort an otherwise efficient
market by reducing incentives for individuals to mitigate their exposure; this raises the long-run
disaster costs for society as a whole, including for state and federal taxpayers.
¢ȱȱȱȱ
Economic theory suggests that every risk is insurable, at a price. This, of course, assumes (1) that
risk averse individuals and businesses will be able to identify their risks, and (2) there is accurate
(...continued)
Insurance Policies, by Rawle O. King.
11 Five states have programs designed specifically to provide windstorm coverage (Alabama, Mississippi, North
Carolina, South Carolina, and Texas), and Florida and Louisiana each have a Citizens Property Insurance Corporation.
State-sponsored Beach and Windstorm Insurance Plans exist in Mississippi, South Carolina, and Texas; these plans
ensure that insurance is available against damage from hurricanes and other windstorms. Fair Access to Insurance
Requirement (FAIR) plans exist in the following states: California, Connecticut, Delaware, Georgia, Hawaii, Maryland,
Massachusetts, Mississippi, New Jersey, New York, North Carolina, Oregon, Rhode Island, Texas, Virginia, and
Washington. Additionally, three states—Georgia, Massachusetts and New York—have Fair Access to Insurance
Requirement (FAIR) plans that provide wind and hail coverage for certain coastal communities. New Jersey does not
have a Beach and Windstorm Plan but its WindMap was created to help homeowners in coastal areas obtain
homeowners insurance. Florida and Louisiana created state-run high-risk insurance companies to offer windstorm
insurance coverage to residents in coastal counties in their respective states.
ȱȱȱ
Şȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
pricing so that insurance companies are able to sell insurance coverage at a risk premium the firm
believes is sufficient to cover the risk it has assumed. In order for the insurer to calculate the risk
premium, the firm must be able to calculate expected losses and establish an appropriate price to
charge for the coverage. Historical claims and exposure data collected over an extended period
usually form the basis for projecting future expected costs. Inherent problems arise, however,
when using historical loss data and experience to project catastrophe losses.
Insurers generally endeavor to underwrite insurance for catastrophic loss events on the basis of a
handful of historical loss data points and actuarial science. When the insurer does not have
confidence in the catastrophe modeling or the ability to set a price due to the infrequency or
potential magnitude of losses, the firm will stop selling new policies, not renew existing policies
or withdraw from the market altogether, and subsequently reallocate the capital to other lines of
insurance. This situation usually creates a “hard insurance market” in catastrophe lines of
coverage—prices rise and insurers limit the supply of insurance coverage in the marketplace.
From a traditional insurance perspective, natural catastrophe risk could be considered uninsurable
for at least three reasons: (1) limited amount of capital (policyholders surplus) allocated to
catastrophe lines of insurance; (2) uncertainty in measuring catastrophe losses and pricing
catastrophe losses; (3) insurance market imperfection. The remainder of this section discusses
each of these reasons why catastrophic risk may be considered uninsurable.
ȱȬ¢ȱ¢ȱ
Although the 2005 hurricanes caused unprecedented catastrophe losses, they were not solvency-
threatening to the industry, as a whole, nor did they cause a net reduction in aggregate claims-
paying capacity. The property and casualty insurance industry reportedly earned unprecedented
profits—net income of $44.2 billion in 2005; $65.8 billion in 2006; and $61.9 billion in 2007 (see
Table 2).
Table 2. Property-Casualty Insurance Industry Income, 2003-2007
2003 2004 2005 2006 2007
Net
Written
Premiums
$404.4 $424.1 $425.5 $443.5 $440.8
Percent
Change
9.4% 4.9% 0.3% 4.2 (0.6)
Earned
Premiums
386.3 413.8 417.6 435.5
$439.1
Losses
Incurred
$238.7 $247.8 $256.5 $231.3 246.2
Loss
Adjustment
Expenses
Incurred 50.0 53.1 55.1 52.6 52.4
Other
Underwriting
Expenses
100.7 106.8 109.8 117.1 119.0
Policyholder
Dividends
1.9 1.7 1.9 3.4 2.4
Underwriting
Gain/Loss
(4.9) 4.3 (5.6) 31.1 19.0
Investment
Income
38.6 40.0 49.7 52.3 54.6
Miscellaneous
Income/Loss
0.0 (0.3) 1.0 1.2 (1.0)
Operating
Income/Loss 33.8 44.0 45.1 84.6 72.7
Realized
Capital
Gains/Losses
6.6 9.1 9.7 3.5 9.0
Incurred Fed. Income Taxes/Credits
10.3 14.6 10.7 22.4 19.7
ȱȱȱ
şȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
2003 2004 2005 2006 2007
Net Income After Taxes
30.0
38.5
44.2
65.8
61.9
Policyholders Surplusa
$358.1 $402.1 $437.6 $503.2 $537.2
Sources: Insurance Services Office (ISO).
a. Data on policyholders surplus comes from 2008 Best’s Aggregates & Averages—Property Casualty, published
by A.M. Best Company, p. 406. Figures include state funds.
The increase in natural catastrophe loss and exposure, however, has raised public policy concerns
about whether there is sufficient capacity within the private catastrophe insurance and reinsurance
industry to cover the nation’s payout requirements for mega-catastrophic events (1-in-100 year
events), and what insurance reforms would improve insurers’ access to capital in order to ensure
adequate capacity to meet consumer needs and solvency of the industry.12
Catastrophe reinsurance markets are thought to be limited in their ability to insure against a
mega-catastrophe. Most observers would argue that for the very highest layers of catastrophe risk,
the federal disaster relief (and consequently the taxpayer) is now, by default (due to limited
private-sector capacity in the traditional reinsurance market), the insurer of last resort, particularly
for uninsured property owners. National insurance markets, even backed by global catastrophe
reinsurance capacity, are limited in terms of the amount of catastrophic risks that can be covered.
The total catastrophe reinsurance capacity is not presently large enough to allow primary insurers
to adequately hedge their catastrophe risk to meet society’s emerging needs.
