Jill Naamane, Wesley Phillips, and William Shear dissect the differences in approach to catastrophe management on both sides of the Atlantic
Natural catastrophes and terrorist attacks can place enormous financial demands on households, businesses, and the insurance industry, in addition to causing significant loss of life. For example, the four hurricanes that primarily affected Florida in 2004 caused over $20bn in insured losses in the state due to property destruction. Forecasting the timing and severity of such events poses unique challenges to property/casualty insurers, and the large losses associated with catastrophes can threaten insurer solvency.
Insurers frequently respond to catastrophic events by cutting back coverage or substantially increasing premiums. After Hurricane Andrew crossed southern Florida in 1992, many insurance and reinsurance companies raised premiums or stopped offering catastrophic coverage in the state. Similar reactions took place in the California insurance market after the Northridge earthquake of 1994 and in worldwide insurance markets after the September 11, 2001, terrorist attacks. To the extent that insurers are unable or unwilling to insure against catastrophic events, a subsequent lack of affordable coverage in the marketplace could impede economic recovery and development.
In response to such insurance market disruptions, governments and the private sector have taken steps to enhance the capacity of the insurance industry to address catastrophic risk.
This article summarises the findings in the US Government Accountability Office's report, Catastrophe Risk: US and European Approaches to insure Natural Catastrophe and Terrorism Risks (GAO-05-199).
Insurers and state governments have taken steps to enhance the industry's capacity to address natural catastrophe risk. However, a major event, or series of events, surpassing the $20bn of losses in Florida incurred after the 2004 hurricane season could severely disrupt insurance markets and impose substantial recovery costs on governments, businesses, and individuals. According to the insurers, regulators, and analysts we contacted, the following government and industry actions have strengthened insurers' capacity to respond to catastrophic events:
- the establishment of state catastrophe authorities, such as the Florida Hurricane Catastrophe Fund (FHCF) and the California Earthquake Authority (CEA);
- the establishment of stronger building codes in areas at risk from natural catastrophes;
- the development and use of computer programs to model insurers' estimated losses from particular catastrophic scenarios, and to control exposures accordingly;
- the implementation of higher deductibles, which shift a greater share of the losses associated with natural catastrophes from insurers to policyholders; and
- the creation of new reinsurance companies in Bermuda that specialise in catastrophic risk.
Preliminary information suggests that several of these changes have generally facilitated the industry's ability to absorb the losses associated with the 2004 hurricanes when compared with losses from Hurricane Andrew in 1992. For example, only one company failed in 2004, in contrast to the 11 companies that failed after Andrew. Nevertheless, the losses in Florida from the four hurricanes are far below the potential losses associated with a major event or series of events (hurricanes or earthquakes of such magnitude that they have a 1% to 0.4% chance of occurring annually), which could be $50bn or more. Such an event could exhaust the available financial resources of affected state authorities, generate higher premiums, and would probably result in the failure of some companies.
While several insurance and reinsurance companies currently use catastrophe bonds to enhance their capacity to address the most severe types of natural catastrophe, the bonds occupy a small niche in the global catastrophe reinsurance market. Most of the catastrophe bonds issued provide coverage for catastrophic risk with high financial severity and low probability.
The appeal of catastrophe bonds to some insurers and institutional investors was evidenced by the reported 50% growth of the market from year-end 2002 to year-end 2004 to a total of $4.3bn in bonds outstanding worldwide.
However, that amount was still small compared with industry exposures to natural catastrophes, and the bonds have not yet achieved widespread insurance industry acceptance. In addition, catastrophe bonds have not been issued to address terrorism risk in the US.
European approaches to catastrophe risk
Among the six European countries we studied, we found a mix of government and private-sector approaches to providing natural catastrophe and terrorism insurance. For example, natural catastrophe coverage is mandatory in France and Spain, and the national governments are explicitly committed to providing financial support to insurers through state-backed entities and unlimited state guarantees. Switzerland also makes natural catastrophe coverage mandatory, but the government does not provide an explicit financial commitment.
Instead, Swiss insurers have developed programs to share catastrophe losses.
Germany, Italy, and the UK do not require natural catastrophe insurance and do not offer national insurance programs for natural catastrophes.
To cover terrorism risk, four of the European national governments we studied - France, Spain, Germany, and the UK - have established national programs in conjunction with the insurance industry. In France and Spain, a state-backed entity administers the essentially mandatory terrorism insurance program, and the state provides an unlimited guarantee. In Germany and the UK, the government provides a limited state guarantee to an otherwise private and voluntary terrorism insurance program. In contrast, Italy and Switzerland do not have national terrorism insurance programs, and private companies provide the limited coverage that is available.
Each of the six countries we studied allowed insurance companies to establish tax-deductible reserves (often called catastrophe or equalisation reserves) for future catastrophic events, although there can be significant differences in the reserving approaches used in each country. For example, in Germany and the UK, insurers must follow established standards in determining the amount of money that can be added to the reserves each year and the conditions under which the money may be withdrawn to cover catastrophe losses. In contrast, insurers in the other four countries have more discretion to determine the level of contributions to the reserves and when the funds may be used.
Under a new international accounting standard designed to improve the transparency of insurer financial statements, which became effective in 2005, insurance groups are no longer allowed to include catastrophe reserves in their consolidated financial statements. Nevertheless, European insurers and regulators we contacted said that countries may allow the subsidiaries or affiliates of insurance groups to continue using the reserves for tax purposes.
Although the industry has improved its ability to respond to the losses associated with natural catastrophes - at least those on the scale of the 2004 hurricane season - without widespread market disruptions, industry capacity has not yet been tested by a major catastrophe or series of catastrophes, which could result in significant disruptions to insurance markets. In addition, it is not yet clear the extent to which the catastrophe bond market has the potential to materially enhance industry capacity and thereby mitigate financial risks. In response to these risks, major European countries have, with important exceptions, generally adopted policies that rely on national government intervention to enhance industry capacity to a greater extent than is the case in the US.
European approaches to addressing natural catastrophe and terrorism risks illustrate benefits and drawbacks that may be useful for consideration by policymakers. The mandatory national programs for natural catastrophe risk in Spain and France, for example, help to ensure that coverage is widely available for such risks, particularly in the wake of catastrophic events. However, such programs also involve significant government intervention in insurance markets, such as setting premium rates, which may not be actuarially based. Consequently, the capability of governments and insurers to control risk-taking by policyholders and minimise potential government liabilities may be limited, although some governments have tried to minimise this liability by implementing loss prevention programs.
Concerning terrorism insurance, the programs in France and Spain ensure that most policyholders have such coverage, although these programs also involve government intervention in setting premium rates and in monitoring risk-taking. In contrast, the purely voluntary national terrorism program in Germany and the private sector approaches in Switzerland and Italy have not yet been successful in ensuring that policyholders have terrorism coverage. Many policyholders choose not to purchase terrorism coverage because they view their risks as acceptably low, or the premiums for terrorism coverage as too high.
- Jill Naamane is senior analyst, Wesley Phillips is assistant director, and William Shear is director at the US Government Accountability Office.