should the government provide insurance for catastrophes?largely attributable to government...

Should the Government Provide Insurance for Catastrophes?

J. David Cummins

Hurricane Katrina, which made landfall onSeptember 8, 2005, is the most costly catastrophicevent in history, with projected insured lossesin the range of $40 to $60 billion. The mostcostly prior natural catastrophe was HurricaneAndrew in 1992, which cost insurers $22.3 bil-lion. The most costly man-made disaster wasthe September 11, 2001, terrorist attack on theWorld Trade Center (WTC) in New York, whichresulted in about $40 billion in insured losses.

The increasing costs of catastrophes havesignificantly stressed insurance markets. Insur-ance works best for high-frequency, low-severityevents, which are statistically independent andhave probability distributions that are reasonablystationary over time. Catastrophic events, andparticularly mega-catastrophes such as Katrinaand the WTC terrorist attack, violate to somedegree nearly all of the standard conditions forinsurability. These are low-frequency, high-

T he frequency and severity of naturaland man-made catastrophes haveincreased significantly in recent years.Natural catastrophes include events

such as hurricanes, earthquakes, floods, andtsunamis; and man-made disasters include oilplatform explosions, aviation disasters, and ter-rorism. As shown in more detail below, prior to1986, the number of catastrophes rarely reached150 per year; but since 1993, there have been atleast 270 catastrophes per year.1 Of the 40 mostcostly disasters since 1970, 34 have occurredsince 1990 and 15 have occurred since 2000.

This paper evaluates the need for a government role in insuring natural and man-made catastrophesin the United States. Although insurance markets have been stressed by major natural catastrophes,such as Hurricane Katrina, government involvement in the market for natural catastrophe insuranceshould be minimized to avoid crowding-out more efficient private market solutions, such ascatastrophe bonds. Instead, government should facilitate the development of the private marketby reducing regulatory barriers. The National Flood Insurance Program has failed to cover mostproperty owners exposed to floods and is facing severe financial difficulties. The program needsto be drastically revised or replaced by private market alternatives, such as federal “make available”requirements with a federal reinsurance backstop. A federal role may be appropriate to insureagainst mega-terrorist events. However, any program should be minimally intrusive and carry apositive premium to avoid crowding-out private market alternatives.

Federal Reserve Bank of St. Louis Review, July/August 2006, 88(4), pp. 337-79.

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2006 337

1 These figures are from Swiss Re (2006). Swiss Re defines a catas-trophe as an event that causes a specified amount of monetary lossor loss of life above a certain threshold: In 2005, the monetarythreshold for an event to be defined as a catastrophe is $77.5 millionand the fatality threshold is 20. The monetary threshold is adjustedover time so that the catastrophe count is consistent across years.Loss statistics are in terms of insured losses. Total losses, includinguninsured losses and infrastructure, would be much larger.

J. David Cummins is the Harry J. Loman Professor of Insurance and Risk Management at the Wharton School of the University of Pennsylvania.The author acknowledges helpful comments and suggestions from William R. Emmons, Scott E. Harrington, Dwight Jaffee, Howard Kunreuther,Christopher M. Lewis, and Erwann Michel-Kerjan.

© 2006, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.

severity events that violate statistical independ-ence by affecting many insured exposures at onetime. Although considerable progress has beenmade in modeling natural catastrophes, conven-tional methods are much less effective in evalu-ating losses from terrorism, given that terroristsare continually modifying their strategies andtactics.

Insurance markets tend to respond adverselyto mega-catastrophes. They respond to largeevents, particularly those that cause them to re-evaluate their estimates of the probability andseverity of loss, by restricting the supply of insur-ance and raising the price of the limited coveragethat is made available. This occurred, for example,following Hurricane Andrew in 1992 and theNorthridge earthquake in 1994 and occurred againfollowing the WTC terrorist attack. Because insur-ance plays an important role in the economy,instability in the availability and price of coveragegenerally leads to pressure for government inter-vention in insurance markets. State governmentsintervened in Florida and California followingAndrew and Northridge, and the widespreadavailability of windstorm coverage in Florida andearthquake coverage in California seems to belargely attributable to government intervention.The federal government has provided subsidizedflood insurance since 1968 and entered the marketfor terrorism insurance as reinsurer of last resortthrough the Terrorism Risk Insurance Act of 2002(TRIA). Governments in several other industrial-ized nations, including France, Germany, Spain,and the United Kingdom, also have intervenedin catastrophe insurance markets.

The objective of this paper is to evaluate theappropriateness of government intervention incatastrophe insurance markets with a particularfocus on mega-catastrophes, both natural and man-made. The paper begins with a statistical overviewof the recent history of catastrophes and then turnsto a discussion of the insurability of such eventsthrough the private sector, considering the theo-retical criteria usually associated with insurableevents. The resources of the U.S. insurance indus-try and the global reinsurance industry are thenevaluated to provide perspective on the insura-bility of large catastrophes. The last major section

of the paper evaluates potential public and privatesector solutions to the catastrophe insuranceproblem, considering alternative risk financingmechanisms such as catastrophe (CAT) bonds aswell as the most promising models for govern-ment involvement. The discussion includes anevaluation of the effectiveness of TRIA and thelikely effect of sun-setting TRIA on the market forterrorism insurance.

CATASTROPHES: THE RECENTHISTORY

The number of natural and man-made catas-trophes since 1970 are shown in Figure 1. Thefigure indicates a clear upward trend in the num-ber of catastrophes; and a linear trend line fittedto the total number of catastrophes has an adjustedR2 of 0.87. There seems to be a pronounced shiftin the data approximately in 1988 and anothershift in 1994. Although scientists have not reachedconsensus on whether the frequency of naturalcatastrophes such as hurricanes has been increas-ing, the major reason for the increasing numberof catastrophes is the accumulation of propertyvalues in disaster-prone areas such as California,Florida, the Gulf Coast, and, increasingly, Asia.

The value of insured catastrophe losses fromnatural and man-made events, adjusted to 2005price levels, is shown in Figure 2. Because cata-strophic events also cause significant losses touninsured property, such as highways, sewer sys-tems, and other infrastructure components, thetotal value of losses from such events is higherthan Figure 2 suggests. However, the insuredlosses are relevant in evaluating the insurabilityof such events. Figure 2 shows that, except for theWTC event in 2001, natural disasters cause moreinsured losses than man-made events. However,the WTC event illustrates that terrorism has addeda significant source of volatility that was not pre-viously present. The severity data also show ashift in the late 1980s/early 1990s. Prior to 1987,total insured catastrophe losses never exceeded$10 billion per year; but beginning in 1987, losseshave exceeded $10 billion in every year and haveexceeded $20 billion in 11 of 19 years. Following

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338 JULY/AUGUST 2006 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

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400

350

300

250

200

150

100

50

0

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Man-Made

Natural

Figure 1

Number of Catastrophes, 1970-2005

SOURCE: Swiss Re (2006).

90,000

80,000

70,000

60,000

50,000

40,000

30,000

20,000

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Man-Made

Natural

0

10,000

2005 $ Millions

Figure 2

Worldwide Insured Catastrophe Losses, 1970-2005


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Table 1Top 40 Insured Catastrophe Losses: 1970-2005

Insured loss1

(2005 $ millions) Victims2 Date (start) Event Country/Area

45,000 1,326 8/24/2005 Hurricane Katrina U.S. Gulf of Mexico, Bahamas

22,274 43 8/23/1992 Hurricane Andrew U.S., Bahamas

20,716 2,982 9/11/2001 Terrorist attacks on WTC, Pentagon U.S.

18,450 61 1/17/1994 Northridge earthquake (M 6.6) U.S.

11,684 124 9/2/2004 Hurricane Ivan: damage to oil rigs U.S., Caribbean

10,000 34 9/20/2005 Hurricane Rita: floods, damage to oil rigs U.S.. Gulf of Mexico, Cuba

10,000 35 10/16/2005 Hurricane Wilma U.S., Caribbean

8,272 24 8/11/2004 Hurricane Charley U.S., Caribbean

8,097 51 9/27/1991 Typhoon Mireille/No 19 Japan

6,864 95 1/25/1990 Winterstorm Daria France, U.K. et al.

6,802 110 12/25/1999 Winterstorm Lothar France, Switzerland et al.

6,610 71 9/15/1989 Hurricane Hugo Puerto Rico, U.S.

5,170 38 8/26/2004 Hurricane Frances U.S., Bahamas

5,157 22 10/15/1987 Storm and floods France, U.K. et al.

4,770 64 2/25/1990 Winterstorm Vivian Europe

4,737 26 9/22/1999 Typhoon Bart/No 18 Japan

4,230 600 9/20/1998 Hurricane Georges U.S., Caribbean

4,136 3,034 9/13/2004 Hurricane Jeanne: floods, landslides U.S., Haiti

3,707 45 9/6/2004 Typhoon Songda/No 18 Japan, South Korea

3,475 41 6/5/2001 Tropical Storm Allison U.S.

3,403 45 5/2/2003 Thunderstorms, tornados, hail U.S.

3,304 167 7/6/1988 Explosion on platform Piper Alpha U.K.

3,169 6,425 1/17/1995 Great Hanshin earthquake (M 7.2), Kobe Japan

2,814 45 12/27/1999 Winterstorm Martin Spain, France, Switzerland

2,768 70 9/10/1999 Hurricane Floyd: floods U.S., Bahamas et al.

2,692 59 10/1/1995 Hurricane Opal U.S., Mexico

2,621 38 8/6/2002 Severe floods Europe

2,438 26 10/20/1991 Forest fires affecting urban areas, drought U.S.

2,427 0 4/6/2001 Hail, floods, and tornados U.S.

2,366 246 3/10/1993 Blizzard and tornados U.S., Mexico, Canada

2,233 20 12/3/1999 Winterstorm Anatol Denmark, Sweden, U.K.

2,227 4 9/11/1992 Hurricane Iniki U.S., N. Pacific Ocean

2,088 23 10/23/1989 Explosion in a petrochemical plant U.S.

2,068 220,000 12/26/2004 Seaquake (MW 9.0): tsunamis Indonesia, Thailand

2,024 0 8/29/1979 Hurricane Frederic U.S.

1,993 39 9/5/1996 Hurricane Fran U.S.

1,981 2,000 9/18/1974 Tropical Cyclone Fifi Honduras

1,947 100 7/4/1997 Floods after heavy rain Poland, Czech Republic et al.

1,923 116 9/3/1995 Hurricane Luis Caribbean

1,887 18 8/1/2005 Winterstorm Erwin Denmark, Sweden, U.K.

NOTE: 1 Property and business interruption, excluding liability and life insurance losses. 2 Dead and missing: Figures are approximateand from various sources.


a record-year in 2004, when losses totaled $48billion, losses nearly doubled to $80 billion in2005 with the devastation of hurricanes Katrina,Rita, and Wilma. Katrina in particular not onlywas an unprecedented natural disaster from aninsurance perspective but also raised significantquestions about the U.S. system for assessing,mitigating, and financing disasters and disasterrelief.2

The top 40 insured catastrophe losses since1970 are shown in Table 1: 34 of the top 40 haveoccurred since 1990 and 15 have occurred since2000; 7 of the 10 most costly hurricanes in U.S.history occurred during the 17-month period ofAugust 2004 through October 2005 (Hartwig, 2005).All but 3 of the top 40 losses are from natural catas-trophes, and the losses from the WTC terroristattack are roughly six times the previous largestman-made catastrophe, which was the explosionand fire on the Piper Alpha oil platform in 1988.

The table also shows that the United States is theprimary source of large catastrophe losses world-wide. In 2004, for example, 67.7 percent ofworldwide insured catastrophe losses wereNorth American (primarily U.S.) events (SwissRe, 2005a); and in 2005, the North Americantotal reached 87.1 percent of worldwide losses(Swiss Re, 2006).

Figure 3 places the catastrophe losses in abroader perspective by showing total insuredcatastrophe losses as percentages of world andU.S. gross domestic product (GDP). In relation toworld GDP, catastrophe losses were less than 0.05of 1 percent until the late 1980s and have fluctu-ated around 0.10 of 1 percent in more recent years.In relation to U.S. GDP, catastrophe losses wereless than 0.20 of 1 percent until the late 1980sand have been above 0.30 of 1 percent in severalyears since 1990. There is a significant upwardtrend in both series, with adjusted R2 values ofaround 0.35 in linear time trend regressions.Figure 3 suggests that catastrophe losses are largeand volatile from the perspective of the insurance

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0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Catastrophe/World GDP

Catastrophe/U.S. GDP

0.10

0.05

0.00

Percent

Figure 3

Catastrophe Losses Relative to World and U.S. GDP

SOURCE: Catastrophe losses: Swiss Re (2005a); World GDP: The World Bank; U.S. GDP: U.S. Department of Commerce.

2 For an excellent analysis of the lessons to be learned from Katrinain terms of disaster assessment, prevention, mitigation, and financ-ing, see Daniels, Kettl, and Kunreuther (2006).

industry but are more manageable from aneconomywide or societal perspective.

THE INSURABILITY OF CATASTROPHE LOSSES

This section evaluates the insurability ofcatastrophe losses. The section begins with adiscussion of the theoretical criteria for insura-bility and an analysis of the differences betweennatural and unintentional man-made catastropheson the one hand and intentional events such asterrorism on the other. The section concludes withan evaluation of the resources of the insurance andglobal reinsurance industries and an economicevaluation of the insurance crises and cycles.