Several mega-catastrophic scenarios could be imagined that could overwhelm the current claims-
paying capacity of both the private insurance and state residual markets. Insurance industry
calculations suggest that a repeat of the 1906 San Francisco Earthquake could cause $80 billion in
insured property losses, based on total property losses approaching $300 billion.13 Reinsurers
appear unable to provide complete diversification of catastrophe risks both because catastrophes
appear to be correlated across risks (hurricanes, floods, and earthquakes among others) and
because estimates of the probable maximum loss (PML) from catastrophes have risen
dramatically.14
In 2007, AIR Worldwide Corporation, a catastrophe modeling firm based in Boston, simulated
estimates of potential insured catastrophe losses caused by U.S. hurricanes, earthquakes, and the
fires that follow earthquakes. Loss estimates were provided for the 1%, 0.4%, and 0.2% annual
occurrence probabilities, which correspond to return periods of 100, 250, and 500 years losses.
Table 3 shows that the national probable maximum losses (PML) for hurricanes and earthquakes
is $108.4 billion for the 1% return period, $164.5 billion for the 0.4% return period, and $217
billion for the 0.2% return period. The corresponding numbers for earthquakes and fire
12 J.D. Cummins, M. Doherty, and A. Lo, “Can Insurers Pay for the Big One?: Measuring the Capacity of an Insurance
Market to Respond to Catastrophic Losses,” Journal of Banking and Finance, vol. 26, 2002, p. 557-583.
13 A.M. Best Company, Best Review, April 1, 2006, located at http://goliath.ecnext.com/coms2/gi_0199-5429124/All-
shook-up-if-the.html.
14 Dwight M. Jaffee and Thomas Russell, “Can Security Markets Save the Private Catastrophe Insurance Market?”
paper delivered at the Asian-Pacific Risk and Insurance Association Conference, July 19, 1998, p. 11.
ȱȱȱ
ŗŖȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
(combined) losses are: $50 billion for 1% events, $90 billion for 0.4% events, and $119 billion for
0.2% events.
Table 3. Estimated Insured Hurricane and Earthquake Losses for 10 States for the
1-in-100-Year, 1-in-250-Year and 1-in-500-Year Catastrophes
($ in millions)
100-Year Expected
250-year Expected
500-Year Expected
Rank Area/State
Loss (1%)
Loss (0.4%)
Loss (0.2%)
United
States
$108,387.18
$164,525.21
$217,031.79
1 Florida
87,764.37
144,249.92
200,125.61
2 California
38,955.37
66,317.74
94,020.46
3 Texas
21,314.38
32,808.29
44,156.20
4 Louisiana
12,121.11
18,552.82
24,530.98
5 New
York
9,331.85
24,587.73
35,829.62
6 North
Carolina
9,326.91
15,343.76
21,395.14
7 South
Carolina
7,706.53
14,629.53
20,559.48
8 Alabama
6,022.22
11,402.77
16,255.20
9 Massachusetts
4,968.07
9,134.62
13,793.45
10 New
Jersey
4,003.32
10,699.68
17,597.08
Source: AIR Worldwide, Inc.
Table 2 shows that the capital base supporting the entire U.S. property and casualty insurance
industry—both commercial and residential—is about $537.2 billion, as of December 31, 2007. It
would appear that this sizeable surplus for unexpected losses would be sufficient for the property
and casualty insurance industry, as a whole, to be able to underwrite needed levels of catastrophe
insurance. However, only about 20% of the industry-wide policyholder surplus, a measure of
capacity, is generally considered to be allocated to catastrophe insurance lines of business. The
remaining 80% is needed to support non-catastrophic risks. This means that approximately $108
billion of policyholders’ surplus is available for catastrophic property losses nationwide. When
comparing total claim-paying capacity of the insurance industry to the probable maximum losses,
one can conclude that the insurance industry’s financial resources are insufficient to cover
anything more than a 1-in-100 year loss.
In light of the concerns about the capacity of insurers to pay claims after mega-catastrophes,
primary insurers have increasingly turned to private capital markets for risk-transfer capacity to
complement traditional reinsurance markets. Professor Kenneth A. Froot of Harvard University
has suggested that one reason for the search for alternatives to reinsurance has been the supply
restrictions associated with capital market imperfections and market power exerted by traditional
reinsurers.15 This situation is a matter of basic economics of supply and demand: a limited
15 Kenneth A. Froot, “The Market for Catastrophe Risk: A Clinical Examination,” Journal of Financial Economics,
May 2, 2001, pp. 529-571.
ȱȱȱ
ŗŗȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
number of reinsurers with specialized knowledge and unique access to global capital markets can
exert substantial control over prices and supply. Given recent historical losses and concerns with
future mega-catastrophes, property catastrophe reinsurance capacity is increasingly seen as
insufficient to meet societal demand, and the search for alternatives continues.
To some, this line of reasoning arguably suggests federal intervention in natural catastrophe
insurance markets to address potential market failure in the range between the 0.4% to 0.2%
return periods.16 Some finance experts may also be concerned about projections that catastrophic
losses will likely double every 10 years and the present government insurance approach might not
be adequate.17 John Seo, co-founder and Managing Principal at Fermat Capital Management,
LLC, asserted during discussions with CRS in preparation for this report that a government
insurance program might become challenged in its ability to cover losses for less than one
generation’s worth of exposure growth. As an illustration, a $100 billion exposure becomes $200
billion after 10 years; $400 billion after 20 years; and $800 billion after 30 years. Ten years ago a
1-in-100 event would have cost insurers $55 billion. Ten years from now a 100 year event could
cost $220 billion.
¢ȱȱȱȱȱȱ¡ȱ
In general, efficiently functioning insurance markets require insurers to: (1) classify risk so that
differences in risk can be observed and incorporated in insurance premiums; (2) accurately
predict the total expected losses for the pool of insured properties; and (3) accurately reflect the
underlying economic costs in the price of insurance coverage.
