Financing Recovery from Large-Scale Natural Disasters

Financing Recovery from
Large-Scale Natural Disasters
November 18, 2008
Rawle O. King
Analyst in Financial Economics and Risk Assessment
Government and Finance Division



Financing Recovery from Large-Scale Natural Disasters
Summary
Two important issues before Congress are (1) securing the nation’s capacity to
prepare for, respond to, and recover/rebuild from natural catastrophe events, and (2)
determining whether and how the federal government should intervene in catastrophe
insurance markets. Since the devastating Gulf Coast hurricanes of 2004 and 2005,
and a sequence of tornadoes, wildfires, earthquakes, Hurricanes Ike and Gustav, and
the Midwestern floods in 2008, public attention has focused on: (1) the potential high
cost of recovery and financing of natural disaster losses; (2) the supply and relatively
narrow scope of private sector disaster insurance; (3) the extent to which Americans
living in disaster-prone areas may be uninsured or underinsured; and (4) potential
increases in federal outlays for disaster assistance.
After Hurricane Katrina in 2005, the property insurance industry revisited
catastrophe exposures with the help of recalibrated catastrophe models for Atlantic
tropical storms. Based on this new analysis insurers arguably face greater potential
losses in severe catastrophe events than was previously appreciated. This enhanced
appreciation of risk has implications for property insurance capacity, underwriting,
and pricing. Many insurers responded to recent hurricanes by requesting rate
increases or refusing to renew hundreds of thousands of policies sold in areas along
the Atlantic and Gulf Coasts. Where insurance became either too expensive or
unavailable, homeowners and small business owners who could not otherwise obtain
property insurance in the private markets turned to state-operated “residual market
facilities” that serve as insurers of last resort in these areas. As a result, many of
these facilities have expanded. Nevertheless, there is evidence to suggest that state-
operated facilities may not be fully capable of resolving the problems of insurance
availability or affordability. For example, Florida’s inability to issue debt (bonding
capacity) during the global financial crisis in advance of the 2008 hurricane season
threatened to unravel the state’s property insurance system.
In the wake of financial market turmoil in 2008, one point of view contained in
this report stresses the importance of bringing more transparency to the markets for
innovative new risk transfer financial products. Some of these risk transfer
instruments, such as credit default swaps and other derivative products, are not
regulated, and regulators have no valid data upon which to perform oversight of them
in the credit markets. Some economists believe that more transparency and
regulation are important components of credit market reform.
Several Members of Congress have debated mechanisms to ensure adequate
capacity and solvency of the insurance industry to meet customer demand. Many
proposals have been introduced that would improve insurers’ access to capital in the
reinsurance, banking, and securities markets. They include (1) study commissions
— H.R. 537/S.292/S. 2286; (2) tax reform incentives — H.R. 164/H.R. 1787/S.

926/S.2327/S. 927; (3) flood insurance reform — H.R. 920/H.R. 3121/S. 2284; (4)


risk retention group reform — H.R. 5792; and (5) risk securitization and federal
reinsurance and loans — H.R. 91/H.R. 330/H.R. 3355/S. 928/S. 2310. Congress
could also be called upon to decide whether transparency mechanisms are appropriate
for resolving the broader issues presently disrupting all financial markets



Contents
Introduction ......................................................1
Congressional Interest in Natural Disasters..............................2
The Catastrophic Loss Financing Problem..............................4
Role of Disaster Relief and Private Insurance........................4
Property Insurance Price and Capacity Problem......................5
Economic Factors Contributing to Price and Capacity Crisis............6
Demand-Side Effects.......................................6
Supply-Side Effects........................................6
Residual Market Mechanisms for Property Insurance..................9
Insurability of Natural Disasters.....................................10
Insurer Claims-Paying Capacity..................................10
Uncertainty in Measuring and Pricing Catastrophe Exposures..........14
Insurance Market Imperfections..................................14
Alternative Risk Transfer Mechanisms................................15
Financial Market Turmoil in 2008 ...................................16
Impact of Credit Market Illiquidity on Catastrophic Risk Financing.....18
Opaque Capital Markets...................................19
Illuminating Opaque Credit Markets..........................20
Transparency and Regulation....................................21
Federal Intervention in the Catastrophe Insurance Market.................22
Arguments For Intervention.....................................23
Arguments Against Intervention.................................24
Potential Points of Agreement...................................24
Legislative Proposals..............................................24
Legislative Action............................................27
Concluding Remarks..............................................28
Appendix A. Legislative Options.....................................31
List of Tables
Table 1. Ten Most Costly Insured Catastrophes in the United States,
1989-2008 ...................................................7
Table 2. Summary of Changes in Property-Casualty Insurance Industry
Surplus, 2003-2008...........................................11
Table 3. Estimated Insured Hurricane and Earthquake Losses for 10 States for
the 1-in-100-Year, 1-in-250-Year and 1-in-500-Year Catastrophes......12th
Table 4. Major Federal Disaster Insurance Legislation in the 110 Congress...31



Financing Recovery from
Large-Scale Natural Disasters
Introduction
Ever since eight costly hurricanes struck the East and Gulf Coasts in 2004 and
2005, large national property and casualty insurers have significantly scaled back
their willingness to underwrite property insurance for homes located on or near
coastlines. Hurricanes Dolly, Gustav and Ike were the major storms of 2008, and
they renewed fears about the economic effects of the destruction of thousands of
homes, businesses, and infrastructure. Public attention is now focused on issues such
as the cost of disaster relief and reconstruction in the wake of financial market
turmoil and growing fiscal deficits, whether and where gaps in private insurance (and
reinsurance) coverage currently exist, why insurance coverage might become
expensive and unavailable, and whether new forms of private-public risk-transfer
partnerships are needed to manage the financial impact of large-scale natural
disasters.
Natural disasters in the U.S. have the potential to cause economic losses in the
tens or even hundreds of billions of dollars. The federal government has played a
large financial role in responding to (uninsured) natural disasters. During the 20-year
period from FY1989 to FY2008, Congress appropriated $250 billion dollars for1
disaster assistance.
Given the increasing frequency and severity of East and Gulf Coast hurricanes
and growing disaster relief expenditures, there is an urgency in Congress to ensure
the effective financing of catastrophic risks coupled with fair and efficient resolution
of policyholder claims. Property value in key U.S. earthquake and hurricane zones
has doubling every 10 years. Meanwhile, global insurance and reinsurance capital
allocated to covering hurricane and earthquake perils is not keeping pace.
Economists have observed that this fundamental shortfall between risk and capital
growth represents a major public policy challenge for Congress.
In addition to federal outlays, private sector expenditures have been
considerable; according to data from the Insurance Services Office’s Property Claims
Unit, private insurers paid $261.9 billion in insured catastrophe losses from 1980
through 2007. Insurance companies play a key role in managing risks of catastrophic


1 See CRS Report RL33226, Emergency Supplemental Appropriations Legislation for
Disaster Assistance: Summary Data, by Justin Murray and Bruce R. Lindsay.

events.2 Individuals and businesses usually insure against catastrophes in order to
reduce financial volatility and avoid potential ruin. Insurers, in turn, will transfer a
portion of that risk to a reinsurer, thereby spreading globally the burden of
catastrophic risks. However, some have contended that the capacity of the traditional
international reinsurance market to finance a mega-catastrophic event remains
inadequate.3
New forms of innovative risk financing instruments have developed to help
insurers and reinsurers increase their capacity to manage their peak catastrophic risk.
Two main categories of alternative risk transfer (ART) solutions are insurance-linked
securities (ILS), which are direct risk transfer instruments that provide funds to offset
catastrophe losses, and contingent debt agreements (e.g., contingent surplus notes and
equity puts), which can replenish policyholders’ surplus (i.e., an insurer’s capital)
after catastrophe losses. ART mechanisms complement traditional reinsurance by
transferring risk directly to capital market participants such as hedge funds and
institutional investors.
This report provides an analysis of the challenges facing property and casualty
insurance and reinsurance companies in financing large-scale natural disasters,
particularly during financial market turmoil. The report begins with a discussion of
congressional interest in financing recovery from natural disasters, and the role and
limitations of federal disaster assistance and private insurance. This is followed by
an assessment of the problem of financing catastrophic risk (i.e., issues of availability
and affordability of residential property insurance coverage in coastal areas), and a
discussion of insurability of natural disasters given insurers’ claims-paying capacity.
In the final three sections, the paper examines ART mechanisms, such as ILS and
contingent debt securities that complement traditional reinsurance, the effects of the
financial crisis on unraveling capital structures that underlie some state property
insurance systems, and possible roles for the federal government in the market for
catastrophe insurance coverage as it considers policy options for resolving the
broader financial market crisis. The report concludes by summarizing the legislative
options under consideration in the 110th Congress.
Congressional Interest in Natural Disasters
The U.S. has always been exposed to risks of natural disaster. Large-scale
natural disasters, such as wildfires, windstorms (i.e., hurricanes, tornadoes, and other
wind damage), floods, and earthquakes, however, have become increasingly frequent
and costly. In 2005, private insurers paid a record $60.4 billion in insured