Criteria for Insurability

Individuals are averse to pure risk and arewilling to pay amounts greater than the expectedvalue of losses in return for transferring risk to aninsurer.3 Most businesses also have a demand forrisk transfer and, like consumers, are willing topay more than the expected loss to transfer risk toanother party. The amounts greater than expectedlosses that individuals and businesses are willingto pay for risk transfer give rise to gains from tradethat have motivated the development of the insur-ance and reinsurance industries.

The role of the insurer is to assume risk fromindividuals and businesses and to diversify riskby pooling the losses of many policyholders. Thestatistical foundation of insurance is the law oflarge numbers. The role of insurers can be eluci-dated by specifying a simple statistical model ofa risk pool. Let X1,…,XN be a random samplefrom a probability distribution with finite meansµi and variances σi

2, where Xi represents the losssuffered by the ith policyholder in a risk pool. Itis helpful to assume that the Xi are normally dis-tributed, although they are not necessarily inde-pendent.4 The law of large numbers then statesthat

(1)

where

is the sample mean based on a realization oflosses from the N policies,

is the average mean loss, and ε is an arbitrarilysmall number. Intuitively, the law of large numberssays that the sample mean becomes arbitrarilyclose to the population mean as the sample sizeincreases. Thus, the expected loss is highly pre-dictable in a sufficiently large sample.

With the normality assumption, we can usethe central limit theorem to specify the amountof equity capital needed by the insurer. We assumethat insurers hold equity capital to achieve a speci-fied insolvency probability, ε. Insolvency proba-bilities are not driven to zero because holdingcapital in an insurance company is costly due tocorporate income taxation, agency costs, regula-tory costs, accounting rules, and other factors(Jaffee and Russell, 1997). The central limit theorem specifies that the following variableapproaches normality as the sample size increases:

(2)

The parameter σN2, the insurer’s loss portfolio

variance, is defined as

(3)

where σij = Cov(Xi,Xj). The normal distributionimplies that

(4)

where z is the standard normal variate and zε isthe value from the standard normal distribution

Pr ,X N

zi

i

N

N

−<

= −=∑ µ

σεε

1 1

σ σ σN ii

N

iji

j

j

N2 2

1 1

1

22= +

= =

−

=∑ ∑∑ ,

zX Ni

i

N

N

=−

=∑ µ

σ1 .

µµ

=∑ i

i N

XXN

i

i= ∑

lim Pr ,N

X→∞

− < =µ ε 1

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3 This discussion is based in part on analysis in Cummins and Weiss(2000).

4 The law of large numbers does not require normality. Normalityis assumed here because it provides a convenient explanation ofthe role of equity capital in the insurance market.

such that Pr[z < zε] = 1 – ε. The amount of equitycapital needed to achieve a target insolvencyprobability of ε is zεσN, assuming that policyholderpremiums cover the expected loss, Nµ–.

The standard normal result for equity capitalcan be used to illustrate the effects of pooling.Assume that the N risks in the portfolio are statisti-cally independent, so that all of the covariancesin equation (3) are zero. Then equity capital perpolicy is

(5)

where

is the average variance. Thus, equity capital perpolicy goes to zero as N goes to infinity, implyingthat large insurers insuring independent risks withreasonably small variances can charge a premiumvery close to the expected value of loss.5 I callinsurance markets with independent risks, mod-erate standard deviations per risk, and large Nlocally insurable. The U.S. market for personalautomobile insurance is an example of a locallyinsurable market.

The motivation for reinsurance becomesapparent when we relax the assumptions underwhich risks are locally insurable. For example,reinsurance markets are likely to be required forrisks with large variances and small N, even if wemaintain for the moment the assumption that risksare statistically independent. Further motivationfor the development of reinsurance markets is pro-vided by relaxing the assumption that risks areindependent. If risks are dependent, the amountof equity capital needed per risk to achieve a giveninsolvency target becomes

(6) z

N

N N N

NN ijεσ σ σ

=+ −( )2 1

,

σ σ2 2

1=

=∑ ii

N

N/

zN

z

NNε εσ σ=

2,

where σ–ij is the the average covariance amongthe N risks. It is easy to see that the amount ofequity capital needed per policy approaches

If the average covariance is small, the risks maystill be locally insurable, but the market outcomeis inefficient in that the risk charge per policyhas not been reduced to approximately zero.

However, risks that are locally dependentmay be globally independent, for example, therisk of tornadoes in the American Midwest versusAustralia. This provides an economic motivationfor reinsurance markets because insurers canreduce their prices relative to competitors byceding the covariance risk to a reinsurer who canpool the risk with independent risks from otherregions of the world. We call risks that are glob-ally diversifiable through reinsurance globallyinsurable.

Implicit in this discussion are some additionalcriteria for insurability. One important criterionis that N be sufficiently large for the law of largenumbers to operate such that the insurer achieveseffective diversification either locally or globally.Also important is that σ–2 and σ–ij (if the latter isnon-zero) be sufficiently “small”—again to ensurethat effective diversification takes place. If N istoo small or σ–2 and σ–ij too large, then the amountof capital the insurer must hold to achieve a suffi-ciently small insolvency probability may be toolarge for insurance to be feasible. Essentially, thecost of capital may push the price of insuranceabove the level that buyers are willing to pay forcoverage, eliminating the gains from trade.

Another important implicit assumption is thatsufficient data are available to enable the insurerto estimate the parameters of the loss distribution,µi and σi

2, and the covariances among risks, σij, ifthe risks are not independent. This is a non-trivialrequirement, given that real-world risks are notidentically distributed such that applicants forinsurance have heterogeneous parameters. It iswell-known that insurance markets can breakdown as a result of adverse selection if the insureris not able to discriminate among risks (Rothschildand Stiglitz, 1976). A final requirement is that the

z Nijε σ � � .as → ∞

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5 Notice, however, that this does not imply that large insurers needno equity capital. The equity capital needed to achieve a targetruin probability of ε with independent risks is

which approaches infinity as N goes to infinity.

z Nε σ 2 ,

loss distribution should be reasonably stationaryso that parameters estimated from past data arereasonably good predictors of future loss distribu-tions. If the loss distribution shifts significantlyduring short periods of time, such as one or twoyears, the insurer will be unable to estimate pre-miums or the required amount of equity capitaland insurability will break down.

The violation of any of the principal insura-bility conditions may create situations where risksare neither locally nor globally insurable. However,if other conditions are satisfied, such risks maybe globally diversifiable through capital markets.Consider the example of events with low frequencyand very high severity, where the covariancesamong the individual risks making up a portfolioare also relatively high. Examples of such risksare unusually severe hurricanes and earthquakesstriking geographical regions with high concen-trations of property values. For example, modelershave estimated that a $100 billion event in Floridaor California has a probability of occurrence in therange of 1 in 100 (i.e., a “return period” of 100years). The capacity of the insurance and reinsur-ance industries may be inadequate to insure suchevents.

However, events of this magnitude are smallrelative to the market capitalization of securitiesmarkets. Thus, by introducing securitized finan-cial instruments representing insurance risk,catastrophic events in the $100 billion range arediversifiable across the financial markets, eventhough they may not be diversifiable in globalinsurance and reinsurance markets. Such eventsalso have relatively low correlations with securi-ties returns, effectively providing an attractivesource of diversification for investors. Securitiza-tion extends the scope of diversification frominsurance and reinsurance markets to the entiresecurities market, thus breaking down the problemof small N, large σ ’s, and intra-insurance marketcorrelations, in much the same way as reinsur-ance can reduce or eliminate the problem ofnon-insurability on the local level. Diversifyinginsurance-linked risk across the securities marketprovides the motivation for CAT bonds, which arediscussed in more detail below.

The final category of risks consists of eventsthat are so severe that they may not be globallydiversifiable even through securities markets. Ithas been estimated that a severe earthquake inTokyo could cause losses in the range of $2.1 to$3.3 trillion, constituting from 44 to 70 percentof the GDP of Japan (Risk Management Solutions,1995). Although it is possible that global securi-ties markets could absorb a significant fractionof such a loss, the full loss is unlikely to be fullydiversifiable. I call such events cataclysmic, orglobally undiversifiable.

Losses from mega-terrorism events may alsofall into the globally undiversifiable category. Suchlosses are similar in many ways to losses arisingfrom war, which are generally not amenable toprivate market insurance or diversification solu-tions. In addition to sharing the problems of smallN and large µ and σ with mega-losses from naturalhazards, terrorism losses also pose the problemof being very difficult to estimate. Modelers havemade significant progress in estimating losses fromnatural hazards. Modeling firms such as AppliedInsurance Research, Equicat, and Risk Manage-ment Solutions have developed highly sophisti-cated models of natural hazard losses based onboth statistical data and scientific models of hur-ricanes and earthquakes. The models have beenparameterized using detailed mappings of expo-sures across the United States and in other majorcountries. The hurricane and earthquake perilsare sufficiently stable in a statistical sense to givemodelers confidence in their ability to predictthe frequency and severity of future events andto enable insurers to use the models to managetheir exposure to catastrophe risk.

Terrorism events are inherently much moredifficult to estimate than natural catastrophes.Few statistical data exist that can be used toestimate the parameters of loss distributions. Dataon terrorism activities obtained by the governmentare confidential for national security reasons andhence not available to insurers to assist in estimat-ing premiums and loss exposure. Moreover, ter-rorists constantly change strategies and tactics,making any predictions from past data inherentlyunreliable. Terrorists are likely to engage in “targetsubstitution,” shifting their attention to targets that

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receive the least amount of security. Althoughsome progress has been made in modeling theseverity of mega-terrorism events, based on scien-tific knowledge about the effects of nuclear andconventional explosions and biological and radi-ation hazards, little information exists that canassist insurers in estimating the probability ofterrorism losses. The possibility that terroristscould use weapons of mass destruction raisespotential losses from mega-terrorism to levels farexceeding the potential losses from even thelargest natural catastrophes.

Another major difference between terrorismand other types of catastrophes is that the fre-quency and severity of terrorist attacks are signifi-cantly affected by U.S. governmental policy. U.S.foreign policy directly impacts the motivation andlikelihood of terrorist attacks from different mili-tant factions. U.S. domestic policy and the successof government homeland security programsalso affect the mitigation of terrorist attacks—both in preventing such attacks and mitigatingthe magnitude of any attack that does occur. More-over, much of the information required to predictterrorist events is likely to remain highly classi-fied and unavailable to those outside of agenciessuch as the FBI and CIA. In fact, one of the argu-ments proffered in support of a federal role inthe provision of terrorism insurance was that ter-rorism events represent a negative externality ofthe national security policies of the sovereigngovernment. Thus, there are significant reasonsto believe that government may have to be theinsurer of last resort, at least for mega-terrorismevents.

Insurance Industry Resources, Cycles,and Crises

As mentioned, insurance works best for high-frequency, low-severity, relatively stationary,relatively independent events with good data andmoderate loss volatilities.6 For such events, insur-ers can accurately estimate premiums and theequity capital needed to reduce insolvency prob-abilities to acceptable levels, and the amount of

required equity does not lead to excessive prices.Even for larger, less-frequent, more-risky eventssuch as commercial liability lawsuits, insurancecan also be effective most of the time. However,there are significant questions about the abilityof the insurance industry to deal with the largestcatastrophic events. For various reasons, it isinfeasible and inefficient for the industry to holdsufficient capital to finance losses arising fromvery-high-severity, low-frequency events (Jaffeeand Russell, 1997). This section provides anoverview of the resources of the U.S. property-casualty insurance industry and the global reinsur-ance industry to gauge the industry’s capabilityto sustain losses from mega-catastrophes.

The total resources of the U.S. property-casualty insurance industry are shown in Figure 4.In 2004, the industry held about $400 billion inequity capital and collected premiums of about$440 billion. Although this might seem to be morethan enough to withstand a catastrophic loss of$100 billion, in fact, most of the premiums repre-sent expected loss payments for high-frequencylines such as automobile insurance and workerscompensation insurance. The premiums for home-owners insurance, the line most exposed to naturaldisasters, are only about 12 percent of the total.Moreover, the $400 billion in equity capital repre-sents the total amount held by insurers writingall lines of business in all states. Only a fractionof the total would be available to pay catastrophelosses in high-exposure states such as Californiaand Florida because insurers not writing policieswith catastrophe exposure in those states couldnot be called upon to pay claims.

Cummins, Doherty, and Lo (2002) investigatedthe capacity of the U.S. property-casualty insur-ance industry to respond to large catastrophicevents during the late 1990s. They considered theaggregate resources of the industry nationwideand also the resources of insurers writing policiesin the catastrophe-prone state of Florida as wellas the correlation of losses among companies,another factor in determining the capacity torespond to catastrophic events. The results indi-cated that the industry could pay more than 90percent of the losses from a $100 billion–lossevent. However, a loss of this magnitude wouldhave caused the failure of approximate 140 insur-

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6 Some additional criteria for insurability are discussed in Swiss Re(2005b).

ance companies. This would be by far the largestfailure rate in the post-1900 history of the U.S.property-casualty industry and would significantlydestabilize insurance markets.

The aggregate equity capital of the globalreinsurance industry is shown in Figure 5. Thefigure indicates that equity capital increasedsignificantly from 1990 to 2003, from about $250billion to about $340 billion, and increased moremodestly in 2004 to $377 billion.7 The premiumsof global reinsurers were about $167 billion in2004 (Standard and Poor’s, 2005).8 However, most

of the premiums are for high-frequency lines ofbusiness. To put the equity capital totals in per-spective, Figure 5 also shows the worldwidecatastrophe losses from Swiss Re (2005a) as aratio to the equity capital of global reinsurers.Catastrophe losses can amount to a significantproportion of equity, exceeding 15 percent in1999 and 2001 and reaching 13 percent in 2004.