For any insurer to meet its contractual financial obligations in the event of a loss, it must first be
able to estimate the expected annual loss (in order to price the coverage) and the magnitude of the
extreme losses (to prevent cash-flow or liquidity problems). One difficulty is that risk-spreading-
and-predicting techniques in the private insurance market generally do not work as well for low-
frequency high-severity events as they do for high-frequency, low-severity risks. The lack of
relevant historical data and experience on rare catastrophic events makes the forecasting of losses
difficult. In addition, losses from catastrophes are correlated across exposures, making it difficult
for insurers to manage such losses. In order to avoid potential insolvency, given the uncertainty
surrounding catastrophe losses, insurers must charge a premium that substantially exceeds
expected losses. Homeowners might perceive this catastrophic risk premium to be too high and,
therefore, may be unwilling or unable to purchase coverage. The challenge for insurance
16 This analysis simplifies the complex worldwide market for catastrophe property insurance and is intended only to
provide an indication of the industry’s overall claims-paying capacity. This analysis, for example, does not determine
the potential effect of natural catastrophes on the financial strength of insurers nor does it consider offsets from the
broad spread and syndication of risk through heavy use of reinsurance, much of it foreign. A significant share of the
impact on surplus associated with a mega-catastrophic event would be transferred to the insurance industry balance
sheet in foreign countries like Germany, Great Britain, Switzerland, and Bermuda. In addition, the analysis does not
consider the total amount of catastrophe reinsurance provided by state residual markets or state catastrophe funds that
would increase the overall ability to insure catastrophic risks. As stated above, some insurers and reinsurers are able to
raise new capital after a major catastrophic event.
17 Insurance Services Office, “Catastrophe Losses Will Double About Every 10 Years, Says Leading Catastrophe
Modeling Expert at PCS Conference,” located at http://www.iso.com/
index.php?id=2276&option=com_content&task=view.
ȱȱȱ
ŗŘȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
companies is to accurately estimate loss probabilities due to the large variance of loss around an
expected occasional extreme event.18
ȱȱ ȱ
Catastrophe reinsurance could arguably become “over-priced” and in relatively short supply due
to natural market forces of supply and demand. Capital market imperfections and market power
enjoyed by a relatively small number of catastrophe reinsurers can potentially also contribute to
the high price and shortage of coverage.19
Economists Dwight Jaffe and Thomas Russell have argued that catastrophe insurance markets fail
because primary insurers are not able to pay annual losses out of annual premiums—a situation
that results from the wide variance in annual expected losses and potential magnitude of
catastrophe losses.20 The process of securitization of catastrophic risk, in theory, should be able to
intertemporally smooth out this “timing problem” by allowing the capitalization of the stream of
future premiums.
ȱȱȱȱ
Securitization has traditionally been used to convert illiquid financial assets (e.g., mortgages,
accounts receivable) into liquid marketable assets (securities), but since the late-1990s it is also
being used to transfer catastrophic risk to investors in the capital market. There are two main
categories of alternative risk transfer (ART) instruments that permit catastrophic risks to be
dispersed into the capital markets: insurance-linked securities (ILS), which in effect are direct risk
transfer instruments, and contingent capital securities, which reduce an insurer’s need for
traditional sources of capital.
• Insurance-linked Securities or “catastrophe bonds”—These are risk transfer
instruments that provide funds to offset catastrophe losses. Capital received is
transferred to a special purpose vehicle (SPV) that then acts much like a
traditional (although a fully collateralized) reinsurer. The distinguishing feature
of these bonds is that the ultimate repayment of principal depends on the
outcome of an insured event. The bonds pay a fixed spread over LIBOR (the
London Inter-Bank Offered Rate). For investors, insurance-linked securities
(ILS) are attractive as they provide an investment in a specific insurance risk
with potentially low correlation with equity and credit markets and with a
reduced counter-party risk because some funds can be held in trust.
18 J. David Cummins, “Should the Government Provide Insurance for Catastrophes?” Federal Reserve Bank of St.
Louis Review, 88(4), July/August 2006, pp 342-343.
19 Kenneth A. Froot, “The Market for Catastrophe Risk: A Clinical Examination,” Journal of Financial Economics,
vol. 60, May 2001, p. 529-571.
20 Dwight M. Jaffee and Thomas Russell, “Catastrophe Insurance: Catastrophe Market and Uninsurable Risks,” Journal
of Risk and Insurance, vol. 64, June 1997, pp. 206-230.
ȱȱȱ
ŗřȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
• Contingent Capital Securities—Insurers are also considering contingent capital
arrangements (reinsurance sidecars, industry loss warranty, surplus notes,
catastrophe options and catastrophe equity puts) that provide post-event capital
that insurers can access after a catastrophic event. These arrangements allow
insurers to raise cash by selling stocks and issuing debt at prearranged terms. The
insurer pays a capital commitment fee to the party that agrees in advance to buy
the equity or debt securities following a loss. Contingent capital arrangements do
not transfer the insurer’s risk of loss to investors; the insurer only receives an
inflow of capital to replenish its policyholders’ surplus after it pays for the loss.
Contingent capital can be available to insurers immediately after a catastrophe,
when the insurer most needs that capital, through a wide range of alternative
capital sources—contingent surplus note arrangements, catastrophe equity put
options, reinsurance sidebars, or industry loss warrants.
ȱȱȱȱŘŖŖŞȱ
In the aftermath of a series of natural disasters in the mid-1990s, insurers, reinsurers, property
owners and public officials recognized that a mega-catastrophic disaster in the U.S. could create
insurance price/capacity constraints in disaster-prone areas. In response, catastrophe insurers and
reinsurers have increasingly turned to capital markets to strengthen their balance sheets and
manage risks associated with a mega-catastrophic event.21 Recent evidence suggests, however,
that private insurance and the ability of state governments to implement catastrophe risk
management strategies could be jeopardized because of the current financial market turmoil.
