Catastrophe losses are getting more and more expensive. Population growth and increasing wealth compound exposures while a changing climate causes more frequent and severe events. Ronald Gift Mullins asks, “Who should pick up the tab?”

Who is to pay for natural catastrophes? Insurers and reinsurers with earnings from their investments and premiums from policyholders? State pools funded by citizens’ taxes? A federal fund financed by US taxpayers? Investment-type instruments backed by the trillions in the world’s capital markets? Charitable and religious groups? A creative combination of one or more of these programmes?

The economic magnitude of catastrophe losses continues to mount. An analysis by AIR Worldwide estimates that over the past three years the insured value of properties in coastal areas of the US continued to grow at a compound annual growth rate of just over 7%. “While the scientific debate over the effects of global warming on the frequency and severity of hurricanes remains inconclusive, there is no question that the significant increase in the number and value of exposed properties over the last decade has and will continue to contribute to increasing hurricane losses for insurers,” said S Ming Lee, CEO of AIR Worldwide.

Finding the appropriate solution to paying the billions in insurance and reinsurance claims from these ever-costly calamities means balancing the often-competing goals of ensuring that citizens are protected while limiting taxpayer exposure. An acceptable resolution becomes more complex and urgent with each passing year.

No perfect solution

In late 2007, the Government Accountability Office (GAO) published a study of what options were available in the public and private sectors for handling losses from catastrophes. The GAO examined the rationale for and resources of federal and state programmes that provide natural catastrophe insurance. It also examined the extent to which Americans living in catastrophe-prone areas of the United States are uninsured or underinsured. It looked at the types and amounts of federal payments to such individuals since the 2005 hurricanes and public policy options for revising the federal role in natural catastrophe insurance markets.

The report examined seven public policy options for changing the federal government’s role, including establishing an all-perils homeowner insurance policy, and providing reinsurance for state catastrophe funds. But these options, which may help better address catastrophe risk by charging risk-based rates, would need to be balanced with the consumers’ demand that rates remain affordable.

“Over the past three years the insured value of properties in coastal areas of the US grew at a compound annual growth rate of just over 7%

For example, establishing an all-perils homeowner policy is a private sector approach that could help create broad participation. But low-income residents living in parts of the United States with high catastrophe risk could require subsidies, resulting in costs to the government. Similarly, federal reinsurance for state programmes could lead to broader coverage, but could displace private reinsurance and require disproportionate contributions from states with little exposure to catastrophes. It could also lead to relaxing zoning rules on building along the US coasts.

The study made no recommendations as to which option should be pursued. It did suggest there was no perfect solution to financing losses from catastrophes.

Flood insurance pool stagnant

The greatest economic and insured losses of any natural catastrophe so far, result from the terrible power of hurricane winds and the widespread flooding that often follows. As an example, in addition to the approximate $60bn paid by insurers/reinsurers following the 2005 Hurricanes Katrina, Rita, and Wilma, nearly $88bn was allocated by Congress for the recovery effort. The National Flood Insurance Program (NFIP) made about $16bn available to homeowners who lacked adequate insurance or had none at all.

Designed to expire at the end of September 2008, the NFIP has been reauthorised by the House and includes some form of wind coverage. Strongly supporting wind coverage within the NFIP were senators from the Gulf of Mexico states. They argued that adjusting claims after such disasters would be easier and simpler as no distinction would have to be made between damage from flooding and that from wind. But the Senate bill passed without including wind coverage.

A reason given for eliminating wind coverage was another study by the GAO. It found that adding wind insurance to the NFIP would expose the federal government to almost $600bn in potential claims over the next five years. The House bill has been embraced by the insurance industry. The Senate bill does forgive $17.5bn in debt the NFIP incurred after Hurricane Katrina. The House measure does not. The controversial wind coverage and forgiveness provisions remain as major obstacles that have to be hammered out by a House-Senate conference. President Bush has indicated he would veto any version of the bill that “shifts liabilities for windstorm damage from the private sector to the NFIP [as such a move] would be fiscally irresponsible”.

“Establishing an all-perils homeowner policy is a private sector approach that could help create broad participation

With the widespread flooding that has engulfed great sections of the US Midwest this spring, the debt of the NFIP will surely rise again once the rivers recede and clean-up begins. Insured losses are expected to reach $850m from the flooding and storms that hit the seven Midwest states, according to the Insurance Services Office.

Federal catastrophe backstop?

Known as the Homeowners’ Defense Act, or HR 3355, the national catastrophe fund has been approved by the House but the bill has not gone anywhere in the Senate. President Bush has vowed to veto the bill should it come to his desk. He says the private insurance sector can best provide coverage.

Importantly, the issue has become part of the campaigns of Senator John McCain, Republican candidate for president, and Senator Barack Obama, the Democrat’s choice. Senator McCain opposes the measure because it ignores the need for private insurance reform to broaden markets and protect “against the cherry-picking of individual states,” an aide said. Other critics believe a national catastrophe fund would encourage development along US coasts even faster than at present. The programme would also require taxpayers in states with little or no catastrophes, such as hurricanes and earthquakes, to ante up to pay for such losses in other states.