Insurance markets are subject to cycles andcrises, which can be triggered by shifts in the fre-quency and severity of losses as well as investmentlosses. The underwriting cycle refers to the ten-dency of property-casualty insurance markets togo through alternating phases of “hard” and “soft”markets. In a hard market, the supply of coverageis restricted and prices rise; whereas, in a softmarket, coverage supply is plentiful and pricesdecline. The consensus in the economics literatureis that hard and soft markets are driven by capitalmarket and insurance market imperfections suchthat capital does not flow freely into and out of

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900

800

700

600

500

400

300

200

100

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Premiums

Equity

0

2004 $ Billions

Figure 4

U.S. Property-Casualty Insurance Industry: Total Resources

SOURCE: A.M. Best Company, Best’s Aggregate and Averages (various years). Resources expressed in real 2004 U.S. dollars using theconsumer price index.

7 The capital numbers somewhat overstate the capacity of globalreinsurers, however, because they represent the total equity capitalof companies writing reinsurance. There are several large companiesparticipating in this market, such as ING, AIG, and AXA, that alsowrite significant amounts of coverage in the primary insurancemarket. Hence, their equity capital supports both their primaryinsurance and reinsurance obligations. In addition, as in the U.S.insurance market, most of the equity capital is committed to supportcoverage in high-frequency lines of business.

8 Unlike the equity capital figures, the premium numbers are indica-tive of business written in the reinsurance market.

the industry in response to unusual loss events(Winter, 1994; Cummins and Danzon, 1997; andCummins and Doherty, 2002). Informationalasymmetries between capital providers andinsurer management about exposure levels andreserve adequacy result in high costs of capitalduring hard markets, such that capital shortagescan develop. Insurers are reluctant to pay outretained earnings during soft markets because ofthe difficulty of raising capital again when themarket enters the next hard-market phase, leadingto excess capacity and downward pressure onprices.

Hard markets are usually triggered by capitaldepletions that result from underwriting or invest-ment losses. The three most prominent hard-market periods since 1980 resulted from thecommercial liability insurance crisis of the 1980s,catastrophe losses from Hurricane Andrew in 1992and the Northridge earthquake in 1994, and theWTC terrorist attack in 2001. The 1980s liability

crisis was triggered by an unexpected increase inthe frequency and severity of commercial liabilityclaims, accompanied by a sharp decline in interestrates in the early 1980s, and the catastrophe andterrorist crises were driven by catastrophe lossesof unexpected magnitude. Each crisis not onlydepleted insurer capital but caused insurers tore-evaluate probability of loss distributions andreassess their exposure management and pricingpractices.

The U.S. property-casualty insurance under-writing cycle is illustrated in Figure 6. The figureplots two important operating ratios for the indus-try—the underwriting profit ratio and the overallprofit ratio. The underwriting profit ratio is thedifference between 100 and the industry combinedratio, which is the sum of the loss ratio (lossesincurred divided by premiums) and the expenseratio (operating expenses divided by premiums),expressed as percentages. If the underwritingprofit ratio is positive, the industry is collecting

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Equity Capital

Catastrophe Losses/Equity Capital

1999 2000 2001 2002 2003 2004

400

350

300

250

200

150

100

50

0

18

16

14

12

10

8

6

4

2

0

Equity (U.S. $ Billions) Catastrophe Losses/Equity Capital (Percent)

Figure 5

Global Reinsurers: Aggregate Equity Capital and Catastrophe Losses

NOTE: Equity is expressed in real 2004 U.S. dollars using the consumer price index.

SOURCE: Standard and Poor’s, Global Reinsurance Highlights (various years).

more in premiums than it is paying out in lossesand expenses—it is incurring an underwritingprofit; and if the ratio is negative, the industry isincurring an underwriting loss. The underwritingprofit ratio is a useful indicator of underwritingperformance, but it is not a very good indicator ofoverall profitability because it does not considerinvestment income. The overall profit ratio cor-rects for investment income by adding the ratioof investment income to premiums to the under-writing profit ratio. If the overall profit ratio ispositive, the implication is that insurers are mak-ing profits when both underwriting and invest-ment results are considered; and if the overallprofit ratio is negative, insurers are realizing over-all losses.

Figure 6 reveals the impact of the liabilitycrisis of the mid-1980s and the catastrophe crisesof 1992-94 and 2001. The underwriting loss in1984 was about 18 percent of premiums, and theoverall profit ratio indicated a net loss of about 7percent of premiums in that year after consideringinvestment income. In 1992, the underwriting

loss, mainly due to Andrew, was 15 percent andthe overall profit ratio showed a loss of about 4percent of premiums. The underwriting loss dueto the WTC attack was also about 15 percent ofpremiums, and the overall loss was about 6.5percent. With losses of this magnitude and volatil-ity, it is not surprising that insurers restrictedsupply and raised prices following these events.9

Another indicator of recent underwriting cycleactivity in the United States is provided by surveydata collected by the Council of Insurance Agentsand Brokers. The Council conducts a quarterlysurvey of its members to determine the changesin commercial lines insurance prices, based onpolicies renewing in each quarter. The averagerate changes from 1999 through 2005 are shownin Figure 7. The figure shows that prices had beenincreasing significantly even before September

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1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Overall Profit Ratio

Underwriting Profit Ratio

10.0

5.0

0.0

–5.0

–10.0

–15.0

–20.0

Percent

Figure 6

U.S. Property-Casualty Insurance Industry Underwriting Profit and Overall Profit Ratios

SOURCE: A.M. Best Company, Best’s Aggregates and Averages (various years).

9 It is also noteworthy that the underwriting profit ratio is negativemost of the time. This is an expected result in terms of insurancefinancial pricing theory. Premiums reflect the expected discountedvalue of claims and operating expenses, whereas losses and expenseare reported at undiscounted values. Hence, even under normalcircumstances, an underwriting loss is the expected outcome.

of 2001, and the prices in umbrella liability andcommercial property insurance spiked after 9/11.However, beginning in early 2002, commercialinsurance prices began to decline sharply, reflect-ing a softening of the market caused by inflowsof new capital and improved underwritingprofitability.

The underwriting cycle interacts with thelevel of capitalization in the industry. A relativemeasure of capitalization is provided by the pre-miums-to-surplus ratio, the most widely usedmeasure of leverage for this industry.10 The pre-miums-to-surplus ratio since 1980 is graphed inFigure 8. The ratio was about 1.5 in the early 1980sand then declined steadily to less than 0.7 in 1999,before increasing again as a result of the hardmarket and 9/11 claims in the early 2000s. Thesharp decline during the 1990s has been attributedto over-capitalization in the industry as well asthe need for additional capital brought about byhigher loss volatility, particularly in liability and

property catastrophe insurance (Cummins andNini, 2002). Deterioration in the premiums-to-surplus ratio is often associated with the onset ofa hard-market phase of the cycle.

Because profitability in reinsurance marketsmirrors the results in primary insurance marketsand because underwriting cycles also exist inmost other industrialized countries, the globalreinsurance market is also subject to underwritingcycles.11 The cycle in the worldwide catastrophereinsurance market is shown in Figure 9, whichplots the rate-on-line index in this market. Therate-on-line is a price measure defined as thepremium for a reinsurance policy divided by themaximum possible payout under the policy.The index increased from 100 in 1990 to approxi-mately 375 in 1993, primarily due to HurricaneAndrew. The index then declined steadily until1999 and increased sharply following the WTCattack and a general hardening of insurancemarkets into the early 2000s. The decline after

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1999

:Q4

2000

:Q1

2000

:Q2

2000

:Q3

2000

:Q4

2001

:Q1

Commercial Auto

Commercial Property

General Liability

Umbrella

Workers’ Compensation

Terrorism

60

50

40

30

20

10

0

–10

–20

Percent Change

2001

:Q2

2001

:Q3

2001

:Q4

2002

:Q1

2002

:Q2

2002

:Q3

2002

:Q4

2003

:Q1

2003

:Q2

2003

:Q3

2003

:Q4

2004

:Q1

2004

:Q2

2004

:Q3

2004

:Q4

2005

:Q1

2005

:Q2

Figure 7

Commercial Property-Casualty Premium Rate Changes by Line

SOURCE: Council of Insurance Agents and Brokers.

10 Surplus or policyholders’ surplus is the industry’s terminologyfor equity capital.

11 For further discussion of the role of reinsurance in cycles andcrises, see Berger, Cummins, and Tennyson (1992).

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1.6

1.5

1.4

1.3

1.2

1.1

1

0.9

0.8

0.7

0.6

Premiums/Surplus Ratio

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Figure 8

Property-Casualty Insurance Industry: Premiums-to-Surplus Ratio

SOURCE: A.M. Best Company, Best’s Aggregates and Averages (various years).

400

350

300

250

200

150

100

50

01990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Index 1990 = 100

Figure 9

World Rate-On-Line Index: Catastrophe Reinsurance

SOURCE: Guy Carpenter (2005).

Andrew reflected improvements in catastrophemodeling and exposure management in theindustry as well as significant inflows of newequity capital, particularly into new and pre-existing insurers located in Bermuda.

Further evidence of the reinsurance under-writing cycle is shown in Figure 10, which plotsthe combined ratio and return-on-revenue ratiofor the global non-life reinsurance industry.12 Thecombined ratio spiked at about 115 in 1992 andagain at nearly 130 in 2001; and the return onrevenue, which also reflects investment earnings,tends to be the reverse mirror image of the com-bined ratio. The losses incurred during crisis

periods lead reinsurers to raise prices and restrictsupply while they recapitalize and reevaluatepricing and exposure management strategies.

The existence of cycles and crises impliesthat the insurance industry goes through periodswhen risk-bearing capacity is limited. Althoughusually triggered by high-volatility lines of busi-ness, the effects of a hard market extend to all linesof business including generally predictable linessuch as automobile insurance and workers com-pensation. Thus, capacity shortages can occureven in high-frequency, low-severity lines ofinsurance, emphasizing the difficulty faced bythe industry in consistently providing capacityfor low-frequency, high-severity losses.

PUBLIC AND PRIVATE SECTORSOLUTIONS TO FINANCINGCATASTROPHIC RISK

This section discusses public and privatesector solutions to financing the risks of natural

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12 The combined ratio is the sum of the loss ratio (losses and loss-adjustment expenses incurred/premiums earned) and the expenseratio (underwriting expenses incurred/premiums written). Theratio is a commonly used measure of underwriting profitability.Return on revenue is analogous but not identical to the overallprofit ratio. Return on revenue is defined as pretax operatingincome/total revenue. Pretax operating income is underwritingprofit (or loss) + net investment income + other income. Net realizedgains or losses are excluded from pretax income. Total revenue isequal to net premiums earned + net investment income + otherincome. See Standard and Poor’s (2005, p. 47).

140

120

100

80

60

40

20

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Combined Ratio

Return on Revenue

0

Combined Ratio

15

10

5

0

–5

–10

Return on Revenue (Percent)

Figure 10

Global Non-Life Reinsurance Industry: Financial Performance

SOURCE: Standard and Poor’s, Global Reinsurance Highlights (2005).

catastrophes and terrorism, beginning with thesecuritization of catastrophic risk. Public sectorsolutions to the catastrophic-risk problem are thendiscussed, including a review of public sectormechanisms currently in place in the UnitedStates and other industrialized nations. The sec-tion concludes with an evaluation of TRIA andrecommendations regarding the need for govern-mental involvement in the future.

CAT Bonds

Following Hurricane Andrew in 1992, effortsbegan to access securities markets directly as amechanism for financing future catastrophicevents. The first contracts were launched by theChicago Board of Trade, which introduced catas-trophe futures in 1992 and later introduced catas-trophe put and call options. The options werebased on aggregate catastrophe-loss indices com-piled by Property Claims Services, an insuranceindustry statistical agent.13 The contracts werelater withdrawn because of lack of trading volume.Insurers had little interest in the contracts for var-ious reasons, including the thinness of the market,possible counterparty risk on the occurrence of amajor catastrophe, and the potential for disruptinglong-term relationships with reinsurers. Anotherconcern was that the contracts were subject toexcessive basis risk; that is, the risk that payoffsunder the contracts would be insufficiently cor-related with insurer losses. A study by Cummins,Lalonde, and Phillips (2004) confirms that basisrisk was a legitimate concern. They found thatmost insurers could not hedge their exposure toFlorida hurricane risk very effectively using astatewide index but that all but the smallestinsurers could hedge effectively using four intra-Florida regional indices.

Another early attempt at securitizationinvolved contingent notes known as “Act of God”bonds. In 1995, Nationwide issued $400 millionin contingent notes through a special trust,Nationwide Contingent Surplus Note Trust.Proceeds from the sale of the bonds were investedin 10-year Treasury securities, and investors were

provided with a coupon payment equal to 220basis points over that of Treasuries. Embedded inthese contingent capital notes was a “substitutabil-ity” option for Nationwide. Given a prespecifiedevent that depleted Nationwide’s equity capital,Nationwide could substitute up to $400 millionof surplus notes for the Treasuries in the trust atany time during a 10-year period for any “businessreason,” with the surplus notes carrying a couponof 9.22 percent.14 Although two other insurersissued similar notes, this type of structure did notachieve a significant segregation of Nationwide’sliabilities, leaving investors exposed to the generalbusiness risk of the insurer and to the risk thatNationwide might default on the notes.