2 Insurers have three major tools at their disposal to manage an increase in risk: (1) raise
equity capital by selling company stock; (2) transfer risk to the reinsurance market; and (3)
limit risk through the underwriting and asset management process.
3 J. David Cummins and Mary A. Weiss, “The Global Market for Reinsurance:
Consolidation, Capacity, and Efficiency,” Brookings-Wharton Papers on Financial
Services, 2000.

catastrophe losses for hurricanes.4 At the same time, uninsured losses from
Hurricanes Katrina, Rita, Wilma and Dennis caused an unprecedented $130 billion
in federal outlays for emergency disaster relief. Consequently, policymakers are
aware that although there is a well-functioning international catastrophe insurance
and reinsurance market, the federal government has increasingly been called upon to
exercise its considerable authority and significant means to reallocate resources
throughout the economy to compensate disaster victims.
The financial volatility of natural disasters and the resulting burden for society
and the economy are important issues for Congress because of its responsibility to
promote national economic growth. A mega-catastrophic event striking some region
of the U.S. could impede interstate and foreign commerce and cause widespread
distress and hardship adversely affecting the general welfare. Uncertainty about how
often catastrophic events will occur (frequency) and the magnitude of catastrophic
events (severity) continue to pose a catastrophic risk financing challenge both to
society as a whole and to the federal government.
In 1995, President Clinton’s National Economic Council Working Group on
Disaster Insurance formulated a set of broad principles and objectives for a federal
insurance program to reduce losses and cover catastrophic risks. In the aftermath of
Hurricane Katrina in 2005 and Ike and Gustav in 2008, these principles and
objectives could set the policy framework to guide policymakers in coping with
natural disasters.
The Working Group concluded that a federal insurance program should:
!reduce total societal costs of catastrophic natural disasters;
!reduce total long-term federal costs of dealing with such events;
!increase personal security in the aftermath of a disaster; and
!increase the extent to which costs of disasters are maintained in the
private sector to create incentives to moderate losses from disasters.
A key question for Congress going forward is whether to proactively address the
issue of managing catastrophic risks through insurance and other risk transfer
mechanisms. One option is to establish an explicit public-private risk transfer
partnership that would allow the federal government to leverage public funds through
the use of insurance, reinsurance, and capital market instruments to accomplish the
above-stated public policy objectives. This report analyzes issues and information
related to building a different relationship between insurers, reinsurers, the capital
markets and the federal government.


4 This figure comes from the Insurance Services Office’s Property Claims Unit.

The Catastrophic Loss Financing Problem
At least two complementary approaches exist to manage the risk of large-scale
natural catastrophes: (1) pre-disaster risk avoidance and mitigation that reduces
physical and environmental vulnerabilities but still requires post-event funding; (2)
risk transfer mechanisms that involve disaster relief, insurance, reinsurance and
capital market instruments designed to compensate disaster victims and reduce
exposure to financial losses. Generally, the federal natural catastrophe risk
management strategy seeks to mitigate the extent of damages through land-use
regulations, strengthening risk assessment and enforcing structural mitigation and
vulnerability reduction measures, such as zoning and building code compliance.
Remaining residual risk is then largely absorbed through a combination of federal
disaster relief assistance, commercial insurance, self-insurance and tax deductions.
Role of Disaster Relief and Private Insurance
Private insurance and federal disaster relief have been relied upon for decades
as complementary mechanisms to compensate disaster victims and provide for
recovery after a natural disaster. Risk management theory, however, suggests at least
three reasons why insurance is the more efficient mechanism of the two for allocating
the risk of large catastrophic events.
!Disaster relief assistance is assumed to have negative incentives for
risk mitigation because benefits are paid whether or not recipients
have taken steps to reduce their loss exposures. The inefficiency
results in higher social and federal costs of disasters, and is
commonly referred to as “moral hazard.”
!From a welfare economics or resource allocation perspective,
disaster relief is inequitable because it is funded through general tax
revenue and the costs of disasters are borne by people or businesses
regardless of their location in hazardous areas — i.e., residents and
taxpayers in high-risk areas are subsidized by those in low-risk
areas.
!Disaster relief is inefficient and inclined to misjudgment because
property owners oftentimes do not fully understand the risks they
face, make risk management decisions based on inaccurate
information, and intentionally rely on disaster relief for
compensation. Insurance is considered a more efficient mechanism
to deal with natural catastrophes; it establishes a price on the hazard,
based on actuarial information, and creates economic incentives to
mitigate losses.
Insurance manages risk pooling; insurers are uniquely exposed to a variety of
risks arising from their risk-bearing (underwriting) function. Insurers typically will
hedge the risk they assume by directly transferring some portion of that risk to a
reinsurance company or indirectly to a special purpose reinsurer set up to transfer the



risk to investors in the capital markets through indemnity-based or index-based
insurance-linked securities (i.e., derivative transactions).5
There are inherent limitations to using insurance or reinsurance as a risk transfer
tool because insurance protection against a mega-catastrophic event is not always
available through private sources. Also, plans, policies, and structures intended to
mitigate the effects of such losses might not always fully anticipate the destructive
aspects of hurricanes, earthquakes and other natural disasters.
Property Insurance Price and Capacity Problem
At the core of the problem of the availability and affordability of homeowners’
insurance in hurricane-prone coastal areas is the way insurers internally raise capital,
the cost of capital required to underwrite exposures in disaster-prone areas, and how
insurers react to situations where their earnings or solvency are threatened. Insurers
must have adequate capital to support the risks assumed and generally meet
capitalization requirements. This can usually be achieved in four ways:
!earn a net profit, thereby increasing policyholders’ surplus;
!sell insurance policies, which increases long-term debt capital;
!account for the value in the assets and liabilities not reported on their
balance sheets (realized and unrealized capital gains); and
!reduce the amount of capital required by reducing exposure to risk.
Insurers generally limit the capital committed to underwrite property insurance
in coastal disaster-prone areas largely because regulatory constraints have led to what
some insurers believe are inadequate returns to attract sufficient capital. Insurers
usually seek a rate of return commensurate with the risk they assume, expecting
higher return from capital allocated to catastrophic risk than from, say, a stable book
of automobile insurance policies where losses do not fluctuate widely from year to
year. In contrast, losses from catastrophic perils are more volatile and potentially
much larger. An insurer must hold significantly more equity to underwrite
catastrophe exposures than it needs to underwrite non-catastrophe exposure. To
remain viable, the insurer must be able to pass on its cost of capital to policyholders.
Shortages of insurance induced by capital shortages led two states, California
(earthquake) and Florida (hurricanes), to establish state catastrophe funds that offer
certain advantages over private sources of capital. State catastrophe funds that
receive tax-exempt status can accumulate funds free of federal insurance tax and use
their government authority to issue debt to pay losses, supported by future
assessments against residents in the state. The states are therefore able to diversify


5 Indemnity-based transactions involve settlement that is directly related to the loss
experience of the company issuing the securities (e.g., catastrophe bonds and contingent
capital facilities such as surplus notes). Index-based transactions involve settlements that
are triggered or derived from the value of an independent index.

(spread) risk over time through the debt financing mechanism within their limited
jurisdictions.
Economic Factors Contributing to Price and Capacity Crisis
Property coverage became expensive and difficult to obtain following the 2004-
2005 hurricane seasons. After the storms, insurers felt compelled to revise their
underwriting and pricing assumptions to reduce their risk exposure and the amount
of capital they needed to maintain profitability and comply with regulatory
requirements. As a result, insurance coverage for residential properties in hurricane-
prone coastal areas became more expensive and scarce for the average resident.
Higher residential property insurance prices and reduced availability of coverage
occurred not because of a financial capacity shortage but rather because of changed
industry assumptions about the frequency and intensity of North Atlantic hurricanes
and uncertainty about the models, methodologies and data used for estimating natural
hazard risk and losses from hurricane events. Insurers were essentially reacting to
the perception, not necessarily based on historical and actuarial data, that more
properties were at risk than previously thought. Residents in areas exposed to these
catastrophic perils have experienced wide fluctuations in the price and availability
of insurance, especially after a major disaster. Uncertainty about the probability of
losses caused by natural catastrophes and concern about insolvency triggered by a
series of disasters are the key reasons for fluctuations in the price and availability of
property insurance in disaster-prone areas.
Increased prices for and reduced availability of insurance have been attributed
to both demand and supply side factors. The next two sections examine demand and
supply side effects that contributed to a scarcity of private-sector disaster insurance
following the 2004 and 2005 hurricane seasons.
Demand-Side Effects. The demand for insurance coverage is a function of
the growth in population and property values along the Gulf and Atlantic coasts and
the perception of increased catastrophic risks. This increased demand has
contributed to disruptions in the coastal wind insurance market. When demand
exceeds supply, prices tend to rise.
Supply-Side Effects. Four factors were key in the development of the
current scarcity of residential property insurance: (1) historic levels of insured
catastrophe claims payments; (2) limited supply of catastrophe reinsurance,
particularly after the devastating 2004 and 2005 hurricane losses; (3) higher capital
adequacy requirements imposed on insurers by credit rating agencies; and (4)
litigation surrounding wind versus flood insurance coverage disputes after Hurricane
Katrina. These factors are discussed below.
First, insurers had to make historically unprecedented levels of payments to
policyholders in 2004 and 2005; this has altered their view of what constitutes an
“infrequent” mega-catastrophe. Consequently, the structure of reinsurance contracts
has changed, forcing primary insurers to retain more risks and pay more for the
expanded coverage. Table 1 shows the ten costliest insured catastrophe loss events