Senator Obama enthusiastically supports the idea saying it would “stabilise the catastrophe insurance market by expanding the capacity of the private insurance market to cover a natural disaster.” He says it would also stabilise premiums for homeowners. He was quoted as saying: “I will commit to supporting this legislation as president”. A number of large homeowners insurers, State Farm, Allstate and Travelers, are supporting its passage, stressing that the potential loss from mega hurricanes could threaten the financial health of insurers.

According to a recent article by Standard & Poor’s, federal government participation through a natural catastrophe backstop programme could limit the amount of losses for insurance carriers while potentially increasing the availability of coverage to these residents. “A federally-backed programme might also supplement the insurance the private market provides and encourage insurance companies to provide more coverage for natural disasters.”

“Federal reinsurance could displace private reinsurance and require disproportionate contributions from states with little exposure to catastrophes

Overall, the article states, it is up to insurance market participants, (re/insurance carriers, regulators, states, the federal government and others) to determine what role the government should play in managing natural catastrophe risk. “Most agree that taxpayers shouldn’t be the source of the funding for a federal-backed programme. From an industry standpoint, a federal-sponsored natural catastrophe reinsurance programme could be viewed the same way as other similar existing federal insurance programmes, such as the National Flood Insurance Programme and the Federal Crop Insurance Programme,” the article states.

“If the government provides reinsurance, it could be considered as another form of reinsurance from a ‘AAA’ reinsurer,” continues the article. As a result, participant insurers of this programme could have improved risk-adjusted capital adequacy if they take part in the programme rather than getting cover from lower-rated reinsurance carriers. One downside is the potential loss of revenue for companies that underwrite natural catastrophe re/insurance. “These companies would be competing with the federal government, which could materially hinder their operating performance and weaken their competitive position,” states the article.

Sovereign insurance

Offering a fresh approach to handling losses from future catastrophes, Swiss Re advocates a strategy that shifts financing from post-event to pre-event. This gives some support to the idea of a federal catastrophe backstop in the US. Reto Schnarwiler, head of Swiss Re’s public sector business development unit, acknowledged that no organisation or country “can fully insulate itself against extreme events. Transferring catastrophic risk therefore has to be a key element in the financial strategy of every disaster-prone country or region in order to enable and sustain growth”.

Swiss Re’s approach is to shift the traditional disaster relief approach, which involves raising funds after an event hits, to an approach that accumulates funds before a disaster occurs. A new generation of sovereign insurance (or “macro-insurance”) instruments can make it easier for governments to cope with disasters. Governments will be able to deliver immediate relief to the victims of natural disasters, according to Swiss Re, without suddenly creating a significant burden on public finances. “New forms of public private partnerships allow them to leverage their funds through the use of insurance and capital market instruments,” said Michel Liès, member of Swiss Re’s executive committee.

Such public-private initiatives have enjoyed success in other parts of the world. They include scope to transfer risk to the capital markets, as well as to traditional insurance and reinsurance companies. Turkey, Taiwan (its earthquake pool launched a catastrophe bond in 2003), New Zealand, Indonesia, Japan and the Caribbean have all successfully launched catastrophe pools with public and private sector backing. Should the US aim for such an approach with its national cat fund, the country’s catastrophe risks could be aggregated and ultimately ceded to the reinsurance and capital markets. If done properly, this model could successfully diversify exposures and ensure adequate funding for the ever-increasing catastrophe losses.

Ronald Gift Mullins is an insurance journalist based in New York City.

Florida running on empty

In the late 1960s due to urban riots, homeowners' coverage in certain areas was not available from private insurers. FAIR (Fair Access to Insurance Requirements) plans were created to provide minimal coverage for riot, fire, vandalism and windstorm. About a dozen states offer liability with homeowners' coverage. In 2006, there were about 2.6 million FAIR policies, producing premiums of close to $4.1bn.
The 2005 hurricanes encouraged state-elected officials to come up with schemes to bolster their windstorm funds, especially those in the Gulf of Mexico. No state in the eastern part of the US has more coastline than Florida and with 1.5 million policies in its FAIR plan and premiums of $3.4bn, it has by far the largest of such plans. Following Hurricane Wilma in 2005, the Florida Hurricane Catastrophe Fund (FHCF) had a deficit of about $1.4bn, according to the Insurance Information Institute.
To eliminate the deficit, all policyholders in the state are being required to help pay for Citizens' 2005 deficit through a surcharge averaging 2% of their annual premium. The legislature has allocated $715m to reduce the amount of assessments policyholders would be required to pay. The remainder of the deficit, about $887m, will be collected over a ten-year period. In early June 2008, the FHCF announced it would sell up to $625m in bonds to pay outstanding claims from Hurricane Wilma of 2005.
Fund officials say there's only about $160m left in the account, enough to settle claims for only a few months. A 1% surcharge on most insurance policies to cover hurricane claims that began in 2007 has been extended for two additional years through 2014. "The ultimate costs are uncertain but this could be enough," said Jack Nicholson, senior officer of the Florida Hurricane Catastrophe Fund. "We'll revisit it next year."
The FHCF typically issues bonds post catastrophe to shore up its funds, but therein lies another issue. "With the contraction of the credit market, it has become difficult to sell the bonds that would provide the cash to pay for potential losses and those that were sold carried a higher than expected interest rate," states the Insurance Information Institute. It essentially puts the citizens of the Sunshine State on the hook for enormous losses if a hurricane should smash into it again.