The structure that has achieved a greaterdegree of success is the CAT bond. CAT bondswere modeled on asset-backed-security transac-tions that have been executed for a wide varietyof financial assets including mortgage loans, auto-mobile loans, aircraft leases, and student loans.The first successful CAT bond was an $85 millionissue by Hannover Re in 1994 (Swiss Re, 2001).The first CAT bond issued by a nonfinancial firm,occurring in 1999, covered earthquake losses inthe Tokyo region for Oriental Land Company, theowner of Tokyo Disneyland.

A CAT bond structure is shown in Figure 11.The transaction begins with the formation of asingle purpose reinsurer (SPR). The SPR issuesbonds to investors and invests the proceeds insafe securities such as Treasury bonds. Embeddedin the bonds is a call option that is triggered by adefined catastrophic event. On the occurrence ofthe event, proceeds are released from the SPV tohelp the insurer pay claims arising from the event.In most bonds issued to date, the principal is fullyat risk; that is, if the contingent event is suffi-ciently large, the investors could lose the entireprincipal in the SPV. In return for the option, theinsurer pays a premium to the investors. The fixedreturns on the Treasuries are usually swappedfor floating returns based on LIBOR or someother widely accepted index. Consequently, the

14 Surplus notes are debt securities issued by mutual insurancecompanies that regulators treat as equity capital for statutoryaccounting purposes. The issuance of such notes requires regulatoryapproval.

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13 Contracts were available based on a national index, five regionalindices, and three state indices for California, Florida, and Texas.

investors receive LIBOR plus the risk premiumin return for providing capital to the trust. If nocontingent event occurs during the term of thebonds, the principal is returned to the investorsupon the expiration of the bonds.

Insurers prefer to use an SPR to capture thetax and accounting benefits associated with tradi-tional reinsurance.15 Investors prefer SPRs to iso-late the risk of their investment from the generalbusiness and insolvency risks of the insurer,thus creating an investment that is a “pure play”in catastrophic risk. As a result, the issuer of thesecuritization can realize lower financing coststhrough segregation. The transaction also is moretransparent than a debt issue by the insurer,because the funds are held in trust and are releasedaccording to carefully defined criteria. The bondsalso are attractive to investors because catastrophicevents have low correlations with returns fromsecurities markets and hence are valuable fordiversification purposes (Litzenberger, Beaglehole,and Reynolds, 1996). Although the $100-billion-

plus “Big One” hurricane or earthquake coulddrive down securities prices, creating systematicrisk for CAT securities, this systematic risk isconsiderably lower than for most other types ofassets, especially during more normal periods.

In the absence of a traded underlying asset,insurance-linked securities have been structuredto pay-off on three types of variables: insurance-industry catastrophe loss indices, insurer-specificcatastrophe losses, and parametric indices basedon the physical characteristics of catastrophicevents. The choice of a triggering variable involvesa trade-off between moral hazard and basis risk.Securities based on insurer-specific (or hedger-specific) losses, often called indemnity CAT bonds,have no basis risk but expose investors to moralhazard; whereas securities based on industry lossindices or parametric triggers greatly reduce moralhazard but expose hedgers to basis risk.

CAT bonds are an innovative financing solu-tion.16 However, although there have been approx-imately 120 bonds issued to date, the amount ofrisk capital that has been raised remains small

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15 Harrington and Niehaus (2003) argue that an important advantageof CAT bonds as a financing mechanism is that corporate tax costsare lower for CAT bonds than for financing through equity; also,CAT bonds pose less risk in terms of potential future degradationsof insurer financial ratings and capital structure than financingthrough subordinated debt.

Figure 11

CAT Bond with a Single Purpose Reinsurer

Insurer SPR Investors

SwapCounterparty

Premium + X Principal

Call Option

SPR Proceeds

Contingent Payment

Principal & Interest

LIBOR – XFixed InterestReturn

16 However, the concept is actually not a new one. It is similar to thepractice of bottomry, which dates at least to classical Greek andRoman times. In a bottomry contract, the lender extended a loanto finance a voyage. If the ship returned to port, the loan was repaidwith interest, but if the ship sank, the loan was forgiven.

relative to the global reinsurance market. Thenumber of issues and risk capital raised are shownin Figure 12, which shows a total of about $10billion raised by March 2005. In comparison, theequity capital of the global reinsurance industryand the U.S. property-casualty insurance industryare approximately $350 billion and $400 billion,respectively. However, the potential for the use ofsecurities markets to finance catastrophic risk issignificant. The amount of asset-backed securitiesoutstanding is nearly $2 trillion (Bond MarketAssociation, 2006).

Because of the as-yet unrealized potential ofthe CAT bond market, it is of interest to explorethe possible reasons for the limited amount ofrisk capital raised to date. One possible explana-tion is that the bonds appear expensive relativeto conventional reinsurance. Structuring a CATbond deal requires significant expenditures onprofessional expertise from investment bankers,accountants, actuaries, and lawyers. In addition,the spreads on the bonds have tended to be high—often several times the expected losses on thebonds.17

Possible explanations for the high-risk premiaon the bonds include investor unfamiliarity withthe contracts (a “novelty” premium), the low liq-uidity of the contracts issued to date (a liquiditypremium), and investor uncertainty about theaccuracy of the models used to estimate expectedlosses of the reinsurance (a “model risk” pre-mium).18 In addition, although the catastrophicevents observed in the United States before themid-1990s have been uncorrelated with returnsin securities markets, this may not be true of amega-earthquake in California or even a hurricaneof the magnitude of Katrina. Thus, the spreadsmay also reflect a “stealth beta” premium.

17 Cummins, Lalonde, and Phillips (2004) tabulate spreads on CATbonds issued from 1997 through March of 2000 and find that themedian ratio of bond spread to expected loss is 6.77.

18 The expected losses under CAT bonds are estimated by catastrophemodeling firms such as Applied Insurance Research and RiskManagement Solutions. These firms have developed elaborate andhighly sophisticated simulation models that simulate catastrophicevents using meteorological and seismological models along withactuarial and other modeling approaches. They have constructedextensive data bases on the value of property exposed to loss inthe United States and other major countries.

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Volume

Number of Deals

Pre-3/1998

2,000

1,800

1,600

1,400

1,200

1,000

800

600

0

30

25

20

15

10

5

0

$ Millions Number of Deals

400

200

4/1998 to3/1999

4/1999 to3/2000

4/2000 to3/2001

4/2001 to3/2002

4/2002 to3/2003

4/2003 to3/2004

4/2004 to3/2005

Figure 12

CAT Bonds: New-Issue Volume and Number of Deals, 1998-2005

SOURCE: Lane Financial (2005).

Although CAT bonds seem to sell at highpremiums over expected losses, in fact, prices ofconventional excess-of-loss reinsurance also tendto have high spreads. Froot (2001) documentsspreads up to seven times expected losses duringthe period 1989-98 in the catastrophe reinsur-ance market. Thus, it is more likely that the highspreads are due to the fact that catastrophe riskis expensive to hedge rather than due to a pecu-liarity of CAT bonds per se. Moreover, the costsof financing catastrophe risk through CAT bondshave been declining. Investment banks have suc-ceeded in reducing transactions costs as they havegained experience with insurance-linked securi-tizations, and the spreads on the bonds have fallenover time. This is shown in Figure 13, which plotsthe average spread on CAT bonds and the averageexpected loss on the left axis and the ratio of thespread to the expected loss on the right axis, fromthe third quarter of 2001 through the fourth quar-ter of 2004. Spreads were averaging 600 basispoints at the beginning of the period shown buthad declined to about 450 basis points by the end

of 2004. In addition, the ratio of the spread to theexpected loss declined from around 7 in 2001:Q3to about 3.5 in 2004:Q4.

Another rationale sometimes given for thelimited size of the CAT bond market is lack ofinvestor interest. Although that may have beentrue at one time, recent data suggest that thereis broad market interest in CAT bonds amonginstitutional investors. Figure 14 shows the per-centage of new issue volume by investor type in1999 and 2004. In 1999, insurers and reinsurerswere among the leading investors in the bonds,accounting for more than 50 percent of the market;that is, insurers were very prominent on both thesupply and demand sides of the market. However,in 2004, insurers and reinsurers accounted foronly 7 percent of demand. Money managers andhedge funds bought 56 percent of the 2004 bondissues, and dedicated CAT bond mutual fundsaccounted for 33 percent. The declining spreadsand increasingly broad market interest in thebonds provide some indication that the bondsmay begin to play a more important role relativeto conventional reinsurance.

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Yields

Expected Loss

Yield/Expected Loss

7

6

5

4

3

2

1

0

Percent

2001

:Q3

2001

:Q4

2002

:Q1

2002

:Q2

2002

:Q3

2002

:Q4

2003

:Q1

2003

:Q2

2003

:Q3

2003

:Q4

2004

:Q1

2004

:Q2

2004

:Q3

2004

:Q4

7

6

5

4

3

2

1

0

Yield/Expected Loss

8

Figure 13

CAT Bonds Absolute and Relative Yields

SOURCE: Lane Financial (2005).

There are also regulatory and accountingissues that may be impeding the more wide-spread usage of CAT bonds. U.S. insurance regu-lators have two concerns about CAT bonds: (i)non-indemnity CAT bonds may expose insurersto excessive basis risk and (ii) insurers may usesecuritized risk instruments as speculative invest-ments. As a result, some regulators may deny rein-surance accounting treatment for non-indemnityCAT bonds. Fortunately, however, it is relativelystraightforward to satisfy both concerns and avoidregulatory problems. Contracts can be structuredto pay-off on narrowly defined geographicalindices or combinations of indices that are highlycorrelated with the insurer’s losses. Concerns aboutspeculative investing can be addressed throughdual-trigger contracts, where two triggers have tobe satisfied for the insurer to collect, one basedon an industry loss index and the second basedon the insurer’s own losses from the event. Theinsurer’s payoff is based on its ultimate net loss,a familiar reinsurance concept equal to theinsurer’s total loss from an event less collectionsunder reinsurance contracts.19

A second potential issue mentioned in somediscussions is uncertainty about whether SPRsneed to be consolidated on insurers’ GAAP (gen-erally accepted accounting principles) financialstatements under new rules regarding “variableinterest entities” (VIEs) that were adopted post-Enron. However, based on conversations withindustry experts, it appears that properly struc-tured CAT bonds do not encounter problems fromVIE rules. With the usual CAT bond structureshown in Figure 11, the SPR is a VIE, but the vari-ability (uncertainty about the payoff from thestructure to investors) is entirely passed throughto the bond holders. The insurer has no variable(equity ownership) interest but merely pays peri-odic premiums to the SPR and receives a contin-gent payout if the defined event occurs. Finally,although CAT bonds have not been granted thetax-free conduit status that is available in themortgage-backed and asset-backed securitiesmarkets, off-shore CAT bonds do not create tax-

19 This dual-trigger approach was developed in the market forindustry loss warranties, which is a segment of the reinsurancemarket offering this type of contract (McDonnell, 2002).

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0 5 10 15 20 25 30 35 40 50

Money Manager

Dedicated CAT Fund

Hedge Fund

Bank

Reinsurer

Primary Insurer

Percent

2004, 3%1999, 30%

2004, 4%1999, 25%

2004, 4%1999, 5%

2004, 15%1999, 5%

2004, 33%1999, 5%

2004, 40%1999, 30%

Figure 14

CAT Bonds: Percentage of New-Issue Volume Purchased by Investor Type

SOURCE: Swiss Re, Economic Research and Consulting.

able events for the issuing insurer. The insurerdeducts the premium payments to the SPR, andthe bond investors pay taxes on the incomereceived from the SPR in the appropriate jurisdic-tion. Hence, although it would facilitate develop-ment of the market to have the regulatory andaccounting rules simplified and clarified, theserules currently do not constitute insurmountableobstacles to risk-linked securitizations.

Besides the Chicago Board of Trade optionsand CAT bonds, other capital market solutions tothe problem of financing catastrophic loss havebeen introduced, including catastrophe equityputs (Cat-E-Puts). Unlike CAT bonds, Cat-E-Putsare not asset-backed securities but options. Inreturn for a premium paid to the writer of theoption, the insurer obtains the option to issuepreferred stock at a pre-agreed price on the occur-rence of a contingent event. This enables theinsurer to raise equity capital at a favorable priceafter a catastrophe, when its stock price is likelyto be depressed. Cat-E-Puts tend to have lowertransactions costs than CAT bonds because thereis no need to set up an SPR. However, becausethey are not asset-backed, these securities exposethe insurer to counterparty performance risk. Inaddition, issuing the preferred stock can dilutethe value of the firm’s existing shares.20

Government Involvement inCatastrophe Insurance Markets

The difficulties faced by insurance marketsin financing catastrophic risk have given rise topressures for government to become involved inthe market. Government involvement usuallyoccurs when there has been a major failure inprivate insurance markets. In the United States,the federal government provides subsidized floodinsurance; and the current markets for hurricanecoverage in Florida and earthquake insurance inCalifornia exist largely due to state governmentintervention.21 By adopting TRIA, the U.S. govern-

ment intervened to create a market for terrorisminsurance. Governments of several other indus-trialized countries have also intervened in themarkets for catastrophe insurance. This sectionprovides a review of the principal governmentprograms for catastrophe insurance. Becausethese programs are subject to book-length treat-ment elsewhere (e.g., Organisation for EconomicCo-operation and Development [OECD], 2005a,b),the discussion of program characteristics is brief.The discussion also emphasizes the programsadopted in the United States.

