Insurance generally serves to transfer risk from one entity who does not want to bear that risk to another entity that does. An initial insurance purchase, such as homeowners buying a policy to cover damage to their home, however, is often only the first transfer of that risk. The initial (or primary) insurer may then transfer (or cede) some or all of this risk to another company or investor, such as a reinsurer. Reinsurers may also further transfer (or retrocede) risks to other reinsurers. Such transfers are, on the whole, a net cost for primary insurers, just as purchasing insurance is a net cost for homeowners.
The Homeowner Flood Insurance Affordability Act of 2014 (P.L. 113-89) revised the authority of the National Flood Insurance Program (NFIP) to secure reinsurance from "private reinsurance and capital markets." Risk transfer to the private market could reduce the likelihood of the Federal Emergency Management Agency (FEMA) borrowing from the Treasury to pay claims. In addition, it could allow the NFIP to recognize some of its flood risk up front through premiums it pays for risk transfers rather than after-the-fact borrowing, and could help the NFIP to reduce the volatility of its losses over time. However, because reinsurers charge premiums to compensate for the assumed risk as well as the reinsurers' costs and profit margins, the primary benefit of reinsurance is to manage risk, not to reduce the NFIP's long-term fiscal exposure.
The most common form of risk transfer is a primary insurer purchasing coverage for its risks from another (re)insurer. The primary insurer continues to service the initial policy, while the reinsurer operates in the background. Reinsurance is particularly important to smaller insurers who may not be large enough to spread correlated local risks, such as a storm hitting a specific area, across a broader geographic area. Reinsurers, however, often have the size to diversify risks on a global scale.
The NFIP's first large reinsurance purchase was in 2017, with additional purchases in 2018, 2019, and 2020. The details of these purchases have varied, but they have all covered losses from a single flooding event starting at $4 billion and going up to $8-$10 billion, with total potential payouts ranging from $1.042 billion to $1.46 billion. FEMA paid premiums ranging from $150 million to $235 million. Claims from Hurricane Harvey exceeded $10 billion, triggering a full claim of $1.042 billion on the 2017 reinsurance. No claims have been made on the 2018 or 2019 reinsurance.
In addition to reinsurance, new forms of "alternative" risk transfer have also developed. One category of such instruments are known as insurance linked securities (ILS)—financial instruments whose values are driven by insurance loss events and which transfer major natural disaster risks to capital market investors. The most common form is catastrophe bonds (or cat bonds), which operate somewhat like other bonds, but whose payout is dependent on the occurrence of a particular catastrophe.
Catastrophe bonds are structured so that payment depends on the occurrence of an event of a defined magnitude or that causes an aggregate insurance loss in excess of a stipulated amount. Only when these specific triggering conditions are met do investors begin to lose their investment. There are three main types of triggers:
Catastrophe bonds were first used in the mid-1990s following Hurricane Andrew and the Northridge earthquake. The public sector has become increasingly interested in the use of cat bonds. In 2009, Mexico became the first sovereign to issue cat bonds, and the World Bank is one of the largest participants in the market. The New York City Metropolitan Transit Authority issued cat bonds to protect against storm surge. According to the reinsurer Swiss Re, $9.7 billion in catastrophe bonds were issued in 2018.
In August 2018, FEMA entered into its first transfer of NFIP risk through an ILS transaction in the form of a three-year agreement with the reinsurer Hannover Re. Hannover Re is acting as a "transformer," transferring $500 million of the NFIP's risk to capital markets by sponsoring issuance of an indemnity-triggered cat bond. Hannover Re will indemnify FEMA for a portion of claims for a single qualifying flooding event that occurs between August 1, 2018, and July 31, 2021. The agreement is structured into two tranches. The first provides coverage for 3.5% of losses between $5 billion and $10 billion, and the second for 13% of losses between $7.5 billion and $10 billion. FEMA paid a premium of $62 million for the first year of coverage. Unlike the earlier reinsurance purchases, which covered all NFIP flood losses, the catastrophe bond applies only to flooding resulting directly or indirectly from a named storm and covers only the 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands. A storm comparable to Hurricane Katrina would result in a total loss for the catastrophe bond investors, while a storm comparable to Hurricanes Sandy or Harvey would erode the principal of both tranches but not cause a total payout.
A second NFIP catastrophe bond was issued on April 16, 2019, transferring an additional $300 million of NFIP's financial risk to the capital markets. The agreement is structured to cover 2.5% of losses between $6 billion and $8 billion, and 12.5% of losses between $8 billion and $10 billion. FEMA paid a premium of $32 million for the first year of coverage.