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

INSIGHTi

The National Flood Insurance Program
(NFIP), Reinsurance, and Catastrophe Bonds
Updated May 28, 2024
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, as natural hazard events are assumed to be uncorrelated: a hurricane making
landfall in Florida is assumed to be independent of a wildfire in California.
NFIP Reinsurance Purchases
The NFIP’s first large reinsurance purchase was in 2017, with additional purchases annually from 2018 to
2024. The details of these purchases have varied, but they have all covered losses from a single flooding
event covering losses varying between $4 billion and $11 billion, with potential payouts of $1.042-$1.46
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billion and premiums of $90-$235 million. As of March 8, 2024, the NFIP has transferred $1.92 billion of
the NFIP’s flood risk to the private sector ahead of the 2024 hurricane season.
Claims from Hurricane Harvey exceeded $10 billion, triggering a 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 $2.275 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 2024);
• 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 2024 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 2024).
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 has issued four catastrophe
bonds since 2013 to protect against storm surge. According to Swiss Re, $15.4 billion of ILS were issued
in 2023, 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 in total has made seven capital market
placements in 2019-2024. 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 2024 issuance, Hannover Re has indemnified FEMA for a single qualifying
flooding event between March 7, 2024, and March 7, 2027. The 2024 agreement is structured to cover
10% of losses between $8 and $9 billion and 2.75% of losses between $9 and $11 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

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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.


Author Information

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





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IN10965 · VERSION 14 · UPDATED

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