Federal Flood Insurance. In the UnitedStates, the federal government provides floodinsurance through the National Flood InsuranceProgram (NFIP), administered by the FederalEmergency Management Agency (FEMA). Theflood program was enacted in 1968 in responseto a market failure in the private flood insurancemarket, where floods were generally viewed asuninsurable because of the concentration of riskin specific areas and the resulting potential forcatastrophes (Moss, 1999). Flood insurance wasviewed from a policy perspective as a way to pre-fund disaster relief and provide incentives forrisk mitigation. This type of insurance is impor-tant because homeowners insurance and othertypes of property insurance policies excludecoverage for floods.

NFIP flood insurance policies are offered atprices that are subsidized for many buyers andare sold through private insurers, although thefederal government bears the risk. The programwas designed to be self-supporting and has theability to borrow from the government to payclaims. The stated objectives of the program are(i) to provide flood insurance coverage to a highproportion of property owners who would benefitfrom such coverage, (ii) to reduce taxpayer-fundeddisaster assistance resulting from floods, and (iii)to reduce flood damage through flood-plain man-agement and enforcement of building standards

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20 For further discussion of capital market approaches to financingcatastrophic risk, see Anderson (2005), Pollner (2001), and Swiss Re(2001). Other innovative solutions, involving hybrids of traditionalreinsurance and newer approaches, are discussed in Cummins(2005).

21 Other states, such as Alabama and Louisiana, have also established

residual market property insurance facilities analogous to the onein Florida; and many other states have Fair Access to InsuranceRequirements (FAIR) residual market plans to provide insuranceto buyers who cannot find coverage in the voluntary insurancemarket. I focus here on the California and Florida plans becauseof their prominence and exposure to large catastrophes.

(Jenkins, 2006). By August 2005, Jenkins (2006)estimated that the NFIP had approximately 4.6million policyholders in 20,000 communities.From 1968 through August of 2005, the NFIP hadpaid $14.6 billion in insurance claims, primarilyfunded by policyholder premium payments.

Although the program might seem to be asuccess (in terms of the amount of coverage pro-vided and claims that have been paid), in fact, theNFIP is badly in need of reform. The program isnot actuarially sound, with some policyholderspaying premiums representing only 35 to 40 per-cent of expected costs (Jenkins, 2006). Followingthe record losses from hurricanes in 2004 and2005, the program is currently bankrupt and couldnot continue to exist in its present state if it werea private insurer. Moreover, the program payssignificant amounts of money to repair or replace“repetitive-loss properties;” that is, propertiesthat receive loss payments of $1,000 or more atleast twice over a 10-year period. It is estimatedthat such properties, which represent only 1 per-cent of covered properties, account for 25 to 30percent of all loss payments (Jenkins, 2006). Insur-ance penetration rates are low, even in the mostflood-prone areas, with as little as 50 percent ofexposed properties covered by insurance. InOrleans Parish, which includes New Orleans, onlyabout 40 percent of properties were covered byflood insurance at the time Katrina struck (Bayot,2005) and coverage rates were even lower in partsof Mississippi. The NFIP also has been criticizedfor not providing effective oversight of the approxi-mately 100 insurance companies and thousandsof insurance agents and claims adjusters whoparticipate in the flood program (Jenkins, 2006).

Reforming the NFIP should become a toppriority for federal disaster planning. Having highrates of flood insurance coverage can significantlyreduce taxpayer-funded disaster-relief paymentsfollowing catastrophes, and charging actuariallysound premiums would provide proper incentivesfor flood-plain management.22 There are twoapproaches that could be taken to reforming theprogram: (i) Continue providing federal flood

insurance but fix the problems with the currentprogram. This would entail charging premiumssufficient to cover both claims and programexpenses and providing a safety cushion to buildup reserves during low-loss years to reduce theneed for federal borrowing during years whencatastrophes occur. Further, other problems identi-fied by the GAO would also need to be rectified.(ii) Adopt a solution with a higher degree of pri-vate sector involvement. This could be done fol-lowing the pattern of the federal terrorism programby requiring private insurers to “make available”private flood insurance policies at actuariallydetermined prices in flood-prone areas. Althoughit is probable that private insurers could providesuch coverage without federal support, by issuingdisaster bonds (similar to CAT bonds) and throughconventional reinsurance solutions, considerationshould be given to providing federal reinsuranceat prices that would be self-supporting in the longrun. The private sector solution is attractive for anumber of reasons, including the relative effi-ciency of insurers in settling insurance claims incomparison with the often chaotic federal responseto disaster relief. Under either solution to NFIPreform, rules should be tightened to eliminaterepetitive-loss properties from the program, andlenders should be required to enforce mandatoryparticipation in the program as a condition forgranting and retaining mortgage loans, as ispresently done for homeowners insurance.

Windstorm Coverage in California andFlorida. Windstorm coverage is presently pro-vided by private insurers through homeownersand other property insurance policies. TheCalifornia and Florida programs are noteworthyin that they do not involve the direct governmentprovision of insurance but the creation of quasi-governmental entities not supported by taxpayers.

Following the 1994 Northridge earthquake,the market for earthquake insurance in Californiacollapsed as private insurers stopped writingcoverage. The California legislature respondedin 1996 by creating a quasi-public entity, theCalifornia Earthquake Authority (CEA), to provideearthquake insurance to Californians. The CEAis not a government agency but operates under

22 For further discussion of the role of insurance in risk mitigation,see Kunreuther (1996).

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constraints mandated by the legislature. Specifi-cally, the policies written by the CEA are earth-quake “mini-policies” designed by the legislaturethat provide less-extensive coverage than providedby private insurers pre-Northridge. The legislaturealso mandated that coverage be provided at soundactuarial prices, although these have been “tem-pered” somewhat to subsidize policyholders inhigh-risk areas. The legislature also required thatthe CEA be funded by capital contributions ofabout $700 million from private insurers licensedin California in lieu of requiring them to writeearthquake insurance. The CEA had claims-payingability of about $6.9 billion at the end of 2004(PricewaterhouseCoopers, 2005). Putting this inperspective, recall that the Northridge earthquakecaused insured losses of $18.5 billion (Table 1).However, because of the mini-policies and becausefewer residences have earthquake insurance nowthan before 1994, it is probable that the CEA couldwithstand damages on the scale of Northridge.

Since the creation of the CEA, private insurershave re-entered the California earthquake market.In 2004, approximately 150 companies wrote non-zero earthquake insurance premiums in California(California Department of Insurance, 2005). Of the$985 million in California earthquake premiumswritten in 2004, however, the CEA accounted for47.3 percent; and private insurers generally writeinsurance in relatively low-risk areas of the state(Jaffee, 2005). Nevertheless, the design of the CEA,and especially its mandate to charge actuariallyjustified premium rates, has had the effect of notcrowding-out the private sector. Something of apuzzle in the California market, however, is thatonly a small proportion of eligible property ownersactually purchase the insurance. In the home-owners market, 33 percent of eligible propertiespurchased earthquake insurance in 1996, theCEA’s first year, but only 13.6 percent had insur-ance in 2003. The rationale usually given for thelow market penetration is that most buyers con-sider the price of insurance too high for the cov-erage provided, even though premiums are closeto the expected losses (Jaffee, 2005).

As in California following Northridge, thehurricane market in Florida was significantly

destabilized by Hurricane Andrew in 1992.23 Inresponse to insurer attempts to withdraw andreprice windstorm coverage following the event,the state placed restrictions on the ability ofinsurers to decline renewal of policies and toincrease rates. To provide an escape valve forpolicyholders who were unable to obtain coverage,the state created the Florida Residential Propertyand Casualty Joint Underwriting Association(FRPCJUA), a residual market facility. Insurersdoing business in the state were required to bemembers of the facility, which insured peopleand businesses who could not obtain propertycoverage from the voluntary insurance market.The FRPCJUA was empowered to assess insurersif premiums were not sufficient to pay claims,and there was no explicit government backing.A similar residual market facility was formed toprovide “wind only” coverage along the coast—the Florida Windstorm Underwriting Association.

In 2002, the two residual market plans weremerged to form the Citizens Property InsuranceCorporation, a tax-exempt entity that providescoverage to Floridian consumers and businesseswho cannot find coverage in the voluntary market.Citizens operates like an insurance company incharging premiums, issuing policies, and payingclaims. If premiums are insufficient, it has theauthority to assess insurers doing business in thestate to cover the shortfall. It also has the abilityto issue tax-exempt bonds if necessary. Citizenswas severely stressed by the four hurricanes thathit Florida in 2004, as it struggled to handle themassive numbers of claims that were filed. In2004, Citizens wrote $1.4 billion in premiums,accounting for 34 percent of the Florida propertyinsurance market. Unlike California earthquakeinsurance, the market penetration of propertyinsurance coverage in Florida is very high, in partbecause mortgage lenders require mortgagors topurchase insurance.

To provide additional claims-paying capacity,Florida also created the Florida HurricaneCatastrophe Fund (FHCF), a state-run catastrophereinsurance fund designed to assist insurers writ-

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23 For further economic analysis of the Florida windstorm insurancemarket, see Grace, Klein, and Liu (2006).

ing property insurance in Florida. Insurers writingresidential and commercial property insurancein the state are required to purchase reinsurancefrom the FHCF based on their exposure to hurri-cane losses in the state. The FHCF does not havestate financial backing. However, it is operated asa state agency and is exempt from federal incometaxes, enabling it to accumulate funds more rap-idly than private insurers. In addition, the fundhas the authority to assess member insurers withinlimits in case premiums and reserve funds areinsufficient and also has the ability to issue tax-exempt bonds. The catastrophe reinsurance issuedby the fund kicks in after an industry retentionof $4.5 billion, and the fund has claims-payingability of about $15 billion. The FHCF helped tostabilize the property insurance market followingthe 2004 hurricane season and Hurricane Wilmain 2005.

The California and Florida experience showsthat government can play an important role inmaking insurance available without directly com-mitting taxpayer funding. These programs alsohave the virtue of not crowding-out private insur-ers, although it is possible that the mandatorypurchase feature of the FHCF may have crowded-out some private reinsurance. However, becausethese are government-mandated and -designedprograms, they probably are not as efficient aspurely private market solutions.

Terrorism Insurance. Prior to the September 11, 2001, terrorist attacks, terrorismwas generally covered by most property-casualtyinsurance policies. In fact, the risk was consid-ered so minimal by insurers that terrorism wasusually included at no explicit price. Likewise,reinsurers generally covered primary companiesfor terrorism as part of their reinsurance coverage;and reinsurers paid most of the claims resultingfrom the WTC attack. After 9/11, however, rein-surers began writing terrorism exclusions intotheir policies, leaving primary insurers with vir-tually no opportunity to reinsure their exposure.As a result, the primary insurers sought to writeterrorism exclusions into their own policies.Recognizing that substantial exposure to terrorismrisk without adequate reinsurance could pose

insolvency risks, state insurance regulators rap-idly approved terrorism exclusions. By early2002, insurance regulators in 45 states allowedinsurers to exclude terrorism coverage from mostof their commercial insurance policies.24

In February 2002, the Government AccountingOffice (GAO) gave congressional testimony pro-viding “examples of large projects canceling orexperiencing delays...with the lack of terrorismcoverage being cited as the principal contributingfactor” (Hillman, 2002, p. 9). According to a surveyby the Council of Insurance Agents and Brokers,in the first quarter of 2002, the market for property-casualty insurance experienced “sharply higherpremiums, higher deductibles, lower limits andrestricted capacity from coast to coast and acrossthe major lines of commercial insurance.”25 InNovember 2002, Congress responded to theseproblems by passing TRIA. Through TRIA, thefederal government required property-casualtyinsurers to offer or “make available” terrorisminsurance to commercial insurance customersand created a federal reinsurance backstop forterrorism claims.

TRIA established the Terrorism InsuranceProgram within the Department of the Treasury.The program, which has been extended throughDecember 31, 2007, covers commercial property-casualty insurance—all insurers operating in theUnited States are required to participate. Insurersare required to “make available property andcasualty insurance coverage for insured lossesthat does not differ materially from the terms,amounts, and other coverage limitations applicableto losses arising from events other than terrorism”(U.S. Congress, 2002, p. 7). The legislation thusnullified state terrorism exclusions and requiresthat insurers offer terrorism coverage. The wordingof the Act implicitly omits coverage of chemical,biological, radiological, and nuclear (CBRN) haz-

24 An exception to the general exclusion of terrorism from commercialinsurance policies following 9/11 is coverage for workers-compensation insurance, which is mandated by state law to coverwork injuries from all causes. The states did not revise the workers-compensation laws to allow terrorism exclusions. Terrorism exclu-sion also were not introduced for personal-lines policies such asautomobile and homeowners insurance.

25 Council of Insurance Agents and Brokers (2002).

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ards, which are not covered by most commercialproperty-casualty policies.26

For the federal government to provide pay-ment under TRIA, the Secretary of the Treasurymust certify that a loss was due to an act of ter-rorism, defined as a violent act or an act that isdangerous to human life, property, or infrastruc-ture, and to have “been committed by an individ-ual or individuals acting on behalf of any foreignperson or foreign interest, as part of an effort tocoerce the civilian population of the United States

or to influence the policy…of the United StatesGovernment by coercion” (U.S. Congress, 2002,p. 3). Acts of war are excluded, and losses fromany terrorist act must exceed a specified monetarythreshold before the Act takes effect. The thresh-old was originally $5 million, increasing to $50million in 2006 and $100 million in 2007.

If a loss meets these requirements, the loss isshared by the insurance industry and the federalgovernment under the deductible, copayment, andrecoupment provisions of the Act. The coveragestructure of the Act is diagramed in Figure 15. In2005, each individual insurer had a terrorisminsurance deductible of 15 percent of its directearned premiums from the prior calendar year,which increases to 17.5 percent in 2006 and 20

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Figure 15

Coverage Under the TRIA of 2002

NOTE: TRIA as extended by the Terrorism Risk Insurance Extension Act of 2005.