in recent years. Six of the 10 largest insured catastrophe losses occurred over the last
four years.6 Hurricane Katrina alone caused private insurers approximately $43.6
billion in insured losses, surpassing the $22.9 billion from 9/11 terrorist attacks and
the $23 billion for Hurricane Andrew in 1992.
Table 1. Ten Most Costly Insured Catastrophes in the
United States, 1989-2008
(cost in billions of 2007 dollars)
RankHurricaneYearInsured Losses
1Hurricane Katrina2005$43.6
2Hurricane Andrew199222.9
3World Trade Center Terrorist Attacks200122.0
4Northridge, CA earthquake199417.5
5Hurricane Wilma200510.9
6Hurricane Charley20048.2
7Hurricane Ivan20047.8
8Hurricane Hugo19897.0
9Hurricane Rita20055.9
10Hurricane Frances20045.0
Source: Insurance Services Office’s Property Claims Services Unit; Insurance Information Institute.
Note: Hurricane Ike (2008) was the third most destructive hurricane to ever hit the United
States, according to the National Weather Service. Although initial estimates put insured losses at
more than $11 billion, Ike has not been officially ranked by the ISO.
Faced with the changed marketplace conditions after the 2005 hurricanes,
primary insurers sought to reduce their exposure to catastrophe losses by decreasing
the number of policies issued on properties in coastal areas. Insurers lowered their
exposure by not renewing policies (coverage) for a significant number of their
customers, not selling new policies, or exiting the market altogether. Although
individual insurers have sought to reduce their presence in coastal areas, the property
insurance industry as a whole continues to supply insurance to virtually every
property in the United States. In states where the insurance market disruption was
most severe (e.g., Florida, Louisiana, Mississippi, and Texas), state officials either
created state-sponsored residual mechanisms or expanded existing ones to provide
insurance to all those who could not purchase coverage in the voluntary market.
The second factor that arguably contributes to the current problem is the limited
supply of catastrophe reinsurance after the devastating 2004 and 2005 hurricane
losses. A critical element in the ability of private insurers to underwrite catastrophe


6 On September 13, 2008, Hurricane Ike made landfall in Galveston, Texas as a Category
2 hurricane. It was the ninth named storm, fifth hurricane and third major hurricane of the

2008 Atlantic hurricane season. Initial estimates put insured losses at more than $11 billion.


The $11 billion is based on computer simulation models. Ike will likely rank just ahead of
Hurricane Wilma in 2005 when the ISO’s Property Claims Service Unit publishes data on
the official insured losses.

risk is the availability of reinsurance.7 Insurers typically purchase reinsurance to
protect themselves from the financial consequences of a single catastrophic event that
causes insured loss to multiple policyholders. Reinsurance markets, however, are
subject to price and availability cycles, often resulting in price increases and supply
restrictions following catastrophic events.8 A significant portion of the insured
catastrophe losses from the 2004 and 2005 hurricanes were paid by reinsurance
proceeds, and, as reinsurers’ capital reserves were depleted, reinsurers needed to
rebuild capacity.9 The limited supply of residential property catastrophe reinsurance
forced many primary insurers to reduce their exposure to catastrophe losses from
hurricanes and to retain more risk than they would prefer. This has driven up their
costs.
Third, primary insurers and reinsurers who underwrite catastrophe lines of
coverage were subject to higher capital adequacy requirements imposed on them by
credit rating agencies like Standard & Poor’s and A.M. Best Company. This change
affected the amount of catastrophe insurance that insurers were willing to sell. A
strong financial rating reduces the insurer’s borrowing costs and, therefore, increases
its competitiveness in the marketplace.
Rating agencies were actually responding to adjustments in catastrophe
modeling firms’ assumptions with respect to probabilities of loss based on a
presumed up-tick in frequency and severity of catastrophic events over a more
immediate time horizon. The “near-term” higher expected frequency of hurricanes
making landfalls and higher estimates of the amount of structural damage repair costs
— both assumptions based on information provided by catastrophe modeling firms
— led to higher predicted losses and ultimately to higher premiums.
After the back-to-back record-setting hurricane seasons in 2004 and 2005, rating
agencies required insurers and reinsurers to plan for a catastrophic event projected
to occur with a frequency of one in 50 years rather than one in 100 years. Insurers’
balance sheets had to be able to withstand multiple extreme events rather than just
a single event. To maintain their financial strength ratings, insurers were required to
maintain a higher level of capital to demonstrate an ability to pay claims under these
two new standards. The consequence of higher capital adequacy requirements was
the sharp increase in demand for residential property reinsurance, which, in turn,
caused the price of this reinsurance to increase dramatically in 2006 through 2008.10


7 Dwight M. Jaffee and Thomas Russell, “Catastrophe Insurance, Capital Markets, and
Uninsurable Risks,” Journal of Risk and Insurance, 1997, vol. 64, p. 205-230.
8 Kenneth A. Froot and Paul J.G. O’Connell, “The Pricing of U.S. Catastrophe
Reinsurance,” in Kenneth Froot, ed., The Financing of Catastrophe Risks (Chicago: The
University of Chicago Press, 1999).
9 A.M. Best Company, “Credit Crunch Clouds Outlook of Hurricane Insurers, Cat Funds,”
2008 Special Report: U.S. Hurricane — Catastrophe Review, May 19, 2008, located at
[http://www3.ambest.com/ D i s p l a yB i n a r y/ D i s p l a yB i n a r y. a s p x ? T Y = P &r ecord_code=142

243&URatingId=1436841].


10 Ibid.

Fourth, litigation surrounding insurance coverage disputes and litigation over
the standard homeowners’ insurance policy exclusions for wind and water damage
created “contract uncertainty” associated with the judicial interpretation of insurance
policy terms and language.11 The legal dispute concerned which portion of the loss
is due to wind (covered by a standard homeowners policy) and which is from rising
water, whether from storm surge or flooding. Realizing that a court’s action could
substantially increase insurers’ risks in hurricane-prone states, some insurers decided
to limit the amount of coverage sold in high-risk coastal areas.
Residual Market Mechanisms for Property Insurance
When residential property insurance becomes scarce and unaffordable,
individuals and businesses who cannot otherwise secure private coverage have turned
to state-sponsored residual market mechanisms.12 State residual markets were
created to improve the availability and affordability of property insurance primarily
for residents and private businesses in coastal high-risk areas. As private insurers
have withdrawn from high-risk areas, state residual markets have become the first
and only choice for many homeowners. Consequently, the programs have expanded
in recent years. Residual market and state catastrophe funds typically charge a lower
risk premium than private insurers because they generally hold little or no capital
reserves against major events. These facilities will typically impose a tax or
assessment after a catastrophe in order to fund resulting claims obligations.
The 2004 and 2005 hurricane seasons demonstrated the limits of residual market
facilities and catastrophe funds, with losses exceeding the facilities’ claims-paying
capacity. Most state residual markets face financial challenges because of the
concentration of property risk underwritten by the facility, the reliance on post-event
assessment and the inadequacy of rates to cover expected losses over time. There is
a growing belief that traditional backstop mechanisms, such as assessments on
insurers that have their own catastrophic losses to fund, are not appropriate protection
against a mega-catastrophic event. Many economists have acknowledged the
political necessity for these facilities but suggest that the lower prices tend to distort
an otherwise efficient market by reducing incentives for individuals to mitigate their


11 CRS Report RL33892, Post-Katrina Insurance Issues Surrounding Water Damage
Exclusions in Homeowners’ Insurance Policies, by Rawle O. King.
12 Five states have programs designed specifically to provide windstorm coverage
(Alabama, Mississippi, North Carolina, South Carolina, and Texas), and Florida and
Louisiana each have a Citizens Property Insurance Corporation. State-sponsored Beach and
Windstorm Insurance Plans exist in Mississippi, South Carolina, and Texas; these plans
ensure that insurance is available against damage from hurricanes and other windstorms.
Fair Access to Insurance Requirement (FAIR) plans exist in the following states: California,
Connecticut, Delaware, Georgia, Hawaii, Maryland, Massachusetts, Mississippi, New
Jersey, New York, North Carolina, Oregon, Rhode Island, Texas, Virginia, and Washington.
Additionally, three states — Georgia, Massachusetts and New York — have Fair Access to
Insurance Requirement (FAIR) plans that provide wind and hail coverage for certain coastal
communities. New Jersey does not have a Beach and Windstorm Plan but its WindMap was
created to help homeowners in coastal areas obtain homeowners insurance. Florida and
Louisiana created state-run high-risk insurance companies to offer windstorm insurance
coverage to residents in coastal counties in their respective states.