Florida’s inability to issue sufficient debt (bonding capacity) during the global financial market
crisis in advance of the 2008 hurricane season, for example, threatened to unravel Florida’s
property insurance system if a major hurricane struck in 2008. In October 2008, officials in
Florida announced that the Florida Hurricane Catastrophe Fund (FHCF) would not be able to
honor the entire $28 billion in reinsurance obligations to insurers in the event of a major hurricane
striking the state, and that additional funds from the federal government might be needed.22
The financial market turmoil has been attributed to a combination of factors, including a lack of
transparency, financial market complacency stemming from years of positive results, and poor or
insufficient regulation.23 In short, the credit-related sectors of the financial services industry were
adversely affected by the way investment banks hedged their risk exposure. Financial engineers
and investment bankers created financial instruments called credit default swaps (CDS) on
structured collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), but,
21 The securitization of insurance risk received a boost after Hurricane Katrina in 2005 and the sharp increase in the
cost of catastrophe property insurance and reinsurance.
22 See The Florida Senate Issue Brief 2009-301, “Status of the Florida Hurricane Catastrophe Fund,” October 2008,
located at http://www.flsenate.gov/data/Publications/2009/Senate/reports/interim_reports/pdf/2009-301bi.pdf; and,
Florida Insurance Council Issues Backgrounder 2008 Cat Fund Reality, October 22, 2008, located at
http://www.flains.org/index2.php?option=com_content&do_pdf=1&id=2438
23 See Testimony of Dr. Luigi Zingales, Professor of Economics at the University of Chicago Graduate School of
Business, before the House Committee on Oversight and Government Reform, “Causes and Effects of the Lehman
Brothers Bankruptcy,” October 6, 2008.
ȱȱȱ
ŗŚȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
in hindsight, these financial contracts lacked sufficient transparency to easily identify, assess and
clear the risks.24
Credit default swaps function as insurance contracts for bond owners to protect themselves in
case bond issuers default on their debt. CDS are not traded on exchanges; rather, they are
privately negotiated contracts and traded on the over-the-counter market. The buyer typically
pays monthly or quarterly premiums to the seller. The size of the notional value outstanding in the
CDS market is estimated at $55 trillion, compared to the entire U.S. Treasuries market of $4.5
trillion, mortgage market of $11 trillion, and the U.S. stock market of $22 trillion. The $55 trillion
CDS market failed as investor appetite for these securities disappeared. Thus, the credit market
crisis spread to the broader financial markets as counterparties, unable to identify and quantify
precisely where losses lay, stopped lending to each other. Because the proper functioning of the
world’s economy is dependent on credit, public officials are working to restore confidence in the
financial system.
Financial market turmoil has already led to the largest corporate bankruptcies and financial
collapses in U.S. history. The credit market crisis has gone beyond mortgages to complex
structured finance transactions involving residential mortgage-backed securities (RMBS),
commercial mortgage-backed securities (CMBS), and CDO markets. Some of the more
prominent episodes in 2008 include:
• the filing for bankruptcy by the fourth largest investment bank, Lehman Brothers;
• collapse of one of the largest U.S. investment banks (Bear Stearns);
• conversion of Goldman Sachs and Morgan Stanley, two of the largest investment
banks, to bank holding companies, a classification that gives these two firms
access to new, low-cost funding sources but also subjects them to more
regulatory oversight;
• the U.S. government taking partial financial ownership of some of the nation’s
largest commercial banks, including Citibank, Bank of America, Goldman Sachs
Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of New York, and
Mellon and State Street Corporation;
• the sale of Merrill Lynch to Bank of America;
• the failure of the largest U.S. thrift institution (Washington Mutual Bank);
• the purchase of Wachovia Bank by Wells Fargo;
• a plan to spend up to $200 billion to shore up the mortgage finance giants Fannie
Mae and Freddie Mac; and
• the Federal Reserve Board’s unprecedented $150 billion secured two-year loan to
American International Group (AIG).25
24 Collateralized debt obligations and collateralized loan obligations were developed to repackage credit risk inherent in
loans, bonds, and other types of debt instruments by creating investment-grade fixed income risk from a pool of
speculative grade or mixed credit quality fixed income securities. For more information see CRS Report RS22932,
Credit Default Swaps: Frequently Asked Questions, by Edward V. Murphy.
ȱȱȱ
ŗśȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
On October 5, 2008, President Bush signed into law the Emergency Economic Stabilization Act
of 2008 (P.L. 110-343) to restore liquidity and stability to the U.S. financial system.26 The law
authorized the Treasury Secretary to create a Troubled Asset Relief Program (TARP) to purchase,
insure, hold, and sell a wide range of financial instruments, particularly those that are based on or
related to residential or commercial mortgages. The Secretary of the Treasury now has the
authority to purchase up to $700 billion of mortgage-backed or other securities from insurers,
banks, thrifts, credit unions, and broker-dealers.
Under the new law, the Secretary of the Treasury is charged with developing the terms and
conditions used to insure troubled assets, and collect premiums from participating financial
institutions. The TARP would be operated in consultation with the Board of Governors of the
Federal Reserve System, the Federal Deposit Insurance Corporation, the Comptroller of the
Currency, the Director of the Office of Thrift Supervision and the Secretary of Housing and
Urban Development. The plan is to make money available to banks; the banks would then lend to
keep the credit markets open.