SOURCE: GAO (2004), Marsh (2005b).

Overall Liability Limit = $100 Billion

Federal Share90% in 2005-06, 85% in 2007,with Discretionary Recoupment

Program Trigger$ 5 Million in 2005$ 50 Million in 2006$100 Million in 2007

Insurer Maximum Loss$32.5 Billion in 2006$37.4 Billion in 2007

Insu

rer

Shar

e10

% in

200

6,15

% in

200

7

Deductible and Mandatory RecoupmentDeductible (% of Premiums): 15% in 2005, 17.5% in 2006, 20% in 2007Aggregate Retention Limit: $15B in 2005, $25B in 2006, $27.5B in 2007

26 The TRIA Extension Act in 2005 excluded some types of commer-cial insurance that had been covered under the original TRIA.Specifically, coverage was eliminated for commercial auto, burglary,surety, professional liability, and farmowners multiple-peril insur-ance (Marsh, 2005b).

percent in 2007. Above the deductible, the federalgovernment pays for 90 percent of all insuredlosses in 2005-06, decreasing to 85 percent in2007. However, the law provides for mandatoryrecoupment of the federal share of losses up tothe level of the “insurance marketplace aggregateretention,” which is $15 billion in 2005, $25billion in 2006, and $27.5 billion in 2007. Thisrecoupment is to occur through premium sur-charges on property-casualty insurance policiesin force after the event, with a maximum surchargeof 3 percent of premiums per year. In addition,the Secretary of the Treasury has the discretionto demand additional recoupment, taking intoaccount the cost to taxpayers, the economic con-ditions of the commercial marketplace, and otherfactors. In other words, the Secretary of theTreasury could choose to recoup 100 percent offederal outlays under this program through expost premium surcharges. The total, combinedliability of the government and private insurersis capped at $100 billion.

In both 2006 and 2007, insurers are exposedto potentially large losses under TRIA. As shownin Figure 15, the deductible and recoupment pro-visions expose insurers to possible losses as highas $32.5 billion in 2006 and $37.4 billion in 2007.Although these losses would be large by historicalstandards, they are of the same order of magnitudeas the losses from the World Trade Center andKatrina, which the industry was able to absorb.In addition, the analysis of Cummins, Doherty,and Lo (2002) suggests that the industry couldsustain losses of this magnitude without destabi-lizing insurance markets.

Government Catastrophe Insurance in OtherCountries. This section provides a brief overviewof the government role in catastrophe insurancein other countries based on OECD (2005a,b), GAO(2005), and other sources. Natural disaster pro-grams are discussed first, followed by terrorism.

In many OECD countries, governments usetax revenues to establish prefunded disaster-relieffunds. This approach is used in countries suchas Australia, Denmark, Mexico, the Netherlands,Norway, and Poland (Freeman and Scott, 2005).In several of these countries, the government pro-vides compensation only for losses that cannot

be privately insured. This approach is somewhatsimilar to the disaster-relief funding provided bythe federal government in the United States.

Several countries have established governmentinsurance programs to provide coverage for naturaldisasters. The government collects premiums inreturn for the coverage, and private insurers gen-erally market the policies and handle claims settle-ment and other administrative details. An exampleis Consorcio de Compensacion de Seguros (CCS),which was established by the Spanish governmentin 1954. CCS is a public corporation that providesinsurance for “extraordinary risks,” includingboth natural catastrophes and terrorism. Theextraordinary risks coverage is mandatory and isprovided as an add-on to private market propertyinsurance policies. A premium is collected forthe coverage, which is passed along to CCS bythe private insurers.

Another approach, somewhat similar to TRIA,is for the government to act as a reinsurer ratherthan a primary insurer as it does in Spain. Anexample is France, which has two programs,the National Disaster Compensation Schemeand Fonds National de Garantie des CalamitesAgricoles. The former is backed by a state-guaranteed public reinsurance program, CaisseCentrale de Reassurance (CCR), which providesunlimited government backing for catastrophelosses. Catastrophe insurance is mandatory forall private non-life insurance policies. Insurerscan then reinsure the risk with CCR, which essen-tially serves as reinsurer of last resort. Premiumsurcharges for the catastrophe insurance are setby the French government.

Another example of the government as rein-surer is provided by the Japan EarthquakeReinsurance Company, which reinsures naturalhazards such as earthquakes and tsunamis inJapan. All earthquake insurance written by privateinsurers in Japan is reinsured with the JapanEarthquake Reinsurance Company. Reinsurancecoverage is based on a layering approach, suchthat 100 percent of the loss in the lowest-loss layer,up to 75 billion yen, is borne by private insurers;the loss is split evenly between private insurersand the government when the loss is between 75billion and 1.0774 trillion yen; and 95 percent of

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the loss is paid by the government when the lossis between 1.0774 and 4.5 billion yen (Freemanand Scott, 2005).

According to the OECD (2005b), there aregovernment terrorism insurance programs ineight OECD countries: Australia, Austria, France,Germany, the Netherlands, Spain, the UnitedKingdom, and the United States. All of the pro-grams were established after the September 11,2001, terrorist attacks except for the Spanish pro-gram, where coverage is provided by CCS, andthe U.K. program, which was established in 1993in response to Irish Republican Army terroristattacks. The programs vary along several importantdimensions, including coverage layers andamounts, the limitations on the liability of privateinsurers, whether a premium is charged for thegovernment reinsurance, and whether the plan istemporary or permanent. In the following, I giveexamples based on the most prominent plansrather than providing a comprehensive analysis.

In December 2001, a new reinsurer calledGestion de l’Assurance et de la Reassurance desRisques Attentats et Actes de Terrorisme(GAREAT) was established in France to reinsureterrorism risk insurance written by private insur-ers. The French government acts as reinsurer oflast resort, providing unlimited reinsurance cov-erage through CCR. As is common in conventionalcatastrophe reinsurance, government terrorismreinsurance coverage is provided in a sequenceof layers. The first layer of 400 million euros ofcoverage is provided by the private insurers whoparticipate in GAREAT. As of 2005, there are twolayers of private market reinsurance: The first layerprovides limits of 1.2 billion euros in excess ofthe 400 million euro primary layer, and the secondlayer provides 400 million euros in excess of 1.6billion euros. Above 2 billion euros, unlimitedcoverage backed by a government guarantee isprovided by CCR. As with other catastrophe insur-ance in France, terrorism coverage is mandatoryfor all property insurance. A premium is collectedfor the government reinsurance, which is remittedto the government. GAREAT is set to expire at theend of 2006 (Michel-Kerjan and Pedell, 2005).

In Spain, terrorism insurance is providedunder the CCS program. Therefore, it is mandatory

for all non-life insurance. There is no layering.All extraordinary risks coverage is ceded to CCS,which is backed by an unlimited government guar-antee. Policyholders pay a premium surchargefor the coverage provided by CCS, including ter-rorism coverage. The program is permanent.

In Germany, a specialist insurer, EXTREMUS,was established in 2002 to provide terrorisminsurance. The program is set to terminate at theend of 2007. Coverage is not mandatory inGermany, and demand for terrorism insurance isreportedly very low. The first 2 billion euros ofcoverage is provided by private insurers and rein-surers, and there is excess reinsurance coverage(8 billion euros in excess of 2 billion euros) pro-vided by the German government in return for apremium. The annual maximum indemnity foreach client is limited to 1.5 billion euros.

In the United Kingdom, a mutual reinsurancecompany, Pool Re, was established in 1993 toprovide terrorism reinsurance to insurers writinginsurance in the United Kingdom. Pool Re has aretrocession arrangement with the British Treasuryto provide the ultimate layer of reinsurance. Thefirst layer of coverage is provided by primaryinsurers, up to 75 million pounds per event or150 million pounds per year (in 2005), industry-wide. Coverage is then provided by Pool Re upto the full amount of its resources. Coverage forevents that exhaust the funds in Pool Re is pro-vided by the government in return for a premium.

Among the eight OECD terrorism programscovered in OECD (2005b), only Austria’s doesnot involve some form of government insurance.Among the seven programs with government back-ing, five are temporary and four have fixed expira-tion dates. Government reinsurance is unlimitedin France, Spain, and the United Kingdom. Amongthe countries with limits on the liability of thegovernment reinsurance, the highest limit is inthe U.S. TRIA program. Among the programs withgovernment backing, only the U.S. programdoes not charge a premium for the reinsurance,although the Secretary of the Treasury has theauthority to seek recoupment of losses exceedingthe industry participation limits. The lack of apremium is a defect in the U.S. program becauseit has the effect of crowding-out private reinsurers,who cannot compete with free coverage.

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An Evaluation of TRIA. In making the casefor TRIA, the president of the United States,Congress, and business leaders argued that thelack of terrorism insurance was having an adverseeffect on important segments of the economy,citing cancelled or postponed construction proj-ects, downgrades of commercial and multi-familymortgage securities, and other deleterious effects.However, the evidence was mostly anecdotaland solid evidence of a macroeconomic impactfrom the restrictions on terrorism insurance dur-ing 2002 has been hard to find. One paper thatlooked at several macroeconomic time series,such as bank construction lending and new con-struction put in place, did not find any notice-able interruption in trends that had existed beforeSeptember 11, 2001 (Brown et al., 2004).27

Nevertheless, the general assumption has beenthat restrictions on terrorism insurance are bad

for the economy, providing a rationale for afederal role. This section briefly considers themacroeconomic impact of TRIA, analyzes TRIA’ssuccess in restoring the market for terrorisminsurance, and evaluates the likely impact ifTRIA eventually expires.

Brown et al. (2004) provide evidence on theexpected economic effects of TRIA by investigatingthe stock price reaction to the Act’s adoption onthe industries most likely to be affected by terror-ism insurance. They conduct a standard eventstudy of 11 TRIA-related news announcements,culminating in the president signing the bill intolaw on November 26, 2002. The stock price impacton affected industries of the bill’s passage byCongress on November 20, 2002, is representativeof the general conclusions of the study. The results,shown in Figure 16, reveal that TRIA’s passagehad an adverse impact on the stock prices of firmsin the insurance, banking, real estate investmenttrusts, and transportation industries and a negativelong-window impact on public utilities. Only inthe construction industry is there any evidenceof a positive stock price impact from TRIA, and

27 A paper by Hubbard and Deal (2004) purports to show that theexpiration of TRIA would have a significant adverse impact onthe macroeconomy. However, the paper appears to have beenwritten as an advocacy document, and the analysis is not veryconvincing.

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Pro

per

ty a

nd C

asua

lty

Life

Age

nts

Insu

ranc

e To

tal

Rea

l Est

ate

Inve

stm

ent

Trus

ts

Co

nstr

ucti

on

Tran

spo

rtat

ion

Uti

litie

s

Ban

ks

(–1, +1)

(–5, +5)

(–10, +10)

4.0

2.0

0.0

–2.0

–4.0

–6.0

–8.0

–10.0

Percent

Figure 16

Stock Price Impact of the Passage of TRIA (11/20/2002)

SOURCE: Brown et al. (2004).

this effect is not statistically significant. Theresults imply that TRIA’s passage caused the stockmarket to reduce its estimates of expected futurecash flows in nearly all affected industries.

It is relatively easy to explain the negativestock price reaction of property-casualty insurersto the passage of TRIA. Prior to TRIA, the avail-ability of terrorism insurance was sharply cur-tailed, revealing that many insurers did not believethey could write terrorism insurance at a profit.TRIA nullified most coverage restrictions andrequired insurers to offer coverage that they didnot want to provide and, moreover, exposed insur-ers to significant potential losses from TRIA’sdeductible, copayment, and recoupment provi-sions. Although TRIA left the pricing of terrorisminsurance to the private market, states regulateinsurance prices; and attempts by insurers toavoid providing coverage by offering insuranceat excessive prices would attract adverse regula-tory attention. Thus, as shown further below, aconsiderable amount of terrorism insurance hasbeen offered under TRIA that probably wouldnot have been available without TRIA’s “makeavailable” rule.

Because the purchase of terrorism insuranceis not mandatory under TRIA, it is more difficultto explain the adverse stock price reaction inindustries that are buyers rather than sellers ofinsurance. At first glance, the Act provided firmsin these industries with a no-obligation option tobuy terrorism insurance that may not have beenavailable otherwise. However, a more careful lookreveals some possible reasons for the negativestock price reaction. Brown et al. (2004) providetwo possible explanations. A first explanation isa type of “Samaritan’s dilemma” problem. That is,the Act may have reduced market expectationswith respect to future federal assistance for firmsand industries affected by terrorist events bysubstituting a federal reinsurance program for apotentially more open-ended implicit governmentcommitment. The second explanation is that TRIAmay have created insurance market inefficienciesby impeding the development of more-efficientprivate market mechanisms for financing terrorismlosses, especially because no premium is chargedfor the federal reinsurance. A third possible

explanation, which conflicts somewhat withthe Samaritan’s dilemma argument, is that TRIAimplicitly excludes coverage for CBRN hazards,which have the potential to cause the most severelosses.

Although initial reports indicated that take-uprates (the percentage of buyers who accept insur-ers’ offers of terrorism insurance) under TRIAwere very low, more recent data reveal that signifi-cant amounts of terrorism insurance have beenpurchased under TRIA. Marsh (2004, 2005a) sur-veyed their clients in 2004 and 2005 to provideinformation on terrorism coverage. The resultsare shown in Figure 17, which provides quarterlytake-up rates based on approximately 2,400 Marshclients from 2003:Q2 to 2004:Q4. The take-up rateincreased from 23 percent in 2003:Q2 to 48 percentin 2004:Q4. Thus, the large firms which constituteMarsh’s clientele demonstrated a significantdemand for terrorism insurance, especially in2004.