exposure; this raises the long-run disaster costs for society as a whole, including for
state and federal taxpayers.
Insurability of Natural Disasters
Economic theory suggests that every risk is insurable, at a price. This, of
course, assumes (1) that risk averse individuals and businesses will be able to identify
their risks, and (2) there is accurate pricing so that insurance companies are able to
sell insurance coverage at a risk premium the firm believes is sufficient to cover the
risk it has assumed. In order for the insurer to calculate the risk premium, the firm
must be able to calculate expected losses and establish an appropriate price to charge
for the coverage. Historical claims and exposure data collected over an extended
period usually form the basis for projecting future expected costs. Inherent problems
arise, however, when using historical loss data and experience to project catastrophe
losses.
Insurers generally endeavor to underwrite insurance for catastrophic loss events
on the basis of a handful of historical loss data points and actuarial science. When
the insurer does not have confidence in the catastrophe modeling or the ability to set
a price due to the infrequency or potential magnitude of losses, the firm will stop
selling new policies, not renew existing policies or withdraw from the market
altogether, and subsequently reallocate the capital to other lines of insurance. This
situation usually creates a “hard insurance market” in catastrophe lines of coverage
— prices rise and insurers limit the supply of insurance coverage in the marketplace.
From a traditional insurance perspective, natural catastrophe risk could be
considered uninsurable for at least three reasons: (1) limited amount of capital
(policyholders surplus) allocated to catastrophe lines of insurance; (2) uncertainty in
measuring catastrophe losses and pricing catastrophe losses; (3) insurance market
imperfection. The remainder of this section discusses each of these reasons why
catastrophic risk may be considered uninsurable.
Insurer Claims-Paying Capacity
Although the 2005 hurricanes caused unprecedented catastrophe losses, they
were not solvency-threatening to the industry, as a whole, nor did they cause a net
reduction in aggregate claims-paying capacity. The property and casualty insurance
industry reportedly earned unprecedented profits — net income of $47.7 billion in

2005 and $70.6 billion in 2006 (see table 2).



Table 2. Summary of Changes in Property-Casualty
Insurance Industry Surplus, 2003-2008
2003 2004 2005 2006 2007 2008
Beginning Balance$294.8$358.1$402.0$437.5$502.7$548.2
Net Underwriting Income5.02.07.331.719.35.8
Net Investment Income41.141.851.954.754.956.5
Other Income (Expense)0.20.31.72.80.40.5
Pretax Operating Income35.943.546.389.273.861.8
Realized Capital Gains6.59.212.13.67.04.0
Federal Income Taxes10.714.610.722.221.719.5
Net Income31.738.147.770.659.246.3
Unrealized Capital Gains26.712.75.821.36.52.0
Contributed Capital13.59.114.34.13.94.0
Stockholder Dividends10.814.415.624.923.025.0
Other Changes2.31.55.05.91.12.2
Ending Policyholders Surplus$358.1$402.0$437.5$502.7$548.2$573.3
Total Changes in PHS ($)63.343.935.565.245.525.1
Change in PHS from Prior Year (%)21.512.38.814.99.04.6
Sources: A.M. Best Company, Inc.,Special Report: U.S. P/C Industry Records Strong Results, But
for How Long?,” Jan. 28, 2008.
The increase in natural catastrophe loss and exposure, however, has raised
public policy concerns about whether there is sufficient capacity within the private
catastrophe insurance and reinsurance industry to cover the nation’s payout
requirements for mega-catastrophic events (1-in-100 year events), and what insurance
reforms would improve insurers’ access to capital in order to ensure adequate13
capacity to meet consumer needs and solvency of the industry.
Catastrophe reinsurance markets are thought to be limited in their ability to
insure against a mega-catastrophe. Most observers would argue that for the very
highest layers of catastrophe risk, the federal disaster relief (and consequently the
taxpayer) is now, by default (due to limited private-sector capacity in the traditional
reinsurance market), the insurer of last resort, particularly for uninsured property
owners. National insurance markets, even backed by global catastrophe reinsurance
capacity, are limited in terms of the amount of catastrophic risks that can be covered.
The total catastrophe reinsurance capacity is not presently large enough to allow
primary insurers to adequately hedge their catastrophe risk to meet society’s
emerging needs.
Several mega-catastrophic scenarios could be imagined that could overwhelm
the current claims-paying capacity of both the private insurance and state residual


13 J.D. Cummins, M. Doherty, and A. Lo, “Can Insurers Pay for the Big One?: Measuring
the Capacity of an Insurance Market to Respond to Catastrophic Losses,” Journal of
Banking and Finance, vol. 26, 2002, p. 557-583.

markets. Insurance industry calculations suggest that a repeat of the 1906 San
Francisco Earthquake could cause $80 billion in insured property losses, based on
total property losses approaching $300 billion.14 Reinsurers appear unable to provide
complete diversification of catastrophe risks both because catastrophes appear to be
correlated across risks (hurricanes, floods, and earthquakes among others) and
because estimates of the probable maximum loss (PML) from catastrophes have risen
dram at i cal l y. 15
In 2007, AIR Worldwide Corporation, a catastrophe modeling firm based in
Boston, simulated estimates of potential insured catastrophe losses caused by U.S.
hurricanes, earthquakes, and the fires that follow earthquakes. Loss estimates were
provided for the 1%, 0.4%, and 0.2% annual occurrence probabilities, which
correspond to return periods of 100, 250, and 500 years losses. Table 3 shows that
the national probable maximum losses (PML) for hurricanes and earthquakes is
$108.4 billion for the 1% return period, $164.5 billion for the 0.4% return period, and
$217 billion for the 0.2% return period. The corresponding numbers for earthquakes
and fire (combined) losses are: $50 billion for 1% events, $90 billion for 0.4%
events, and $119 billion for 0.2% events.
Table 3. Estimated Insured Hurricane and Earthquake Losses
for 10 States for the 1-in-100-Year,
1-in-250-Year and 1-in-500-Year Catastrophes
($ in millions)
100-Year 250-year500-Year
Ex pect ed Ex pect ed Ex pect ed
RankArea/StateLoss (1%)Loss (0.4%)Loss (0.2%)
United States$108,387.18$164,525.21$217,031.79
1 Flo rida 87,764.37 144,249.92 200,125.61
2 California 38,955.37 66,317.74 94,020.46
3 T exas 21,314.38 32,808.29 44,156.20
4 Louisiana 12,121.11 18,552.82 24,530.98
5New York9,331.8524,587.7335,829.62
6North Carolina9,326.9115,343.7621,395.14
7South Carolina7,706.5314,629.5320,559.48
8 Alabama 6,022.22 11,402.77 16,255.20
9 Massachusetts 4,968.07 9,134.62 13,793.45
10New Jersey4,003.3210,699.6817,597.08
Source: AIR Worldwide, Inc.


14 A.M. Best Company, Best Review, April 1, 2006, located at
[http://goliath.ecnext.com/ coms 2/gi _0199-5429124/All-shook-up-if-t he.html ].
15 Dwight M. Jaffee and Thomas Russell, “Can Security Markets Save the Private
Catastrophe Insurance Market?” paper delivered at the Asian-Pacific Risk and Insurance
Association Conference, July 19, 1998, p. 11.