ȱȱȱȱ ¢ȱȱȱȱȱ
The financial market turmoil poses a serious threat to state government catastrophe risk
management strategies that rely on pre-loss financing using catastrophe (re)insurance, ILS, and
contingent capital to cover any cash shortfalls needed to satisfy claims obligations. As an
illustration, at the beginning of the 2008 hurricane season, Florida officials could not sell bonds in
the weak credit markets to fund their catastrophe risk management program. Florida officials
instead agreed to pay Warren Buffett’s Berkshire Hathaway $224 million for a conditional pledge
to buy $4 billion in 30-year tax-free bonds with a 6.5% coupon, if the state fund incurs total
storm-related claims of more than $25 billion in 2008. This pre-loss (debt) financing arrangement
cold help fund the operations of the Florida Hurricane Catastrophe Fund (FHCF), a state-run
catastrophe fund that provides insurers with cheaper reinsurance and issues tax-free bonds to pay
insurers’ claim losses beyond agreed caps. In a normally functioning credit market, state residual
market plans raise the money they need by selling bonds, but a consequence of the current credit
market turmoil is that not enough funds can be raised. According to Raymond James &
Associates Inc., the FCHF’s financial manager, the $224 million fee charged by Berkshire
Hathaway compared favorably to the state’s alternative, which was buying reinsurance at a cost
of approximately $1.2 billion.
(...continued)
25 American International Group (AIG) is a federally regulated financial holding company that owns 71 U.S.-based
insurance companies and 176 other financial services companies throughout the world. The company operates banks,
securities firms, and non-U.S. insurers and other related businesses such as premium finance companies. Some critics
of state insurance regulation have taken the position that the failure of AIG and the $150 billion line of credit offered
by the Federal Reserve demonstrates the need for federal insurance regulation. Representatives of the National
Association of Insurance Commissioners (NAIC) have responded by pointing out that the 71 U.S. based insurers are
financially solvent and able to pay claims presented by policyholders and claimants. The failure of AIG, instead, stems
from the company’s investments in collateralized debt instruments (e.g., credit default swaps) on mortgage-backed
securities that are subject to federal regulatory oversight by the Securities and Exchange Commission, not state
insurance regulation.
26 For more information see CRS Report RS22966, Financial Turmoil: Comparing the Troubled Assets Relief Program
to the Federal Reserve’s Response, by Marc Labonte.
ȱȱȱ
ŗŜȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
ȱȱȱ
With excessive complexity being the enemy of transparency, regulators have expressed interest in
finding a market transparency solution that is applicable across all current risk transfer categories
and one that can identify in real time the interaction of multiple transactional, operational, and
performance risks and provide an early warning system for systemic failure. Some have argued
that the best way to resolve the financial crisis rests on the assurance of market transparency, so
that information about a financial contract and its counterparties flows freely and all parties are
informed about all relevant aspects of the market transaction. Transparency in the pricing and
terms of securities is considered by many to be essential for financial market efficiency.
It has been argued that in the long run, greater transparency leads to more developed financial
markets,27 greater resiliency to shocks,28 and better allocation of capital.29 Transparency
regulation has been presented as a way to improve the allocation of resources, which can arguably
reduce financial fragility by strengthening market discipline and making financial institutions and
markets more accountable to customers and taxpayers. Transparency has been defined in several
ways and is often measured based on subjective perceptions of individuals. One objective
definition of transparency is the accuracy and frequency of economic information released to the
public.30 Consideration is typically made to address the direct costs of complying with disclosure
requirements and the indirect transparency costs stemming from having to protect proprietary
rights.
From a public policy standpoint, the idea is for public officials and regulators to promote market
transparency in order to ensure a well-functioning financial industry that is able to make new
loans, offer lines of credit, and provide capital for risk transfer (i.e., insurance, reinsurance,
insurance-linked securitization) services. In theory, a regulatory regime that focuses on market
transparency could address issues of fairness (subsidy to investors at taxpayers’ expense),
ambiguity (with respect to the mission, and oversight of the newly created Troubled Asset Relief
Program) and the long-term economic effects of the rescue plan.
ȱȱȱȱ
On one level, what is proposed by the National Association of Insurance Commissioners, the
Federal Reserve, and other financial sector regulatory agencies to solve the current financial
market crisis can be interpreted as the replacement of individual silos of traditional business
models in favor of unification of the forms and methodologies for credit risk transfer that result in
financial products. According to this model, all risk transfer, whether insurance- or capital
markets-related, can be allowed to compete on an open playing field. Regulation would still be
27 C. Leuz and R.E. Verrecchia, “The Economic Consequences of Increased Disclosure,” Journal of Accounting
Research, vol. 38, 2000, pp. 91-124.
28 Boon Johnson and E. Friedman, “Corporate Governance in the Asian Financial Crisis,” Journal of Financial
Economics, vol. 58, No. 1-2, 2000, pp. 141-186.
29 J. Wurgler, “Financial Markets and the Allocation of Capital,” Journal of Financial Economics, Vol. 58, No. 1-2, pp.
187-214.
30 This is the definition used by Rachel Glannerstgern and Yongseok Shin in their article entitled, “Does Transparency
Pay?” International Monetary Fund Staff Papers, Vol. 55, No. 2, 2008.
ȱȱȱ
ŗŝȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
required to contain market excesses and occasional disruptions. Such regulation in turn requires
data and analytics to keep it informed.
Michael Erlanger, an inventor and corporate executive of Marketcore, an intellectual property
development company focused on the financial service and insurance industry, claims to have
identified the problems in the financial markets that led to the credit and liquidity crisis, and to
have devised a solution. Erlanger asserts that the crisis is caused by the absence of “real-time”
data flows in the financial services industry that would allow all market participants and
regulators to determine or discover appropriate transaction terms, prices, and performances. The
lack of “real-time” data flows has arguably contributed to market illiquidity, inefficient risk
pricing, and operational inefficiencies to the detriment of all market participants.
According to Michael Erlanger, two things are needed to address opaque capital markets: (1) a
framework for disclosure and reporting of comprehensive data and analytics pertaining to all
financial instruments, including loans, lines of credit, other financial products, as well as
insurance, reinsurance and securitized insurance risks; and (2) a transaction platform, or other
data highway, such as the Internet, in which financial products are bought and sold, and where
detailed data on the composition of the assets and of the transactions are collected, stored, and
displayed. These data are available, wherever possible, on a real-time basis. The activity on the
transaction platform is facilitated by what Erlanger calls “Transaction Credits” as buyers and
sellers redeem those credits to either do more business, or to access market and product
information. The transaction credits themselves can provide a consistent tracking mechanism in
which all transaction details, including underwriting standards and actual per instrument financial
performance, are retained and displayed as they occur.