Further evidence on terrorism insurancetake-up rates is provided by surveys conductedby the U.S. Department of the Treasury (2005) aspart of its congressional mandate to provide anevaluation of TRIA’s effectiveness. The Treasurysurveys are a valuable complement to the Marshsurveys because they also included smaller firms.The results, shown in Figure 18, indicate that thetake-up rate increased from 27 percent in 2002 to54 percent in 2004. This provides further evidencethat a strong demand for terrorism insurance hasexisted under TRIA. The 2002 results are alsoimportant because they reveal that terrorism insur-ance did not disappear between September 11,2001, and the passage of TRIA. In fact, significantamounts of coverage were being offered and pur-chased during this period, even though no federalreinsurance was in effect.

The final source of evidence on take-up ratesis a survey conducted in 2004 by the MortgageBankers Association (2004). The Association sur-veyed the commercial and multi-family mortgagemarket to determine the prevalence of terrorisminsurance protection for properties covered bythese types of mortgages. The results, shown inFigure 19, reveal that lenders require terrorisminsurance for mortgages, accounting for about 94

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60

50

40

30

20

10

02002 2003 2004

27%

40%

54%

Percent Buying Any Terrorism Insurance

Figure 18

Policyholder Terrorism Insurance Take-Up Rates

SOURCE: U.S. Department of the Treasury (2005).

0 5 10 15 20 25 30 35 40

2003:Q2

2003:Q3

2003:Q4

2004:Q1

2004:Q2

2004:Q3

Percent

45 50

2004:Q4

23%

26%

33%

44%

46%

44%

48%

Figure 17

Terrorism Insurance Take-Up Rates: Marsh Estimates

SOURCE: Marsh (2005a).

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0 100 200 300 400 500 600 700

$ Billions

Total Loan Balance

Loan Balance withTerrorism Insurance in Place

Loan Balance withTerrorism Insurance without TRIA

Loan Balance withTerrorism Insurance Required

$656.34

$616.21

$548.06

$132.31

Figure 19

Terrorism Insurance in the Commercial/Multi-family Mortgage Market, 2004

SOURCE: Mortgage Bankers Association (2004).

2003

2004

6

5

4

3

2

1

0<100 100 to 500 501 to 1,000 >1,000

Percent

Total Insured Value($ Millions)

Figure 20

Terrorism Insurance Price as a Percentage of Property Insurance Premiums


percent of loan balances. Of the $616 billion inloan balances where terrorism coverage wasrequired, insurance was purchased for $548 bil-lion, or 89 percent. Respondents estimate that only$132 billion would have been covered by terror-ism insurance absent TRIA. Although the accuracyof this counterfactual estimate is not clear, theresults do indicate the respondents’ belief thatTRIA plays a major role in creating a supply ofterrorism insurance.

The pricing of terrorism insurance was alsoanalyzed in the Marsh and U.S. Treasury surveys.Results from Marsh (2005a) are presented inFigure 20. The figure indicates that terrorisminsurance constituted between 4 and 5 percent oftotal commercial property insurance premiumsfor the Marsh clients included in the survey andthat prices increased in 2004 for larger properties.However, even at the 2004 levels, prices do notseem unreasonable in a relative sense. Figure 21provides information on the absolute values ofterrorism insurance prices from the Marsh survey.

Terrorism insurance premiums represented 0.01percent of insured value for relatively low-valuedproperties, dropping to about 0.004 percent forthe largest properties.

Further pricing results from the Treasurysurveys are summarized in Figure 22. Perhapssurprisingly, the results reveal that many insurerswere still not charging an explicit price for terror-ism insurance following the enactment of TRIA.In 2002, about 80 percent were not charging forterrorism coverage, but this had dropped to 40percent by 2004. Including both the zero price andpositively priced insurance, terrorism insuranceaccounted for about 1 percent of total propertyinsurance premiums in 2002, rising to approxi-mately 2 percent in 2004. Considering only thepositive-premium terrorism insurance, the terror-ism premium was about 3 percent of total premi-ums in 2004. Hence, the price of terrorism coveragedoes not seem to be exorbitant under TRIA.

I now turn to an evaluation of what the terror-ism insurance market might look like without

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2003

2004

0.0120

0.0100

0.0080

0.0060

0.0040

0.0020

0.0000<100 100 to 500 501 to 1,000 >1,000

Percent

Total Insured Value($ Millions)

Figure 21

Terrorism Insurance Pricing: Median Rates by Total Insured Value


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Insurers Charging a Positive Premium (left scale)

% of Insurers Charging a Zero Premium (right scale)

Terrorism Premiums/Total Premiums (left scale)

4.0

3.5

3.0

2.5

2.0

1.5

1.0

2002 2003 2004

Percent

0.5

0.0

90

80

70

60

50

40

30

Percent

20

10

0

Figure 22

Terrorism Insurance Premiums as a Percentage of Total Premiums


Insurers Writing Non-Certified Terrorism Insurance

Insurers Writing Terrorism Insurance100

90

80

70

60

50

40

2002 2003 2004

Percent

30

20

10

0

Figure 23

Extent of Terrorism Coverage


TRIA. Some evidence helpful in making this eval-uation is provided in the U.S. Treasury surveys.In addition to terrorism insurance reinsured underTRIA, which is limited to foreign terrorism, someinsurers also write non-certified terrorism cover-age, which insures against events such as domesticterrorism not covered by TRIA. The percentagesof insurers writing certified (i.e., TRIA-reinsured)coverage and non-certified coverage for 2002through 2004 are shown in Figure 23.28 Theresults are striking—approximately 90 percentof insurers wrote certified terrorism coverage in2002 through 2004, but only 40 percent wrotenon-certified coverage. Given that non-certified(i.e., domestic) terrorism events are generallyviewed as less risky than foreign terrorism, theseresults may suggest that no more than 40 percentof insurers would continue to offer terrorismcoverage for foreign terrorism if TRIA expires.

The Treasury also queried responding insurersabout their 2005 renewals that extend into 2006,when TRIA’s renewal was uncertain. Fifty percentof the respondents indicated that they would notprovide terrorism coverage “that is roughly similarto TRIA coverage” for the segment of the policyperiod extending into 2006 (U.S. Treasury 2005,p. 75). Of these respondents, 55 percent plannedto exclude terrorism altogether in 2006, 22 percenthad a contingent exclusion for terrorism goinginto 2006, and 24 percent included coverage thatwas not comparable to TRIA coverage. Theseresults do not bode well for the availability ofterrorism insurance coverage absent TRIA.

In conclusion, it is clear that TRIA has beeneffective in making terrorism insurance widelyavailable. That about half of policyholders do notbuy terrorism insurance seems to be more a reflec-tion of the fact that many policyholders do nothave significant terrorism exposure rather than abelief that terrorism prices are too high. In fact,terrorism coverage is being made available atprices representing only a small proportion oftotal property insurance premiums. However,because the government reinsurance is being pro-vided for free, it is likely that the current pricesmainly reflect insurer expected losses under the

deductible and copayment provisions of TRIA.Thus, prices can be expected to rise once the ter-rorism deductibles, copayments, and recoupmentprovisions increase beginning in 2006.

The survey results also suggest that availabil-ity of terrorism insurance is likely to declinesharply if TRIA eventually expires. This couldbe a temporary decline until private market solu-tions begin to emerge. However, the experiencewith catastrophic risk insurance in California andFlorida suggests that many buyers, especially inhigh-risk areas, will not be able to obtain terrorisminsurance without some form of governmentinvolvement in the market. Although suchinvolvement does not necessarily imply that thegovernment should serve as reinsurer of last resort,the experience of other OECD countries suggeststhat some form of government reinsurance may beneeded to sustain the market for terrorism cover-age in the future. However, care should be takenin designing any federal terrorism program, toavoid adverse incentives and unintended conse-quences. For example, an economic analysisconduced by Michel-Kerjan and Kunreuther(2006) shows that it would be possible for largeinsurers to “game” the system under TRIA, shift-ing responsibility for terrorism losses to smallerinsurers and policyholders.29

EVALUATION OF GOVERNMENTINVOLVEMENT MECHANISMS

This section begins with an evaluation oftheories of government involvement in insurancemarkets. The discussion then turns to an evalua-tion of the principal mechanisms for governmentinvolvement and recommendations for improvingthe markets for insurance against catastrophes.

Theories of Government Involvement

Three primary theories of public policy arerelevant in evaluating the role of government inaddressing market failures in the insurance indus-

29 For further economic analysis of terrorism insurance, seeKunreuther and Michel-Kerjan (2004), Kunreuther et al. (2003),Lakdawalla and Zanjani (2002), and Wharton Risk and DecisionProcesses Center (2005).

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28 This distinction is not meaningful in 2002 because federal terrorismreinsurance did not exist for most of the year.

try: laissez faire, public interest, and marketenhancement. Laissez faire theory maintains thatany market-based equilibrium, however imperfect,provides a more efficient allocation of resourceswithin the economy than an equilibrium involvinggovernment intervention. From this perspective,government intervention in markets results prima-rily from rent-seeking behavior of special interestgroups (e.g., Stigler, 1971). Thus, industry callsfor government protection against catastrophicrisk are viewed as opportunistic attempts to securean ex ante wealth transfer from taxpayers.

Several types of inefficiencies can arise fromgovernment insurance programs. Provision ofsubsidized insurance is likely to crowd out privateattempts to enter the market, permanently locking-in an inefficient solution to financing catastrophelosses. Government programs tend to developconstituencies that engage in intensive lobbyingto maintain government support, strengtheningconcerns about rent-seeking by special interests.30

Subsidized insurance also tends to create moral-hazard problems whereby policyholders under-invest in loss prevention. Government insurancealso may create resource allocation problems ifsubsidized terrorism insurance leads to over-building of building types and locations that arerelatively vulnerable to terrorism. Actuarial pric-ing of government insurance can alleviate some ofthese problems. However, because the design ofgovernment programs is determined by politicsrather than the operation of markets, even unsub-sidized insurance programs are not likely to rep-resent the most efficient solution.

The public interest theory of regulation contests the laissez faire view (e.g., Musgraveand Musgrave, 1984). This theory suggests thatmarket failures can lead to suboptimal allocationof resources and that government interventiontargeted at addressing the market failures canimprove welfare. Although laissez faire policysuggests that private sector coordination is opti-mal, public interest theory suggests that, in spe-cific instances, the government can improve upon

the market equilibrium by substituting for privatesector coordination. Proponents of public interesttheory, therefore, maintain that the informationasymmetries and bankruptcy costs associated withthe market for terrorism insurance may necessitatethe role of the government in “completing” themarket for terrorism insurance.

The third view of public policy intervention,the market-enhancing view, takes a middle posi-tion (e.g., Lewis and Murdock, 1999). The market-enhancing view recognizes that market failurescan create suboptimal allocations of wealth andthat private sector coordination is not always effec-tive. This view holds that public policy shouldfacilitate the development of the private marketbut should not create new governmental institu-tions to substitute for private solutions. The market-enhancing policy recognizes that government(de)regulation can help facilitate the creation orenhancement of private institutions for solvingmarket failures, such as how the federal govern-ment facilitated mortgage securitization markets.31

Mechanisms for GovernmentInvolvement

This section first considers natural catastro-phes and then analyzes terrorism. The privateinsurance market seems to have difficulty in pro-viding adequate coverage for the largest naturalcatastrophes. Projected catastrophes, such as a$100 billion California earthquake or Floridahurricane, are large relative to the resources ofthe insurance industry; and holding additionalequity capital in the industry to shield againstsuch events does not seem to be feasible (Jaffeeand Russell, 1997). GAAP accounting rules do notallow insurers to establish reserves for events thathave not happened. Similarly, insurers are notpermitted to take tax deductions for events thathave not yet occurred, requiring that capital topay for catastrophe claims has to be accumulatedout of after-tax income.32 In addition, large pools

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30 At least one lobbying group, the Council to Insure AgainstTerrorism, was formed specifically to lobby for renewal of TRIAon behalf of business insurance buyers. Several groups representinginsurance agents and insurance companies also have active TRIAlobbying efforts.

31 Of course, there is always the risk that government-sponsoredenterprises’ special privileges may remain fully in place yearslater, even if the market failures no longer exist.

32 It is noteworthy that both the California Earthquake Authorityand Florida’s residual market and catastrophe insurance planshave been allowed to establish reserves using pre-tax revenues.

of capital tend to attract corporate raiders andmay induce management to engage in negativenet-present-value projects. Raising capital to paylosses following a large-loss event also is difficultbecause informational asymmetries betweencapital markets and insurers regarding lossexposure and reserve adequacy raise the cost ofcapital to potentially prohibitive levels. Thus,private insurance markets tend to be much moreefficient at cross-sectional rather than cross-timediversification.

There are several possible solutions to thecross-time diversification problem. Because theresources of capital markets are more than adequateto fund large catastrophes, a market-enhancingapproach would be for the government to facilitatethe growth of the insurance-linked securitiesmarket. This is an attractive solution because itcould be implemented without committing taxdollars to paying for catastrophe losses. There areseveral areas where removal of remaining regula-tory and bureaucratic barriers as well as simpli-fication and clarification of rules and approvalprocedures would facilitate the securitization ofcatastrophic risk. The GAAP consolidation rulesshould be clarified and codified for CAT-linkedsecurities, and such securities should be givenconduit status for federal income tax purposes.State insurance regulations should be clarifiedand streamlined to reduce transactions costs andenhance the speed to market of new securities.

