In Support of Federal
Catastrophe Reinsurance:
HR-21 and S. 1361
Gordon K. Hay
October 2000 CAS Special Interest Seminar
(Same as 2000 CAS Spring Meeting)
Outline
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Context: Sources of Financial Response
Why a Federal Role?
HR-21 -- After House Markup
How different from a year ago?
Senate “companion” bill S. 1361
Questions
Sources of Financial Response
Return
Interval
(Years)
???
Disaster Aid (Government & Private Sector)
or Non-Recovery?
500
250
Federal Reinsurance?
Securitization
and
Reinsurance?
100
Reinsurance?
75
50
25
0
Tax-Favored
Primary
Catastrophe
Carriers'
Reserves?
Retained
Capital And
Current Pre-Tax Earnings
Traditional
Reinsurance
Securitization
( Mortgages,
Etc. )
People
Cope
Self Insurance (includes deductibles, loss above limits)
Prevention / Mitigation -- Pre-Loss and Post-Loss
Insurance Capacity Sustainable?
• Capacity to pay for catastrophes comes
from capital accumulation (high recently)
and operating profit (low recently).
• Recent high asset values fueled by record
length economic expansion, bull stock
market and low interest rates in the 1990’s
• Primary product prices aren’t sufficient to
retain capital, esp. for cat-prone products.
• Structural change coming? How fast?
Why Did the American People
Create a Federal Government?
Why Did the American People
Create a Federal Government?
• Confront problems too big for the states
Why Did the American People
Create a Federal Government?
• Confront problems too big for the states
• Confront problems shared across state lines
Why Did the American People
Create a Federal Government?
• Confront problems too big for the states
• Confront problems shared across state lines
• CATASTROPHES ARE A “NATURAL.”
A Relevant Example
• After riots in the late 1960’s, urban property
insurance markets failed
• Underlying reasons took years to study
• Urgent mandate to create FAIR plans
• States enabled by Federal Riot Reinsurance
• FAIR plans turned out to be self-sustaining
• No sustained demand for riot reinsurance
• Basis of Need: Social/Political Catastrophe
A Second Example
• Recall the Savings and Loan crisis?
• The basic cause? Short duration deposits
mismatched with long duration mortgages
• Big and small S&L’s failed, drowning the
Federal Savings and Loan Insurance Corp.
• Fannie Mae was created, with Federal
backing, to help revive the mortgage market
• Federal backing gave an early boost to your
private market for securitized mortgages
Enacting HR-21 Means
• Federal reinsurance, available if, and only if
privately unavailable
• Capacity far above any state’s
• Capacity beyond what compassion alone
inspires in post-event disaster aid
• Buyers of Federal coverage must support
mitigation
Indirect Benefits
• If vulnerable structures are built in harm’s
way, less justification for post-event aid
• Encouragement for risk-based primary
insurance prices
• Mitigation and prevention more clearly a
property owner’s responsibility
• Commercial property owners seem more
cognizant than residential
Current HR-21 Provisions
• December 7, 1999 “Final Discussion Draft”
• After markup in House Banking Committee
(Nov. 10, 1999)
• Question & answer format to summarize
and highlight actuarial issues
Who Would Buy?
• Eligible State Programs, under Sec. 6
• Any interested entity, by bidding for Sec. 7
Auction Contracts
• Fractions of Sec. 7 Auction Contracts could
be resold to anybody in the secondary
market
“Eligible State Program?”
• State interest & operation, no industry pools
• Exists to assure availability, and terminable
• Not supplant coverage “that is otherwise
reasonably available and affordable”
• Exempt from all Federal income taxation
• Provide adequate protection
• Single peril, residential property only
• Rates no less than full actuarial costs
Covering What Perils?
• Earthquake & ensuing perils, including fire
and tsunami , or
• Hurricane, or
• Tornado, or
• Volcanic eruption, or
• Coverage following Eligible State Program
• In any case, no multi-peril contracts
What Retention Per Event?
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Treasury Secretary sets for each contract
General minimum triggers per state/region:
Greatest of $2 Billion to $5 Billion, or
Loss from a 100-250 year event, or
for Sec. 6, state program capacity
May be set higher
Must be high enough to prevent displacing
or competing with private markets.
