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NATURAL CATASTROPHE EXPOSURES

FINANCING MAJOR NATURAL CATASTROPHES

THE ISSUE IS... Finding solutions to allow insurance companies to be better prepared for mega-catastrophes.

IT'S IMPORTANT BECAUSE... The probability is increasing that a major catastrophe will strike the United States and cause tens of billions of dollars in insured losses. In 2004, four hurricanes and one tropical storm caused over 2 million claims and an estimated $21.6 billion in insured losses. In 1992, Hurricane Andrew caused $16 billion in insured losses. This figure could have been $50 billion if Andrew had hit just 40 miles away in Miami. With all of the development that has taken place on the Southeast coast over the last 30 years, the chance that a major hurricane will hit a heavily populated area has increased tremendously. In 1994, the Northridge Earthquake caused $13 billion in insured losses. It is only a matter of time before another major earthquake strikes the United States. A $50-$100 billion catastrophe could cause insurer insolvencies and major disruptions throughout the industry and the United States economy as a whole.

For many years, the insurance industry has been struggling to craft a program that would allow companies to be better prepared for a mega-catastrophe. Most of these attempts have resulted in proposals that either do not achieve the desired goals, contain too much federal government involvement or provide a competitive advantage to certain segments of the industry.

Three states with the most severe exposures -- California, Florida, and Hawaii -- have created state programs to prepare for major catastrophes. These programs have increased insurers' ability to continue to write business in these states. Unfortunately, the possibility exists that a mega-catastrophe could exceed the claims paying ability of these state programs. In recent years, some in Congress and the insurance industry have supported legislation that would provide a federal backup to official state programs such as the California Earthquake Authority.

Past Congresses have considered legislation to authorize the Secretary of the Treasury to offer annual federal reinsurance contracts to eligible state insurance or reinsurance programs that provide coverage for homes, condominiums, and the contents of apartments for damage caused by hurricanes and earthquakes as well as perils resulting from earthquakes such as fires and tsunamis. The legislation would also establish a program under which the Treasury Department would auction off excess of loss contracts in several separate regions of the country to private insurers, reinsurers, state pools and other interested entities. In order for the contracts to pay-out for either the state program or the regional auction program, a $2 billion or one-in-100 year event, whichever is greater, would have to occur. Maximum total pay-outs on the contracts could not exceed $25 billion annually.

In addition, some members of Congress and the National Association of Insurance Commissioners (NAIC) and are considering proposals to allow insurance companies to set up catastrophe reserves, which would receive favorable tax treatment. This approach is intended to address the needs of individual companies. Legislation has been considered in Congress to allow property/casualty insurers to set up tax-deferred reserves for future catastrophes. Under this proposal, each company's reserve would be subject to a cap, based upon its catastrophe exposures for qualifying lines of business. Each insurer's net written premiums for each business line would be multiplied by a cap factor. An insurer could access the reserve funds only to cover actual losses associated with events declared to be catastrophes by the U.S. President, the state or territorial chief executive or the Property Claims Service. Qualifying events would include hurricanes, cyclones, tornadoes, earthquakes, fires following earthquakes, severe winter storms, fires, tsunamis, floods, volcanic eruptions and hail storms. An insurer could draw from the funds to the extent that losses incurred exceed the lesser of the prior year's reserve cap or 30 percent of the insurer's prior year surplus. The reserves would be phased in over a 20-year period.

A third approach is insurance securitization, which is the transfer of risk from an entity, whether insurance company or other legal person, to investors via the cedant's or an intermediary's issuance of securities that generate or make available the capital for underwriting the risk transferred. This can be accomplished through the use of "special purpose reinsurance vehicles" (SPRVs). Under current law, insurance securitization through SPRVs can only be accomplished offshore. The transactions are greatly complicated by U.S. tax law and state regulation, and therefore, are limited to only those companies that are willing to bear the cost of the transaction and wade through the regulatory complexity. A proposal is being circulated that would allow for insurance securitization onshore, while at the same time limiting the burden of U.S. tax law and state regulation.