Even if all regulatory impediments wereremoved, the CAT bond market still might notattain sufficient size to fund major catastrophes.However, it is also possible that “critical mass”would be reached, where scale economies and theability to form worldwide CAT bond portfolioswould reduce transactions costs and spreads tothe point where the market would rival the asset-backed securities market. The costs of relaxingthe regulatory and accounting rules are low, soit would seem to be worthwhile to conduct theexperiment. The federal government could playa major role by creating a task force to coordinatewith Congress, the Financial AccountingStandards Board, and the National Associationof Insurance Commissioners to bring down theregulatory barriers.

A somewhat more intrusive solution to thetime diversification problem would be to exploitthe federal government’s ability to implementintergenerational diversification through federalborrowing. Unlike private insurers, the federalgovernment can effectively accomplish cross-timediversification because it can raise money follow-ing a disaster by borrowing at the risk-free rateof interest.33 The government’s ability to time-diversify led to a Clinton administration proposalfor government intervention in the market forcatastrophe property insurance (Lewis andMurdock, 1999), whereby the federal governmentwould hold periodic auctions of catastropheexcess-of-loss (XOL) reinsurance contracts toinsurers and reinsurers in loss layers where privatemarket reinsurance is not available. The auctionswould be conducted subject to a reservation pricesufficient to support the expected loss and expensecosts under the contracts as well as a risk premiumto encourage private market “crowding out” ofthe federal reinsurance. If a catastrophe were tooccur that triggered payment under the contracts,the federal government would finance the losspayments by issuing bonds. Although the proposalwas not adopted, it could provide a model for adifferent type of federal involvement in the terror-ism insurance market consistent with the market-enhancing view of regulation. However, giventhat securitization offers a viable private marketsolution, it would be advisable to give higherpriority to exploring that option.

Another alternative to government interven-tion to enhance the private market would be topermit insurers to accumulate tax-deductiblereserves for catastrophe losses, a proposal thathas been advocated by the insurance industryfor at least a decade. One obvious problem withthe proposal is that it would reduce federal taxrevenues, when other solutions such as securiti-zation are available that would not have this effect.Another problem is that there would be no wayto prevent insurers from reducing reinsurancepurchases in such a way as to substitute tax-advantaged reserves for other forms of hedging,

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33 The assertion that the government has superior ability to time-diversify may be challenged on the grounds that it places risks ontaxpayers regardless of their willingness to bear them.

with little or no net gain in risk-bearing capacity.Finally, a tax-subsidized reserving program wouldhave a crowding-out effect on the securitizationmarket.

As mentioned above, state governments haveintervened to “make markets” in catastropheinsurance in California, Florida, and other states.These might be considered market-enhancingefforts, except to the degree that they involve anelement of coercion. That is, insurers are requiredto participate in the California and Florida pro-grams if they wish to continue to participate inthe states’ other lucrative insurance markets, suchas the market for automobile insurance. It is likelythat less insurance would be available in thesestates, at least on a cyclical basis, if the state-mandated plans had not been adopted. However,it is also possible that the private market wouldprovide adequate coverage if insurance priceswere deregulated, allowing the market to clear.The periodic difficulties in private markets fornatural catastrophe coverage provide additionalimpetus for developing the CAT bond marketbecause insurers might be more willing to writecoverage on a voluntary basis if more reasonablypriced diversification mechanisms were availablefor mega-catastrophes.

The market response to the increasing fre-quency and severity of catastrophe insurancelosses since the 1990s has potentially quite signifi-cant implications. In spite of the lack of federalgovernment intervention in the market for naturalcatastrophe insurance, the private market fornatural catastrophe insurance did not collapsecompletely. Although insurance and reinsuranceprices rose following Andrew and Northridge,significant amounts of new equity capital flowedinto the industry and reinsurance prices eventu-ally declined (Guy Carpenter, 2005). For themost part, insurance continued to be available indisaster-prone areas, such as Florida, and privateinsurers eventually re-entered the market forCalifornia earthquake insurance. There is evidenceof continuing market anomalies, however, such asthe skewness of reinsurance toward the coverageof relatively small catastrophes and the thinnessof reinsurance coverage for mega-catastrophes(Froot, 2001). Nevertheless, private markets for

natural catastrophe insurance have continued tofunction with reasonable efficiency in the absenceof federal support.

Terrorism, and particularly mega-terrorismevents, pose more-difficult problems for privateinsurance markets than natural catastrophes—mega-terrorism events potentially cause muchmore extensive losses than natural hazards; thefrequency and severity of terrorist events are dif-ficult to estimate, both inherently and becausemuch of the most useful information is confiden-tial for national security reasons; and terroristscan adjust strategies and tactics to defeat effortsto protect against terrorism and mitigate lossseverity. The same factors that make terrorismdifficult to insure and its similarity to war riskmay rule out terrorism-risk securitization, atleast on a large scale. Among the other obstacles,the existence of terror-linked securities mightinfluence target selection by terrorists, and ter-rorists and their sympathizers could attempt toprofit by trading in terror-linked securities.34

Consequently, even if government provision ofinsurance against natural catastrophes is notneeded, there may be a legitimate role for govern-ment in the market for terrorism insurance. Theexperience under TRIA provides somewhat mixedmessages on the need for a government role—thestock market reacted negatively to the adoption ofTRIA but survey evidence strongly suggests thatTRIA succeeded in making terrorism coveragewidely available.

There are various mechanisms for governmentto become involved in the terrorism insurancemarket. Because there is great uncertainty sur-rounding the insurability of terrorism risk, a guid-ing principle of any government involvementshould be that programs be designed to not crowdout the private market. This necessitates that theprogram be explicitly priced and that the price

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34 However, there is some evidence that securities markets mightprovide a source of risk-bearing capacity for terrorist events. In2003, the Golden Globe Financing transaction resulted in a $260million securitization covering the risk of the cancellation of the2006 FIFA World Cup. The transaction explicitly included terror-ism risk. Swiss Re has executed two securitization transactionscovering catastrophic mortality risk, including mortality spikesfrom terrorism. A key to the success of these issues may be thatthey are multi-event bonds, not applying strictly to terrorism(Swiss Re, 2005b).

be set above the expected value of loss. One pos-sibility would be to adapt the Clinton administra-tion proposal and auction off federally backedXOL terrorism reinsurance contracts. Anotherwould be a reinsurance program patterned afterTRIA but with a positive premium charge andcontinuing increases in insurance industrydeductibles to encourage the private market todevelop gradually.

Another important problem is how to handleCBRN hazards. Under TRIA, the federal policyapproach is to “look the other way” and to per-mit insurers to exclude CBRN hazards to theextent they were excluded from non-terroristcommercial coverages. In this respect, CBRNhazards are being treated similarly to war risks.If an XOL reinsurance or TRIA-like program isto be implemented going forward, a case couldbe made for including CBRN hazards. Becausegovernment is likely to compensate CBRN victimsafter the fact, it might make sense to handle asmuch compensation as possible through a formalinsurance program rather than as disaster relief.As Katrina has shown, the federal response to adisaster can be chaotic and inefficient, whereasprivate insurers are very effective at settling claimsand have incentives to settle them efficiently pro-vided the government insurance has appropriatedeductibles and copayment provisions to controlmoral hazard.

CONCLUSIONSThe frequency and severity of losses from

natural catastrophes such as hurricanes, earth-quakes, and tsunamis have increased dramaticallyin the past 15 years. Even though the resourcesof insurers and reinsurers worldwide also havegrown, the rising costs of catastrophic risks haveplaced significant stress on insurance markets.Man-made disasters also have led to monetarylosses and loss of life. However, until the terroristattacks of September 11, 2001, terrorism lossesdid not fall into the mega-catastrophe category;and, in fact, insurers routinely covered terrorismlosses for little or no charge. The 9/11 lossesrevealed a shift in the terrorism probability of lossdistribution, which led insurers and reinsurers

to exclude terrorism losses from many insurancepolicies. Governments in several countriesresponded by adopting government terrorisminsurance programs. The U.S. Terrorism RiskInsurance Act of 2002 (TRIA) requires insurers tooffer terrorism coverage in commercial property-casualty insurance policies and provides federalterrorism reinsurance. This paper investigates theappropriateness of government insurance pro-grams for catastrophic risk, focusing on coveragefor natural catastrophes and terrorist events.

A review of the resources of the insuranceand reinsurance industries as well as the currentstate of the market for insurance against earth-quakes and windstorms in the United Statesreveals little need for a government role, beyondthe programs currently in effect in Florida andCalifornia. Adequate insurance is now availablein the states with the highest exposure to naturalcatastrophes. The earthquake and hurricane insur-ance markets in the United States fall under thecategory of a second-best solution; that is, betterthan an alternative system involving a more-intrusive role for government

Although few policyholders in Californiapurchase earthquake coverage, windstorm insur-ance is widely purchased in Florida. The lack ofinterest in earthquake coverage among buyers inCalifornia is a matter of concern, and the resourcesof the California Earthquake Authority (CEA)would be inadequate to pay claims from a majorearthquake if coverage were more widespread.This situation is likely to lead to pressures formassive governmental disaster relief following amajor earthquake. Hence, measures should be con-sidered, such as making earthquake insurancemandatory in quake-prone areas of the state andstrengthening the resources of the CEA, on thehypothesis that it is more efficient to provideassistance through prearranged programs whereclaims are settled by private industry rather thanby ex post government assistance programs.

Even though government insurance for hur-ricanes and earthquakes does not seem to beneeded, government could deepen and enhancethe markets for these and other catastrophe cov-erages by removing regulatory impediments to thedevelopment of the market for insurance-linked

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securities. This would involve clarifying and/orchanging GAAP accounting rules for special-purpose reinsurers, granting insurance-linkedsecurities conduit status for federal tax purposes,and giving non-indemnity securities reinsurancestatus under state regulatory accounting rules.Giving insurers the ability to accumulate catas-trophe reserves on a pre-federal income tax basiswould reduce federal tax revenues without nec-essarily adding net capacity to insurance markets.

The federal government is already involvedin the market for flood insurance, providing sub-sidized insurance through the National FloodInsurance Program. However, the program is badlyin need of reform. It is currently bankrupt andgenerally does not charge actuarially sound pre-miums or have a provision for building upreserves in low-loss years to minimize the needfor federal borrowing to pay claims. Flood insur-ance penetration rates are very low, and the pro-gram is not effectively meeting its stated objectivesof encouraging loss mitigation and flood-plainmanagement. Although the program could andshould be fixed, a better alternative would be todevelop private sector solutions by requiringinsurers to make available flood insurance cover-age, perhaps with a federal reinsurance backstop,and requiring lenders to enforce flood-coveragerequirements, as is presently done for homeownersinsurance.

Terrorism is a more difficult problem forprivate insurance markets than natural hazards,for several reasons. Terrorism is a deliberate act,similar to war, which has long been excludedfrom private insurance policies. Moreover, becauseterrorists can potentially use weapons of massdestruction, terrorism losses are potentially muchlarger than losses from natural hazards. Terrorismlosses are also much more difficult to estimatethan losses from natural catastrophes. Predictionis made especially difficult because terrorists areconstantly changing strategies, targets, and tactics.Finally, the likelihood of terrorist attacks is affectedby government policies for homeland security,foreign affairs, and defense; and much of the infor-mation that would be useful to insurers in estimat-ing premiums remains confidential for nationalsecurity reasons. Consequently, a case can be made

for some degree of government involvement inthe terrorism insurance market.

Terrorism insurance did not disappear after9/11, and some coverage will undoubtedly con-tinue to be available if TRIA eventually expires.However, a review of survey data provides con-vincing evidence that terrorism insurance is muchmore widespread under TRIA than it would havebeen with no government reinsurance in place.Thus, insurance availability will decline, at leastinitially, if government reinsurance is withdrawn,especially for the most vulnerable targets andlocations. As with natural catastrophes, it is likelyto be more efficient to cover terrorism lossesthrough a pre-existing insurance program ratherthan through ex post government assistance.Fairly priced terrorism insurance also providesthe proper incentives for resource allocation interms of the siting of construction projects andprivate mitigation efforts.

If government does continue to participatein the terrorism insurance market, care shouldbe taken that the program does not prevent there-emergence of the private market. In particular,terrorism insurance should be priced at theexpected loss plus a sufficient risk margin to makeit attractive for private reinsurers to re-enter themarket and to encourage the development of aterrorism risk-linked securities market. Any gov-ernment terrorism reinsurance should have indus-try deductibles at least as large as under TRIA.Consideration also should be given to coveringthe chemical, biological, radiological and nuclearhazards under public and private terrorism insur-ance. Finally, care should be taken in designingany government terrorism program, to avoid creat-ing adverse incentives and prevent gaming of thesystem by insurers or other market participants.

Future research is needed to determine theeffects of catastrophe losses and catastrophe insur-ance on the macroeconomy. Although catastrophelosses are small relative to U.S. and world GDP,it is still unclear whether such losses and/or theavailability of insurance coverage have significantmacroeconomic effects. It would be useful to fur-ther analyze the relationship between catastrophesand macroeconomic time series, such as construc-tion, bank loans, and mortgages, as well as the

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correlations of catastrophes with securitiesreturns. Such information would be valuable bothto policymakers and to participants in the catas-trophe insurance and insurance-linked securitiesmarkets. Finally, the experience with HurricaneKatrina suggests that the time has come for acomprehensive re-evaluation of disaster assess-ment, prevention, mitigation, and financing inthe United States.

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should the government provide insurance for catastrophes?largely attributable to government...

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