Table 2 shows that the capital base supporting the entire U.S. property and
casualty insurance industry — both commercial and residential — is about $548.2
billion, as of January 2008. It would appear that this sizeable surplus for unexpected
losses would be sufficient for the property and casualty insurance industry, as a
whole, to be able to underwrite needed levels of catastrophe insurance. However,
only about 20% of the industry-wide policyholder surplus, a measure of capacity, is
generally considered to be allocated to catastrophe insurance lines of business. The
remaining 80% is needed to support non-catastrophic risks. This means that
approximately $110 billion of policyholders’ surplus is available for catastrophic
property losses nationwide. When comparing total claim-paying capacity of the
insurance industry to the probable maximum losses, one can conclude that the
insurance industry’s financial resources are insufficient to cover anything more than
a 1-in-100 year loss.
In light of the concerns about the capacity of insurers to pay claims after mega-
catastrophes, primary insurers have increasingly turned to private capital markets for
risk-transfer capacity to complement traditional reinsurance markets. Professor
Kenneth A. Froot of Harvard University has suggested that one reason for the search
for alternatives to reinsurance has been the supply restrictions associated with capital
market imperfections and market power exerted by traditional reinsurers.16 This
situation is a matter of basic economics of supply and demand: a limited number of
reinsurers with specialized knowledge and unique access to global capital markets
can exert substantial control over prices and supply. Given recent historical losses
and concerns with future mega-catastrophes, property catastrophe reinsurance
capacity is increasingly seen as insufficient to meet societal demand, and the search
for alternatives continues.
To some, this line of reasoning arguably suggests federal intervention in natural
catastrophe insurance markets to address potential market failure in the range
between the 0.4% to 0.2% return periods.17 Some finance experts may also be
concerned about projections that catastrophic losses will likely double every 10 years


16 Kenneth A. Froot, “The Market for Catastrophe Risk: A Clinical Examination,” Journal
of Financial Economics, May 2, 2001, pp. 529-571.
17 This analysis simplifies the complex worldwide market for catastrophe property insurance
and is intended only to provide an indication of the industry’s overall claims-paying
capacity. This analysis, for example, does not determine the potential effect of natural
catastrophes on the financial strength of insurers nor does it consider offsets from the broad
spread and syndication of risk through heavy use of reinsurance, much of it foreign. A
significant share of the impact on surplus associated with a mega-catastrophic event would
be transferred to the insurance industry balance sheet in foreign countries like Germany,
Great Britain, Switzerland, and Bermuda. In addition, the analysis does not consider the
total amount of catastrophe reinsurance provided by state residual markets or state
catastrophe funds that would increase the overall ability to insure catastrophic risks. As
stated above, some insurers and reinsurers are able to raise new capital after a major
catastrophic event.

and the present government insurance approach might not be adequate.18 John Seo,
co-founder and Managing Principal at Fermat Capital Management, LLC, asserted
during discussions with CRS in preparation for this report that a government
insurance program might become challenged in its ability to cover losses for less than
one generation’s worth of exposure growth. As an illustration, a $100 billion
exposure becomes $200 billion after 10 years; $400 billion after 20 years; and $800
billion after 30 years. Ten years ago a 1-in-100 event would have cost insurers $55
billion. Ten years from now a 100 year event could cost $220 billion.
Uncertainty in Measuring and Pricing Catastrophe Exposures
In general, efficiently functioning insurance markets require insurers to: (1)
classify risk so that differences in risk can be observed and incorporated in insurance
premiums; (2) accurately predict the total expected losses for the pool of insured
properties; and (3) accurately reflect the underlying economic costs in the price of
insurance coverage.
For any insurer to meet its contractual financial obligations in the event of a
loss, it must first be able to estimate the expected annual loss (in order to price the
coverage) and the magnitude of the extreme losses (to prevent cash-flow or liquidity
problems). One difficulty is that risk-spreading-and-predicting techniques in the
private insurance market generally do not work as well for low-frequency high-
severity events as they do for high-frequency, low-severity risks. The lack of relevant
historical data and experience on rare catastrophic events makes the forecasting of
losses difficult. In addition, losses from catastrophes are correlated across
exposures, making it difficult for insurers to manage such losses. In order to avoid
potential insolvency, given the uncertainty surrounding catastrophe losses, insurers
must charge a premium that substantially exceeds expected losses. Homeowners
might perceive this catastrophic risk premium to be too high and, therefore, may be
unwilling or unable to purchase coverage. The challenge for insurance companies is
to accurately estimate loss probabilities due to the large variance of loss around an
expected occasional extreme event.19
Insurance Market Imperfections
Catastrophe reinsurance could arguably become “over-priced” and in relatively
short supply due to natural market forces of supply and demand. Capital market
imperfections and market power enjoyed by a relatively small number of catastrophe
reinsurers can potentially also contribute to the high price and shortage of coverage.20


18 Insurance Services Office, “Catastrophe Losses Will Double About Every 10 Years, Says
Leading Catastrophe Modeling Expert at PCS Conference,” located at
[ h t t p : / / www.i s o.com/ i ndex.php?i d =2276&opt i on=com_ cont ent &t a sk=vi e w] .
19 J. David Cummins, “Should the Government Provide Insurance for Catastrophes?”
Federal Reserve Bank of St. Louis Review, 88(4), July/August 2006, pp 342-343.
20 Kenneth A. Froot, “The Market for Catastrophe Risk: A Clinical Examination,” Journal
of Financial Economics, vol. 60, May 2001, p. 529-571.

Economists Dwight Jaffe and Thomas Russell have argued that catastrophe
insurance markets fail because primary insurers are not able to pay annual losses out
of annual premiums — a situation that results from the wide variance in annual
expected losses and potential magnitude of catastrophe losses.21 The process of
securitization of catastrophic risk, in theory, should be able to intertemporally smooth
out this “timing problem” by allowing the capitalization of the stream of future
premiums.
Alternative Risk Transfer Mechanisms
Securitization has traditionally been used to convert illiquid financial assets
(e.g., mortgages, accounts receivable) into liquid marketable assets (securities), but
since the late-1990s it is also being used to transfer catastrophic risk to investors in
the capital market. There are two main categories of alternative risk transfer (ART)
instruments that permit catastrophic risks to be dispersed into the capital markets:
insurance-linked securities (ILS), which in effect are direct risk transfer instruments,
and contingent capital securities, which reduce an insurer’s need for traditional
sources of capital.
!Insurance-linked Securities or “catastrophe bonds” — These are
risk transfer instruments that provide funds to offset catastrophe
losses. Capital received is transferred to a special purpose vehicle
(SPV) that then acts much like a traditional (although a fully
collateralized) reinsurer. The distinguishing feature of these bonds
is that the ultimate repayment of principal depends on the outcome
of an insured event. The bonds pay a fixed spread over LIBOR (the
London Inter-Bank Offered Rate). For investors, insurance-linked
securities (ILS) are attractive as they provide an investment in a
specific insurance risk with potentially low correlation with equity
and credit markets and with a reduced counter-party risk because
some funds can be held in trust.
!Contingent Capital Securities — Insurers are also considering
contingent capital arrangements (reinsurance sidecars, industry loss
warranty, surplus notes, catastrophe options and catastrophe equity
puts) that provide post-event capital that insurers can access after a
catastrophic event. These arrangements allow insurers to raise cash
by selling stocks and issuing debt at prearranged terms. The insurer
pays a capital commitment fee to the party that agrees in advance to
buy the equity or debt securities following a loss. Contingent capital
arrangements do not transfer the insurer’s risk of loss to investors;
the insurer only receives an inflow of capital to replenish its
policyholders’ surplus after it pays for the loss. Contingent capital
can be available to insurers immediately after a catastrophe, when
the insurer most needs that capital, through a wide range of


21 Dwight M. Jaffee and Thomas Russell, “Catastrophe Insurance: Catastrophe Market
and Uninsurable Risks,” Journal of Risk and Insurance, vol. 64, June 1997, pp. 206-230.

alternative capital sources — contingent surplus note arrangements,
catastrophe equity put options, reinsurance sidebars, or industry loss
warrants.
Financial Market Turmoil in 2008
In the aftermath of a series of natural disasters in the mid-1990s, insurers,
reinsurers, property owners and public officials recognized that a mega-catastrophic
disaster in the U.S. could create insurance price/capacity constraints in disaster-prone
areas. In response, catastrophe insurers and reinsurers have increasingly turned to
capital markets to strengthen their balance sheets and manage risks associated with
a mega-catastrophic event.22 Recent evidence suggests, however, that private
insurance and the ability of state governments to implement catastrophe risk
management strategies could be jeopardized because of the current financial market
turmoil. Florida’s inability to issue sufficient debt (bonding capacity) during the
global financial market crisis in advance of the 2008 hurricane season, for example,
threatened to unravel Florida’s property insurance system if a major hurricane struck
in 2008. In October 2008, officials in Florida announced that the Florida Hurricane
Catastrophe Fund (FHCF) would not be able to honor the entire $28 billion in
reinsurance obligations to insurers in the event of a major hurricane striking the state,23
and that additional funds from the federal government might be needed.
The financial market turmoil has been attributed to a combination of factors,
including a lack of transparency, financial market complacency stemming from years24
of positive results, and poor or insufficient regulation. In short, the credit-related
sectors of the financial services industry were adversely affected by the way
investment banks hedged their risk exposure. Financial engineers and investment
bankers created financial instruments called credit default swaps (CDS) on structured
collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs),
but, in hindsight, these financial contracts lacked sufficient transparency to easily25


identify, assess and clear the risks.
22 The securitization of insurance risk received a boost after Hurricane Katrina in 2005 and
the sharp increase in the cost of catastrophe property insurance and reinsurance.
23 See The Florida Senate Issue Brief 2009-301, “Status of the Florida Hurricane
Catastrophe Fund,” October 2008, located at
[ h t t p : / / www. f l s e n a t e . go v/ d a t a / Publications/2009/Senate/reports/interim_re p o r t s / p d f / 2 0 0

9-301bi.pdf]; and, Florida Insurance Council Issues Backgrounder 2008 Cat Fund Reality,


October 22, 2008, located at
[ h t t p : / / www.f l ai ns.or g/ i ndex2.php?opt i on=com_ cont ent &do_pdf =1&i d=2438]
24 See Testimony of Dr. Luigi Zingales, Professor of Economics at the University of Chicago
Graduate School of Business, before the House Committee on Oversight and Government
Reform, “Causes and Effects of the Lehman Brothers Bankruptcy,” October 6, 2008.
25 Collateralized debt obligations and collateralized loan obligations were developed to
repackage credit risk inherent in loans, bonds, and other types of debt instruments by
creating investment-grade fixed income risk from a pool of speculative grade or mixed credit
(continued...)