The Marketcore approach to transparency is to create a transaction platform where market
participants as well as state and federal regulators have access to view the disclosures and the
transaction details. Marketcore argues that transparent information about the transaction details
would keep market participants honest, while allowing all parties a reasonable expected profit
from the transaction placed through the platform. Many financial market experts agree that
illuminating credit markets is an efficient way to keep market participants and market regulators
informed, leading to sounder financial decisions. Effective implementation would arguably
require global alignment of accounting, regulatory and due process approaches to provide a
standardize framework and restore confidence in contractual performance, so all participants are
able to rely on the sanctity of a contract.
Transparency in the pricing and terms of securities is considered by many to be essential for
financial market efficiency. By definition, transparent financial markets provide accurate
information to allow for the discovery of transaction prices, as well as terms on securities and
financial instruments of all types. It is considered important that this “real time” information be
readily available to everyone, encouraging market participation.
ȱȱȱ
ŗŞȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
¢ȱȱȱ
Arguably today’s economic environment is characterized by a fundamental lack of financial
market transparency that affects the insurance industry and those that regulate it along with the
general economy. Regulation is usually intended to address market failures. There are many
recent examples of market failures where a contributory factor has arguably been a lack of
transparency. Examples include the bid-rigging and contingent commission scandal in the
insurance world a few years ago and the recent financial guaranty crisis.31 Another market that
functions less efficiently than it arguably could is the market for catastrophe bonds. If the
underlying elements were made more transparent, then different decisions would arguably have
been made about accepting risk at the negotiated opaque price point.
The concept of insurance regulation is relatively simple. The regulator wants to ensure that the
insurers have sufficient assets to make good on the promises they have made to the public
(solvency regulation) and that the insurers treat customers and claimants fairly (market
regulation).
Solvency is monitored by requiring insurers to submit fairly comprehensive financial statements
on an annual basis and each quarter. In addition, insurers are subject to periodic desk-audits and
on-site examinations to verify the accuracy of the financial information provided to regulators.
The current system, however, is considered by some to have shortcomings in that the information
provided to regulators is a snapshot in time revealing the insurer’s opinion of the value of
financial assets relative to the ultimate settlement value of all the liabilities that the insurer has
assumed. Should the underlying markets for either the specific securitizations or their component
parts fail, regulatory solvency tests could become difficult to implement due to limited reliable
transactional pricings. In the case of the financial guaranty insurers (bond insurers), management
is accused of having underestimated the liabilities to which the insurers were exposed because of
the lack of transparency regarding the collateralized debt instruments they were guaranteeing. It
could arguably also have been a misestimation of the value of an asset held by the insurer such as
a bond secured by subprime mortgages.
For effective market regulation, insurance regulators need information on how the market is
functioning. Currently this is done through monitoring consumer complaints, reviewing rates,
reviewing policy language, targeted market conduct examinations and market analysis. A
majority of states are involved in a project to collect market information through a Market
Conduct Annual Statement that requires insurers to answer several interrogatories and provide
some market data to states. Like the financial regulatory framework, the information provided is a
snapshot in time and is in large part influenced by the insurer’s opinion of its performance.
The National Association of Insurance Commissioners is considering ways to strengthen solvency
regulation and market regulation by harvesting financial and market performance data as well as
accurate valuation of assets held by insurers directly from an electronic transaction platform
system. The thinking is that if such a system is established and the appropriate information
outputs are identified and captured, regulators will in theory have a better understanding of the
31 See Jamie Chapman, “Bid-Rigging Scandal Envelops Top Insurance Brokers in U.S.,” October 29, 2004, located at
http://www.wsws.org/articles/2004/oct2004/mars-o29.shtml.
ȱȱȱ
ŗşȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
actual financial position (e.g., accurate valuation of assets) of the insurer and greater insight into
the insurer’s market practices. Over time, as more transactions are captured by the system some
think that the output might supersede the current annual and quarterly financial and market
regulatory reports.
ȱ ȱȱȱȱ ȱ
ȱ
Since the mid-1990s, policymakers and insurance industry participants have come to understand
that a major catastrophic event can cause an unexpected and sudden large loss of insurers’ capital
reserves, and there is a material risk that the price of insurance will rise and supply will fall. This
situation can lead to calls for government financial intervention in catastrophe insurance markets
to expand the private sector’s risk-transfer capacity.
Economists believe that an argument for federal intervention in catastrophe insurance markets can
be made if the following four conditions hold:
• adequate insurance is not provided by the private insurance/reinsurance industry;
• the financial consequences of a major disaster is beyond the ability of the private
insurance/reinsurance industry to cover;
• local communities have adopted and enforced loss reduction measures to mitigate
future natural disaster damages (even if such activities had limited impact); and
• the public insurance strategy is designed to be actuarially fair and financially
sound, and avoids unfunded contingent liabilities implicit in some type of
guaranty.
There is not a consensus among industry participants and experts as to whether these four
conditions are present in today’s catastrophe insurance market. However, if the private insurance
and reinsurance markets are not willing or able to provide risk-transfer capacity for whatever
reason—perhaps due to high cost and limited supply of private capital, the heightened uncertainty
about the frequency and severity of future losses, or insurers’ inability to charge a risk premium to
ensure individual company solvency—this situation could justify federal intervention.
Property and casualty insurers and reinsurers have historically opposed federal intervention in
catastrophe insurance markets, often arguing that natural disasters are insurable if the free market
is allowed to work. The large-scale disruption in private markets created by Hurricane Andrew
(1992), the Northridge earthquake (1994), and Hurricane Katrina (2005), however, has prompted
some insurers and their trade associations to call for a more systemic approach to intervening in
catastrophe insurance markets.