The NAIC is considering this issue and has taken a two-prong approach. First, the NAIC completed a model act for "protected cell companies" that would allow securitization from existing, "host" insurance companies. In addition, a working group of the NAIC approved a model law for creation of SPRVs that would permit creation of entities with legal existence separate from existing insurance companies for the purpose of accepting and securitizing risk. These SPRVs may better serve investors, who may have fears that a protected cell company within a host may not be sufficiently remote from bankruptcy-putting protected cell assets at risk to claimants on the insurance company's general assets.

NAMIC POSITION... NAMIC believes that exposures to mega-catastrophes present a tremendous challenge to the insurance industry. NAMIC is exploring several different avenues to address the problem. Recognizing that companies have differing needs, depending on their books of business, NAMIC believes that there could be several solutions to the problem.

In recent years, the awareness of catastrophe exposures has expanded and the marketplace has responded. An increasing number of insurers have turned to capital market solutions such as surplus notes, catastrophe bonds and derivatives to prepare themselves for mega-catastrophes. Private industry solutions such as these, whereby insurance companies can access the financial markets for coverage at the highest layers, are the most attractive solution to NAMIC members. However, if it is not possible to find suitable private market solutions, NAMIC believes that the next best alternative would be state or targeted regional approaches that could address the needs of specific areas. NAMIC believes that a federal government solution should only be pursued as a last resort.

NAMIC members have conducted a thorough review of the legislation to establish a federal catastrophe reinsurance program. While NAMIC recognizes that the proposal could provide assistance to some types of property/casualty companies, the impact it would have on many of the association's small and regional companies would be non-existent in most cases and minimal at best, particularly in areas that do not have significant earthquake or hurricane exposures. NAMIC further recognizes the fact that in order to preserve the private reinsurance market, high triggers must be established in catastrophe exposed regions. However, these high triggers may prevent smaller NAMIC member companies from accessing the program.

Recognizing that the federal catastrophe reinsurance legislation could benefit some in the property/casualty industry, NAMIC would not stand in the way of its consideration. NAMIC remains concerned, however, that the proposal would lead to too much federal government involvement and provide limited benefit to the majority of its members. NAMIC will continue to consider additional changes to the proposal as well as other alternatives.

NAMIC does support the concept of a voluntary catastrophe reserve with favorable tax treatment. Such a proposal has the potential to more effectively address the needs of individual companies. However, as with any proposal, the costs and benefits associated with the proposal must be considered. It is important to determine the potential cost of a catastrophe reserve to the U.S. Treasury. That cost must then be contrasted against the cost of federal disaster assistance programs. NAMIC is also interested in considering alternative proposals that would achieve the same objective without having a negative impact on the Treasury.

NAMIC believes that insurance securitization through SPRVs is a viable and useful means of risk transfer. Mutual insurance companies by their nature have less convenient access to capital in comparison to stock companies; and SPRVs, as a potential source of capital for undertaking risk, are therefore attractive to these companies. In addition, securitization by way of SPRVs is a market-oriented approach to financing natural disasters, which is preferable to NAMIC than direct federal government intervention. NAMIC generally supports proposals that would allow insurance companies to better manage risks, while at the same time increasing the long-term viability of the industry. Insurance securitization seems to be a sensible approach, and NAMIC will continue to work with Congress and state regulators to ensure the promotion of broader access to capital markets and increased stability of the insurance industry.

Whatever market or governmental solutions are ultimately adopted, NAMIC believes that mitigation provisions are essential to minimize the loss of lives and property from a catastrophe. Strict building codes should be used and enforced in catastrophe prone areas. NAMIC is a member of the Institute for Business and Home Safety, an organization created to enhance and promote the use of building codes and other measures to ensure that structures are safe. NAMIC will continue to support efforts to assist individuals, businesses and communities to responsibly prepare for natural catastrophes.