Credit default swaps function as insurance contracts for bond owners to protect
themselves in case bond issuers default on their debt. CDS are not traded on
exchanges; rather, they are privately negotiated contracts and traded on the over-the-
counter market. The buyer typically pays monthly or quarterly premiums to the
seller. The size of the notional value outstanding in the CDS market is estimated at
$55 trillion, compared to the entire U.S. Treasuries market of $4.5 trillion, mortgage
market of $11 trillion, and the U.S. stock market of $22 trillion. The $55 trillion
CDS market failed as investor appetite for these securities disappeared. Thus, the
credit market crisis spread to the broader financial markets as counterparties, unable
to identify and quantify precisely where losses lay, stopped lending to each other.
Because the proper functioning of the world’s economy is dependent on credit, public
officials are working to restore confidence in the financial system.
Financial market turmoil has already led to the largest corporate bankruptcies
and financial collapses in U.S. history. The credit market crisis has gone beyond
mortgages to complex structured finance transactions involving residential mortgage-
backed securities (RMBS), commercial mortgage-backed securities (CMBS), and
CDO markets. Some of the more prominent episodes in 2008 include:
!the filing for bankruptcy by the fourth largest investment bank,
Lehman Brothers;
!collapse of one of the largest U.S. investment banks (Bear Stearns);
!conversion of Goldman Sachs and Morgan Stanley, two of the
largest investment banks, to bank holding companies, a classification
that gives these two firms access to new, low-cost funding sources
but also subjects them to more regulatory oversight;
!the U.S. government taking partial financial ownership of some of
the nation’s largest commercial banks, including Citibank, Bank of
America, Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan
Chase & Co., Bank of New York, and Mellon and State Street
Corporation;
!the sale of Merrill Lynch to Bank of America;
!the failure of the largest U.S. thrift institution (Washington Mutual
Bank);
!the purchase of Wachovia Bank by Wells Fargo;
!a plan to spend up to $200 billion to shore up the mortgage finance
giants Fannie Mae and Freddie Mac; and


25 (...continued)
quality fixed income securities. For more information see CRS Report RS22932, Credit
Default Swaps: Frequently Asked Questions, by Edward Vincent Murphy.

!the Federal Reserve Board’s unprecedented $123 billion secured
two-year loan to American International Group (AIG).26
On October 5, 2008, President Bush signed into law the Emergency Economic
Stabilization Act of 2008 (P.L. 110-343) to restore liquidity and stability to the U.S.
financial system.27 The law authorized the Treasury Secretary to create a Troubled
Asset Relief Program (TARP) to purchase, insure, hold, and sell a wide range of
financial instruments, particularly those that are based on or related to residential or
commercial mortgages. The Secretary of the Treasury now has the authority to
purchase up to $700 billion of mortgage-backed or other securities from insurers,
banks, thrifts, credit unions, and broker-dealers.
Under the new law, the Secretary of the Treasury is charged with developing the
terms and conditions used to insure troubled assets, and collect premiums from
participating financial institutions. The TARP would be operated in consultation
with the Board of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation, the Comptroller of the Currency, the Director of the Office
of Thrift Supervision and the Secretary of Housing and Urban Development. The
plan is to make money available to banks; the banks would then lend to keep the
credit markets open.
Impact of Credit Market Illiquidity on Catastrophic Risk
Financing
The financial market turmoil poses a serious threat to state government
catastrophe risk management strategies that rely on pre-loss financing using
catastrophe (re)insurance, ILS, and contingent capital to cover any cash shortfalls
needed to satisfy claims obligations. As an illustration, at the beginning of the 2008
hurricane season, Florida officials could not sell bonds in the weak credit markets to
fund their catastrophe risk management program. Florida officials instead agreed to
pay Warren Buffett’s Berkshire Hathaway $224 million for a conditional pledge to


26 American International Group (AIG) is a federally regulated financial holding company
that owns 71 U.S.-based insurance companies and 176 other financial services companies
throughout the world. The company operates banks, securities firms, and non-U.S. insurers
and other related businesses such as premium finance companies. Some critics of state
insurance regulation have taken the position that the failure of AIG and the $123 billion line
of credit offered by the Federal Reserve demonstrates the need for federal insurance
regulation. (On October 9, 2008, the financial relief package grew by another $38 billion,
bringing the total to $123 billion.) Representatives of the National Association of Insurance
Commissioners (NAIC) have responded by pointing out that the 71 U.S. based insurers are
financially solvent and able to pay claims presented by policyholders and claimants. The
failure of AIG, instead, stems from the company’s investments in collateralized debt
instruments (e.g., credit default swaps) on mortgage-backed securities that are subject to
federal regulatory oversight by the Securities and Exchange Commission, not state insurance
regulation.
27 For more information see, CRS Report RS22966, Financial Turmoil: Comparing the
Troubled Asset Relief Program to the Federal Reserve’s Response, by Marc Labonte.

buy $4 billion in 30-year tax-free bonds with a 6.5% coupon, if the state fund incurs
total storm-related claims of more than $25 billion in 2008. This pre-loss (debt)
financing arrangement cold help fund the operations of the Florida Hurricane
Catastrophe Fund (FHCF), a state-run catastrophe fund that provides insurers with
cheaper reinsurance and issues tax-free bonds to pay insurers’ claim losses beyond
agreed caps. In a normally functioning credit market, state residual market plans
raise the money they need by selling bonds, but a consequence of the current credit
market turmoil is that not enough funds can be raised. According to Raymond James
& Associates Inc., the FCHF’s financial manager, the $224 million fee charged by
Berkshire Hathaway compared favorably to the state’s alternative, which was buying
reinsurance at a cost of approximately $1.2 billion.
Opaque Capital Markets. With excessive complexity being the enemy of
transparency, regulators have expressed interest in finding a market transparency
solution that is applicable across all current risk transfer categories and one that can
identify in real time the interaction of multiple transactional, operational, and
performance risks and provide an early warning system for systemic failure. Some
have argued that the best way to resolve the financial crisis rests on the assurance of
market transparency, so that information about a financial contract and its
counterparties flows freely and all parties are informed about all relevant aspects of
the market transaction. Transparency in the pricing and terms of securities is
considered by many to be essential for financial market efficiency.
It has been argued that in the long run, greater transparency leads to more2829
developed financial markets, greater resiliency to shocks, and better allocation of
capital.30 Transparency regulation has been presented as a way to improve the
allocation of resources, which can arguably reduce financial fragility by strengthening
market discipline and making financial institutions and markets more accountable to
customers and taxpayers. Transparency has been defined in several ways and is often
measured based on subjective perceptions of individuals. One objective definition
of transparency is the accuracy and frequency of economic information released to
the public.31 Consideration is typically made to address the direct costs of complying
with disclosure requirements and the indirect transparency costs stemming from
having to protect proprietary rights.
From a public policy standpoint, the idea is for public officials and regulators
to promote market transparency in order to ensure a well-functioning financial
industry that is able to make new loans, offer lines of credit, and provide capital for


28 C. Leuz and R.E. Verrecchia, “The Economic Consequences of Increased Disclosure,”
Journal of Accounting Research, vol. 38, 2000, pp. 91-124.
29 Boon Johnson and E. Friedman, “Corporate Governance in the Asian Financial Crisis,”
Journal of Financial Economics, vol. 58, No. 1-2, 2000, pp. 141-186.
30 J. Wurgler, “Financial Markets and the Allocation of Capital,” Journal of Financial
Economics, vol 58, No. 1-2, pp. 187-214.
31 This is the definition used by Rachel Glannerstgern and Yongseok Shin in their article
entitled, “Does Transparency Pay?” International Monetary Fund Staff Papers, Vol. 55,
No. 2, 2008.