In response to the limited supply and high price of property insurance in coastal areas, past
concerns with the rising level of federal disaster assistance, and limitations in insurers’ and the
state residual markets’ claims-paying capacity, Congress may wish to examine the risks posed to
the U.S. by natural catastrophes, and the means for both mitigating and paying for those losses,
particularly in the uninsured sector of the American public. Federal financial intervention in
catastrophe insurance markets could take any of several forms designed to expand the private
sector’s ability to provide catastrophe insurance, such as adding a high-end federal reinsurance
ȱȱȱ
ŘŖȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
backstop, providing short-term government liquidity loans, or offering federal multiple peril
homeowners insurance policies covering both wind and flood damages.
These approaches to government financial intervention in catastrophe insurance markets could
arguably be justified on the grounds that they address the failure of private markets to offer
affordable disaster insurance to meet societal demand. But while government intervention might
expand the capacity of private insurance and state-sponsored insurance pools to underwrite wind
insurance coverage in high-risk areas, it might also create taxpayer-financed subsidies. In theory,
the subsidy could undermine the economic incentives for homeowners to adopt cost-effective
mitigation measures, a problem also referred to as “moral hazard.”
ȱȱ ȱ
Proponents of federal intervention argue that the government is the de facto insurer of last resort
for mega-catastrophes, largely because the government is thought to be better positioned to bear
catastrophe risk because of its broad resource base and borrowing capacity. The federal
government, however, currently lacks a comprehensive approach to manage the effects of
catastrophic natural disasters, relying instead on ad hoc disaster relief spending to facilitate
recovery and rebuilding following a major disaster.
Federal financial intervention in the catastrophe reinsurance market, some contend, could reduce
the burdens for future disaster relief expenditures, promote efficient risk management by property
owners, and encourage individuals and states to take steps to reduce loss exposure which, in
theory, could ultimately result in overall lower social and federal costs. An explicit ex ante federal
government risk financing approach would arguably be the best way to assess, budget and plan
for the future cost of catastrophe risks before such events occur.
ȱȱ ȱ
Opponents of federal intervention in catastrophe insurance markets insist that there is sufficient
private insurance and reinsurance capacity to adequately cover catastrophic risks if the
government ensures a framework that allows market mechanisms to work without local
regulatory interference (i.e., regulatory price constraints that seek to keep premium rates lower
that expected losses, which is usually based on computer simulation models). Federal intervention
in catastrophe insurance markets, it is argued, creates unexpected side-effects, such as moral
hazard, and reduces the economic disincentives for homeowners and businesses to locate in
disaster-prone areas or neglect risk prevention.
Moreover, opponents of federal intervention in catastrophe insurance markets argue that private
insurers, state residual markets, and state catastrophe funds already protect coastal properties, and
federal government intervention would only distort the insurance market by regulating
availability of coverage and level of premiums, displacing private capital deployed in insurance
and reinsurance, and stifling innovative private sector solutions for managing and financing
catastrophic risks. Government insurance schemes, they say, would not reflect the risk level of the
activity being insured, thereby eliminating a potentially powerful economic deterrent to risky
behavior. Moreover, government intervention could force the public at large to cross-subsidize the
risky behavior of residents in high-risk areas.
ȱȱȱ
Řŗȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
ȱȱȱȱ
There is some consensus that the federal government has a regulatory role to play in creating
incentives for private capital to flow into the property insurance market, establishing strong
building codes, encouraging effective land planning techniques, and creating a state insurance
regulatory environment that fosters competition and risk-based pricing. There is also some
consensus that the federal government could help decrease barriers in the nascent markets for
insurance-linked securities (ILS) and provide liquidity through temporary loans designed to
stabilize the market after a mega-catastrophe. Other common ground topics include clarifying
accounting rules for special-purpose reinsurers, granting insurance-linked securities conduit status
for federal tax purposes, and changing the rules to require foreign and domestic reinsurers to meet
the same collateral requirements.
ȱȱ
Several legislative options are available to Members of the 111th Congress to protect citizens and
the national economy from catastrophic adversities, while arguably reducing both societal and
federal costs of natural disasters. Besides the enactment of the Terrorism Risk Insurance Act of
2002, Congress has not approved any other federal disaster insurance law because of a lack of
consensus that a problem exists or that specific congressional actions is desirable. There is also
concern about creating moral hazard problems and the financial exposure for state and federal
taxpayers.32 These proposals include:
• Bipartisan Study Commissions. Congress could choose to establish a bipartisan
study commission to examine various proposals to improve capabilities of the
insurance marketplace to adequately insure homeowners against natural disaster
risk by facilitating the pooling, and spreading the risk, of catastrophic financial
losses from natural disasters.
• Tax-Policy Incentives. Congress could choose to expand the supply of capital
reserves that stand behind private insurance. This would require an amendment
of the U.S. tax code to allow insurers to accumulate tax-deferred reserves for
catastrophic perils.33 Current tax provisions discourage insurers from reserving
funds for unknown losses. Reserves for such contingencies can only be
accumulated out of after-tax income. In contrast, reserves set aside for reported
losses, or losses incurred but which have not been reported at the end of a given
accounting period, are not taxed by the federal government. Allowing insurers to
accumulate tax-deferred reserves for catastrophe perils could be costly to the
federal government, in terms of reduced tax revenue, and may involve tax
benefits that favor one type of activity over another, raising issues of efficiency.
32 U.S. Government Accountability Office, Natural Disasters: Public Policy Option for Changing the Federal Role in
Natural Catastrophe Insurance, GAO-08-07 (Washington: November 26, 2007), located at http://www.gao.gov/
new.items/d087.pdf.
33 See CRS Report RL33060, Tax Deductions for Catastrophic Risk Insurance Reserves: Explanation and Economic
Analysis, by Rawle O. King.