More on Retentions
• Retentions apply to total event insured loss
in state/region, not contract buyer’s loss
• Transition rules for existing state programs,
new state programs and state programs
whose capacity is down due to losses paid
• Transition rules essentially give 5 years for
convergence to generally applied retentions
• Annual inflation adjustments
Maximum Federal Liability?
• Limits apply to annual aggregate losses, not
individual events
• U.S. total aggregate payout in a year to be
“unlikely to exceed $25 Billion,” with
annual inflation adjustment
• Each state/region annual aggregate limit
<= (500 Yr Loss - 100 Yr Loss) X 50%
• Treasury Secretary sets each contract limit
Source of Technical Expertise?
• Loss Cost Commission must be consulted to
determine return period loss distribution by
state/region, expected losses (called “risk
based price”) and risk loads.
• “… program must be founded upon sound
actuarial principles and priced in a manner
that minimizes the potential impact on the
Treasury.”
How Does Pricing Work?
• Loss Cost Commission does the actuarial
and ratemaking analysis
• Minimum pricing formula is stated in bill
• Treasury Secretary sets state program prices
• For auction contracts, Treasury Secretary
sets reserve prices; auction sets actual prices
• Secondary market for auction contracts
Minimum Technical Pricing
• State programs minimum price = expected
losses + Treasury and Commission expenses
+ risk load
• Auction contracts minimum price = expected
losses + Treasury and Commission expenses
- Adj. for mitigation efforts + risk load
• Expected losses from Loss Cost Commission
• Risk load no less than expected losses
• Treasury may not sell coverage for less
Market Pricing: State Programs
• No less than technical minimum, based on
recommendation of Loss Cost Commission
• Treasury Secretary considers private
reinsurance market pricing
• Any private party is empowered to issue
coverage instead, if found credit worthy
• Federal program effect on availability and
affordability in States to be studied annually
Market Pricing: Auctions
• Reserve price = technical minimum
• Regional auction markets generate actual
sale prices
• If market price < reserve price, no sale
• If market price >= reserve price, winning
bidders may subdivide contracts for resale
in secondary market
What if Some Offered Auction
Contracts Are Reserved?
• Contract purchasers receive an option to
purchase additional contracts from among
those offered at the beginning of the term, at
prices prorated to the end of the term
• Effect is replaced or added coverage to end
of term, not retroactive coverage
• The program sunsets at 10 years -- could be
earlier based on annual report to Congress
Big Changes from Last Year?
• Specific guidance on pricing, especially risk
loads and considering private market input
• Retentions raised as far as needed so as not
to displace or compete with private capital
• Perils added: tornado, volcanic eruption
• “Eligible losses” definition
• Region/state areas no longer limited to six
in number, and goal is rough homogeneity
• Exposure to prorated paid claims is gone
Companion Bill S. 1361
• “Natural Disaster Protection and Insurance
Act of 1999”
• Senate Committee on Commerce, Science,
and Transportation -- Hearing on 4/13/2000
S. 1361 Contrasted to HR-21
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Natural Disaster Insurance Corporation
Not for profit membership corporation.
NDIC to sell federally backed reinsurance
In place of the Commission on Loss Costs,
an Independent Board of Actuaries
• S. 1361 mandates state mitigation plans
• No automatic sunset
Contrast, cont..
• Add to HR-21 perils: wildfire and
windstorm other than hurricane and tornado
• State pools, broadly, would be eligible
purchasers of NDIC reinsurance
• To be eligible, state pools must use
actuarially sound rates, use available local
financing and employ reasonable
underwriting standards.
Even Moderate Catastrophes
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Prompt Federal disaster appropriations
Cause some insurer failures
Trigger retreat in private insurance markets
Reveal risk management opportunities
Show insured property loss is only an subset
of economic damage and human misfortune
• Public interest is broader and deeper than
just insurance!
What’s Right?
Watch while history rewinds and replays over
and over on the expanding screen?
or
Confront the risk management shortfall in
catastrophe exposed residential markets?