risk transfer (i.e., insurance, reinsurance, insurance-linked securitization) services.
In theory, a regulatory regime that focuses on market transparency could address
issues of fairness (subsidy to investors at taxpayers’ expense), ambiguity (with
respect to the mission, and oversight of the newly created Troubled Asset Relief
Program) and the long-term economic effects of the rescue plan.
Illuminating Opaque Credit Markets. On one level, what is proposed by
the National Association of Insurance Commissioners, the Federal Reserve, and other
financial sector regulatory agencies to solve the current financial market crisis can
be interpreted as the replacement of individual silos of traditional business models
in favor of unification of the forms and methodologies for credit risk transfer that
result in financial products. According to this model, all risk transfer, whether
insurance- or capital markets-related, can be allowed to compete on an open playing
field. Regulation would still be required to contain market excesses and occasional
disruptions. Such regulation in turn requires data and analytics to keep it informed.
Michael Erlanger, an inventor and corporate executive of Marketcore, an
intellectual property development company focused on the financial service and
insurance industry, claims to have identified the problems in the financial markets
that led to the credit and liquidity crisis, and to have devised a solution. Erlanger
asserts that the crisis is caused by the absence of “real-time” data flows in the
financial services industry that would allow all market participants and regulators to
determine or discover appropriate transaction terms, prices, and performances. The
lack of “real-time” data flows has arguably contributed to market illiquidity,
inefficient risk pricing, and operational inefficiencies to the detriment of all market
participants.
According to Michael Erlanger, two things are needed to address opaque capital
markets: (1) a framework for disclosure and reporting of comprehensive data and
analytics pertaining to all financial instruments, including loans, lines of credit, other
financial products, as well as insurance, reinsurance and securitized insurance risks;
and (2) a transaction platform, or other data highway, such as the Internet, in which
financial products are bought and sold, and where detailed data on the composition
of the assets and of the transactions are collected, stored, and displayed. These data
are available, wherever possible, on a real-time basis. The activity on the transaction
platform is facilitated by what Erlanger calls “Transaction Credits” as buyers and
sellers redeem those credits to either do more business, or to access market and
product information. The transaction credits themselves can provide a consistent
tracking mechanism in which all transaction details, including underwriting standards
and actual per instrument financial performance, are retained and displayed as they
occur.
The Marketcore approach to transparency is to create a transaction platform
where market participants as well as state and federal regulators have access to view
the disclosures and the transaction details. Marketcore argues that transparent
information about the transaction details would keep market participants honest,
while allowing all parties a reasonable expected profit from the transaction placed
through the platform. Many financial market experts agree that illuminating credit
markets is an efficient way to keep market participants and market regulators
informed, leading to sounder financial decisions. Effective implementation would



arguably require global alignment of accounting, regulatory and due process
approaches to provide a standardize framework and restore confidence in contractual
performance, so all participants are able to rely on the sanctity of a contract.
Transparency in the pricing and terms of securities is considered by many to be
essential for financial market efficiency. By definition, transparent financial markets
provide accurate information to allow for the discovery of transaction prices, as well
as terms on securities and financial instruments of all types. It is considered
important that this “real time” information be readily available to everyone,
encouraging market participation.
Transparency and Regulation
Arguably today’s economic environment is characterized by a fundamental lack
of financial market transparency that affects the insurance industry and those that
regulate it along with the general economy. Regulation is usually intended to address
market failures. There are many recent examples of market failures where a
contributory factor has arguably been a lack of transparency. Examples include the
bid-rigging and contingent commission scandal in the insurance world a few years
ago and the recent financial guaranty crisis.32 Another market that functions less
efficiently than it arguably could is the market for catastrophe bonds. If the
underlying elements were made more transparent, then different decisions would
arguably have been made about accepting risk at the negotiated opaque price point.
The concept of insurance regulation is relatively simple. The regulator wants to
ensure that the insurers have sufficient assets to make good on the promises they
have made to the public (solvency regulation) and that the insurers treat customers
and claimants fairly (market regulation).
Solvency is monitored by requiring insurers to submit fairly comprehensive
financial statements on an annual basis and each quarter. In addition, insurers are
subject to periodic desk-audits and on-site examinations to verify the accuracy of the
financial information provided to regulators. The current system, however, is
considered by some to have shortcomings in that the information provided to
regulators is a snapshot in time revealing the insurer’s opinion of the value of
financial assets relative to the ultimate settlement value of all the liabilities that the
insurer has assumed. Should the underlying markets for either the specific
securitizations or their component parts fail, regulatory solvency tests could become
difficult to implement due to limited reliable transactional pricings. In the case of the
financial guaranty insurers (bond insurers), management is accused of having
underestimated the liabilities to which the insurers were exposed because of the lack
of transparency regarding the collateralized debt instruments they were guaranteeing.
It could arguably also have been a misestimation of the value of an asset held by the
insurer such as a bond secured by subprime mortgages.


32 See Jamie Chapman, “Bid-Rigging Scandal Envelops Top Insurance Brokers in U.S.,”
October 29, 2004, located at [http://www.wsws.org/articles/2004/oct2004/mars-o29.shtml].

For effective market regulation, insurance regulators need information on how
the market is functioning. Currently this is done through monitoring consumer
complaints, reviewing rates, reviewing policy language, targeted market conduct
examinations and market analysis. A majority of states are involved in a project to
collect market information through a Market Conduct Annual Statement that requires
insurers to answer several interrogatories and provide some market data to states.
Like the financial regulatory framework, the information provided is a snapshot in
time and is in large part influenced by the insurer’s opinion of its performance.
The National Association of Insurance Commissioners is considering ways to
strengthen solvency regulation and market regulation by harvesting financial and
market performance data as well as accurate valuation of assets held by insurers
directly from an electronic transaction platform system. The thinking is that if such
a system is established and the appropriate information outputs are identified and
captured, regulators will in theory have a better understanding of the actual financial
position (e.g., accurate valuation of assets) of the insurer and greater insight into the
insurer’s market practices. Over time, as more transactions are captured by the
system some think that the output might supersede the current annual and quarterly
financial and market regulatory reports.
Federal Intervention in the
Catastrophe Insurance Market
Since the mid-1990s, policymakers and insurance industry participants have
come to understand that a major catastrophic event can cause an unexpected and
sudden large loss of insurers’ capital reserves, and there is a material risk that the
price of insurance will rise and supply will fall. This situation can lead to calls for
government financial intervention in catastrophe insurance markets to expand the
private sector’s risk-transfer capacity.
Economists believe that an argument for federal intervention in catastrophe
insurance markets can be made if the following four conditions hold:
!adequate insurance is not provided by the private
insurance/reinsurance industry;
!the financial consequences of a major disaster is beyond the ability
of the private insurance/reinsurance industry to cover;
!local communities have adopted and enforced loss reduction
measures to mitigate future natural disaster damages (even if such
activities had limited impact); and
!the public insurance strategy is designed to be actuarially fair and
financially sound, and avoids unfunded contingent liabilities implicit
in some type of guaranty.



There is not a consensus among industry participants and experts as to whether
these four conditions are present in today’s catastrophe insurance market. However,
if the private insurance and reinsurance markets are not willing or able to provide
risk-transfer capacity for whatever reason — perhaps due to high cost and limited
supply of private capital, the heightened uncertainty about the frequency and severity
of future losses, or insurers’ inability to charge a risk premium to ensure individual
company solvency — this situation could justify federal intervention.
Property and casualty insurers and reinsurers have historically opposed federal
intervention in catastrophe insurance markets, often arguing that natural disasters are
insurable if the free market is allowed to work. The large-scale disruption in private
markets created by Hurricane Andrew (1992), the Northridge earthquake (1994), and
Hurricane Katrina (2005), however, has prompted some insurers and their trade
associations to call for a more systemic approach to intervening in catastrophe
insurance markets.
In response to the limited supply and high price of property insurance in coastal
areas, past concerns with the rising level of federal disaster assistance, and limitations
in insurers’ and the state residual markets’ claims-paying capacity, Congress may
wish to examine the risks posed to the U.S. by natural catastrophes, and the means
for both mitigating and paying for those losses, particularly in the uninsured sector
of the American public. Federal financial intervention in catastrophe insurance
markets could take any of several forms designed to expand the private sector’s
ability to provide catastrophe insurance, such as adding a high-end federal
reinsurance backstop, providing short-term government liquidity loans, or offering
federal multiple peril homeowners insurance policies covering both wind and flood
damages.
These approaches to government financial intervention in catastrophe insurance
markets could arguably be justified on the grounds that they address the failure of
private markets to offer affordable disaster insurance to meet societal demand. But
while government intervention might expand the capacity of private insurance and
state-sponsored insurance pools to underwrite wind insurance coverage in high-risk
areas, it might also create taxpayer-financed subsidies. In theory, the subsidy could
undermine the economic incentives for homeowners to adopt cost-effective
mitigation measures, a problem also referred to as “moral hazard.”
Arguments For Intervention
Proponents of federal intervention argue that the government is the de facto
insurer of last resort for mega-catastrophes, largely because the government is
thought to be better positioned to bear catastrophe risk because of its broad resource
base and borrowing capacity. The federal government, however, currently lacks a
comprehensive approach to manage the effects of catastrophic natural disasters,
relying instead on ad hoc disaster relief spending to facilitate recovery and rebuilding
following a major disaster.
Federal financial intervention in the catastrophe reinsurance market, some
contend, could reduce the burdens for future disaster relief expenditures, promote
efficient risk management by property owners, and encourage individuals and states