ȱȱȱ
ŘŘȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
• Another tax policy incentive could be to allow homeowners to create tax-free
catastrophic savings accounts (CSA) similar to health savings accounts that could
be used to pay hurricane deductibles and costs associated with retrofitting
properties.
• A third tax policy incentive could be to authorize the creation of tax-exempt
(CSA) for consumers and allowing for tax-free distributions to pay expenses
resulting from a presidentially declared major disaster. Economists have raised
the question of whether tax incentives for homeowners would be sufficient to get
people to buy disaster insurance. The cost to the government could be weighed
against possible savings in ad hoc disaster relief outlays.
• Implement a Federal Multiple Peril Insurance Program. One policy response
that Congress might consider in the context of reauthorizing the National Flood
Insurance Program (NFIP) is to create a new option in the NFIP to offer coverage
for both wind and flood risk in one policy.34 Multiple peril insurance could
eliminate the problem of uninsured property owners, but it could also create new
uncertain liabilities for federal taxpayers.
• Federal Reinsurance for Catastrophe Losses. Congress could decide to enact
legislation that would authorize the Secretary of the Treasury to sell a limited
number of excess-of-loss contracts covering industry losses from natural
disasters to private insurers and reinsurers, as well as to state-sponsored
insurance pools. Another federal reinsurance approach would allow states with
their own catastrophe funds to be eligible to purchase reinsurance from the
federal government, thereby encouraging states to establish catastrophic funds to
protect against natural disasters and reduce costs to homeowners. Federal
reinsurance would expand the supply of catastrophe insurance in the private
market and thereby increase the capacity of the industry to write primary
catastrophe insurance.
• Federal Catastrophe Loan Plan. Congress might decide to authorize the U.S.
Treasury to provide loans to state “qualified reinsurance programs” for natural
disasters. The loan program could dampen swings in insurance rates and address
availability deficiencies caused by inefficient capital markets.
• Insurance-Risk Securitization. Some mega-catastrophe exposures may be
beyond the claims-paying capacity of both the private market and state
catastrophe funds. In those cases, Congress might consider implementing a
catastrophe insurance system able to resolve key obstacles currently impeding
broader implementation of catastrophe risk management and financing with
insurance-link securities (catastrophe bonds). One possibility is to authorize the
creation of a public risk-transfer consortium to allow state-run residual insurance
pools and funds to securitize and transfer natural catastrophe risks to investors in
the capital markets.
34 See CRS Report RL34367, Side-by-Side Comparison of Flood Insurance Reform Legislation in the 110th Congress,
by Rawle O. King.
ȱȱȱ
Řřȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
• Risk Retention Group Coverage for Commercial Property Coverage.
Congress could choose to amend the Liability Risk Retention Act of 1986 to
expand the authority of risk retention groups (RRGs) to provide commercial
property insurance to members.
ȱȱ
In recent decades, large-scale natural catastrophes have become increasingly frequent and costly.
The rising economic cost of compensating victims of disaster and rebuilding has become a public
policy issue which Congress may want to address. Some maintain that private markets will not
provide catastrophic risk unless the government acts as reinsurer of the high end of the loss.
Others believe the private sector could handle a mega-catastrophe event, if the government
removes tax, accounting and regulatory barriers.
Several Members of Congress have focused attention on the nation’s significant exposure to
hurricane and earthquake risk and the claims-paying capacity of the private sector, the
effectiveness of emergency federal disaster relief assistance, and whether the federal government
should intervene in catastrophe insurance markets. Based on both computer simulation models
and historical data analysis of catastrophe losses, economists have concluded that the average
expected federal expenditure for disaster relief outlays has been about $20 billion a year.35
Importantly, researchers project that future catastrophic insured losses could exceed $100
billion.36 Given the current approach of federal disaster relief spending in response to natural
catastrophes, researchers project an unfunded liability for natural disaster relief assistance over
the next 75 years comparable to that of Social Security.37
Due to a number of factors, including a lack of consensus on what will work and concerns about
adequate provisions for mitigation and avoidance of unnecessary government intrusion into
markets being served by the private sector, federal disaster insurance legislation has not been
acted upon. Congressional reluctance to establish a federal disaster insurance program since the
enactment of the 1968 flood insurance statute has arguably been based on the premise that such a
program could conflict with economic and actuarial principles that emphasize the “true” cost of
government programs and the forgone benefits of a competitive insurance marketplace.
In response to higher property insurance prices and reduced availability of homeowners insurance
in several Gulf Coast and East Coast states, Members of the 111th Congress might choose to focus
on:
• the current condition of, as well as the outlook for, the availability and
affordability of property insurance in disaster-prone regions of the country;
35 J. David Cummins, Michael Suher, and George H. Zanjani, “Federal Financial Exposure to Natural Catastrophe
Risk,” Federal Reserve Bank of New York, November 30, 2007, located at:http://www.nber.org/chapters/c3036.pdf.
36 Ibid.
37 Ibid.
ȱȱȱ
ŘŚȱ
ȱ
ȱ¢ȱȱȬȱȱȱ
ȱ
• investigation of alternative risk-financing approaches to address the increased
prices and reduced availability of catastrophe property insurance;
• determination of the extent to which a greater reliance on insurance could reduce
federal disaster costs and reduce the likely insolvency of insurance companies in
a catastrophic event;
• the ability of states-sponsored residual market mechanisms designed to provide
adequate insurance coverage and increased underwriting capacity to insurers and
reinsurers in constrained markets;
• the capacity of the private insurance market to cover losses inflicted by natural
catastrophes;
• deciding whether it is possible to develop an actuarial basis for determining
viability of a federal all-hazard insurance program; and
• finding ways to create a transparent marketplace capable of properly assessing,
transacting, and clearing risk transfer in a manner that confirms free market
principles.
ȱȱ ȱ
Rawle O. King
Analyst in Financial Economics and Risk
Assessment
rking@crs.loc.gov, 7-5975
ȱȱȱ
Řśȱ
ȱ