The National Flood Insurance Program (NFIP), Reinsurance, and Catastrophe Bonds




INSIGHTi

The National Flood Insurance Program
(NFIP), Reinsurance, and Catastrophe Bonds

Updated March 23, 2022
Insurance transfers 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, 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.

Reinsurance
The most common form of risk transfer is a primary insurer purchasing coverage for its risks from
another (re)insurer. 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. Reinsurers generally have the size
to diversify risks globally.
NFIP Reinsurance Purchases
The NFIP’s first large reinsurance purchase was in 2017, with additional purchases annually from 2018 to
2022. 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 potential payouts of $1.042-$1.46 billion
and premiums of $150-$235 million. Claims from Hurricane Harvey exceeded $10 billion, triggering a
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full claim of $1.042 billion on the 2017 reinsurance. No reinsurance claims have been made since 2017.
To date, the traditional reinsurance purchases have been a net fiscal negative for the NFIP with a total of
$1.143 billion in premiums paid and $1.042 billion received from claims.
Catastrophe Bonds
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, 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:
Indemnity—bonds triggered by the losses experienced by the sponsoring insurer
following the occurrence of a specified event (e.g., if an insurer’s residential property
losses from a hurricane in Florida exceeds $25 million in 2022);
Industry Loss—bonds triggered by a predetermined threshold of industry-wide losses
following the occurrence of a specified event (e.g., if a total of all insurers’ residential
property losses from floods in 2022 exceeds $20 billion); or
Parametric—bonds triggered by physical conditions occurring during a disaster such as
wind speed or earthquake size (e.g., if a 25-foot storm surge hit New Orleans in 2022).
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 catastrophe bonds. In 2009,
Mexico became the first sovereign to issue catastrophe bonds, and the World Bank is one of the largest
participants in the market.
The New York City Metropolitan Transit Authority issued catastrophe bonds to
protect against storm surge.
According to Swiss Re, $13 billion of ILS were issued in 2021, the highest
recorded year of issuance since the inception of the catastrophe bond market.
NFIP and Catastrophe Bonds
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, and has made four more capital market
placements
in 2019 to 2022. In each case, Hannover Re acts as a “transformer,” transferring between $0.3
and $0.575 billion of the NFIP’s risk to capital markets by sponsoring issuance of an indemnity-triggered
catastrophe bond. In the 2022 issuance, Hannover Re has indemnified FEMA for a single qualifying
flooding event between February 23, 2022, and February 22, 2024. The 2022 agreement is structured to
cover 2.5% of losses between $6 and $7 billion, 5% of losses between $7 billion and $90 billion, and
32.5% of losses between $9 and $10 billion. 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.
Unlike the traditional reinsurance purchases, which cover NFIP losses for a single flood event anywhere
in the United States and its territories, the catastrophe bonds apply only to flooding resulting directly or
indirectly from a named storm and cover only the 50 states, the District of Columbia, Puerto Rico, and the
U.S. Virgin Islands. The NFIP has not claimed on any of the catastrophe bonds.


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According to FEMA, as of January 2022, FEMA has paid more than three times in reinsurance premiums
than the amount it has claimed. However, the six traditional reinsurance payments and five capital market
placements have not resulted in an increased rate for NFIP policyholders.

Author Information

Diane P. Horn
Baird Webel
Analyst in Flood Insurance and Emergency Management Specialist in Financial Economics





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