to take steps to reduce loss exposure which, in theory, could ultimately result in
overall lower social and federal costs. An explicit ex ante federal government risk
financing approach would arguably be the best way to assess, budget and plan for the
future cost of catastrophe risks before such events occur.
Arguments Against Intervention
Opponents of federal intervention in catastrophe insurance markets insist that
there is sufficient private insurance and reinsurance capacity to adequately cover
catastrophic risks if the government ensures a framework that allows market
mechanisms to work without local regulatory interference (i.e., regulatory price
constraints that seek to keep premium rates lower that expected losses, which is
usually based on computer simulation models). Federal intervention in catastrophe
insurance markets, it is argued, creates unexpected side-effects, such as moral hazard,
and reduces the economic disincentives for homeowners and businesses to locate in
disaster-prone areas or neglect risk prevention.
Moreover, opponents of federal intervention in catastrophe insurance markets
argue that private insurers, state residual markets, and state catastrophe funds already
protect coastal properties, and federal government intervention would only distort the
insurance market by regulating availability of coverage and level of premiums,
displacing private capital deployed in insurance and reinsurance, and stifling
innovative private sector solutions for managing and financing catastrophic risks.
Government insurance schemes, they say, would not reflect the risk level of the
activity being insured, thereby eliminating a potentially powerful economic deterrent
to risky behavior. Moreover, government intervention could force the public at large
to cross-subsidize the risky behavior of residents in high-risk areas.
Potential Points of Agreement
There is some consensus that the federal government has a regulatory role to
play in creating incentives for private capital to flow into the property insurance
market, establishing strong building codes, encouraging effective land planning
techniques, and creating a state insurance regulatory environment that fosters
competition and risk-based pricing. There is also some consensus that the federal
government could help decrease barriers in the nascent markets for insurance-linked
securities (ILS) and provide liquidity through temporary loans designed to stabilize
the market after a mega-catastrophe. Other common ground topics include clarifying
accounting rules for special-purpose reinsurers, granting insurance-linked securities
conduit status for federal tax purposes, and changing the rules to require foreign and
domestic reinsurers to meet the same collateral requirements.
Legislative Proposals
Legislation considered by the 110th Congress was intended to protect citizens
and the national economy from catastrophic adversities, while arguably reducing both
societal and federal costs of natural disasters. Besides the enactment of the Terrorism
Risk Insurance Act of 2002, Congress has not approved any other federal disaster



insurance law because of a lack of consensus that a problem exists or that specific
congressional actions is desirable. There is also concern about creating moral hazard
problems and the financial exposure for state and federal taxpayers.33
Table 4 in the Appendix to this report provides a list of major legislative
measures pending before the 110th Congress. These proposals include studying the
issues surrounding the availability and affordability of catastrophe property
insurance, adopting a federal multiple peril policy that includes coverage for wind
and water damage, amending tax laws to create incentives for insurers, policyholders,
and investors, and authorizing direct involvement in the primary insurance markets
or a federal reinsurance program to offset the expected losses from a potential
catastrophic disaster.
Factors to be considered in a debate on federal involvement in insurance
markets include the following: current budgetary constraints, preference for dealing
with state and local problems primarily through government institutions, and past
experience with federal insurance programs, particularly those insuring financial
institutions that are regulated at the state level.
!Bipartisan Study Commissions (H.R. 537/S. 292/S. 2286). These
bills would establish commissions to examine various proposals to
improve capabilities of the insurance marketplace to adequately
insure homeowners against natural disaster risk by facilitating the
pooling, and spreading the risk, of catastrophic financial losses from
natural disasters.
!Tax-Policy Incentives (H.R. 164/S. 926). These proposals would
expand the supply of capital reserves that stand behind private
insurance. This would require an amendment of the U.S. tax code
to allow insurers to accumulate tax-deferred reserves for catastrophic
perils.34 Current tax provisions discourage insurers from reserving
funds for unknown losses. Reserves for such contingencies can only
be accumulated out of after-tax income. In contrast, reserves set
aside for reported losses, or losses incurred but which have not been
reported at the end of a given accounting period, are not taxed by the
federal government. Allowing insurers to accumulate tax-deferred
reserves for catastrophe perils could be costly to the federal
government, in terms of reduced tax revenue, and may involve tax
benefits that favor one type of activity over another, raising issues of
efficiency.
!Another tax policy incentive (S. 2327) would be to allow
homeowners to create tax-free catastrophic savings accounts (CSA)


33 U.S. Government Accountability Office, Natural Disasters: Public Policy Option for
Changing the Federal Role in Natural Catastrophe Insurance, GAO-08-07 (Washington:
November 26, 2007), located at [http://www.gao.gov/new.items/d087.pdf].
34 See CRS Report RL33060, Tax Deductions for Catastrophic Risk Insurance Reserves:
Explanation and Economic Analysis, by Rawle O. King.

similar to health savings accounts that could be used to pay
hurricane deductibles and costs associated with retrofitting
properties.
!A third tax policy incentive (H.R. 1787/S. 927) would be to
authorize the creation of tax-exempt (CSA) for consumers and
allowing for tax-free distributions to pay expenses resulting from a
presidentially declared major disaster. Economists have raised the
question of whether tax incentives for homeowners would be
sufficient to get people to buy disaster insurance. The cost to the
government could be weighed against possible savings in ad hoc
disaster relief outlays.
!A Federal Multiple Peril Insurance Program (H.R. 3121). One
policy response that Congress might consider in the context of
reauthorizing the National Flood Insurance Program (NFIP) is to
create a new option in the NFIP to offer coverage for both wind and
flood risk in one policy.35 Multiple peril insurance could eliminate
the problem of uninsured property owners, but it could also create
new uncertain liabilities for federal taxpayers.
!Federal Reinsurance for Catastrophe Losses (H.R. 91/H.R.
330/S. 928). Congress could decide to enact legislation that would
authorize the Secretary of the Treasury to sell a limited number of
excess-of-loss contracts covering industry losses from natural
disasters to private insurers and reinsurers, as well as to state-
sponsored insurance pools. Another federal reinsurance approach
(H.R. 91 and S. 928) would allow states with their own catastrophe
funds to be eligible to purchase reinsurance from the federal
government, thereby encouraging states to establish catastrophic
funds to protect against natural disasters and reduce costs to
homeowners. Federal reinsurance would expand the supply of
catastrophe insurance in the private market and thereby increase the
capacity of the industry to write primary catastrophe insurance.
!Federal Catastrophe Loan Plan. Title II of H.R. 3355/S. 2310
would authorize the U.S. Treasury to provide loans to state
“qualified reinsurance programs” for natural disasters. The loan
program could dampen swings in insurance rates and address
availability deficiencies caused by inefficient capital markets. Title
III of the same bills would create a Federal Natural Disaster
Reinsurance fund to provide direct federal reinsurance to states for
a state’s insured losses.
!Insurance-Risk Securitization (H.R. 3355/S. 2310). Some mega-
catastrophe exposures may be beyond the claims-paying capacity of


35 See CRS Report RL34367, Side-by-Side Comparison of Flood Insurance Reform
Legislation in the 110th Congress, by Rawle O. King

both the private market and state catastrophe funds. In those cases,
Congress might consider implementing a catastrophe insurance
system able to resolve key obstacles currently impeding broader
implementation of catastrophe risk management and financing with
insurance-link securities (catastrophe bonds). One possibility is to
authorize the creation of a public risk-transfer consortium to allow
state-run residual insurance pools and funds to securitize and
transfer natural catastrophe risks to investors in the capital markets.
!Risk Retention Group Coverage for Commercial Property
Coverage (H.R. 5792). This bill would amend the Liability Risk
Retention Act of 1986 to expand the authority of risk retention
groups (RRGs) to provide commercial property insurance to
members.
Legislative Action
Capital market alternatives, whether in the form of securities such as bonds or
in the form of loans, can potentially stabilize the price of coverage. Congress has
begun consideration of legislation that would encourage the securitization of
insurance risk. On November 8, 2007, the House passed the Homeowners Defense
Act of 2007 (H.R. 3355) that would encourage state-sponsored insurance pools, such
as the Florida Hurricane Catastrophe Fund, to pool their catastrophe risks and transfer
the aggregate risk to the private capital market through risk transfer mechanisms such36
as catastrophe bonds. An identical bill was introduced in the Senate (S. 2310) but
no action has been taken in the 110th Congress. Section 102 of the bill outlines the
functions of the proposed new state-run National Catastrophe Risk Consortium:
At the discretion of the affected members and on a conduit basis, issue securities
and other financial instruments linked to the catastrophe risks insured or
reinsured through members of the Consortium in the capital markets... act as a
centralized repository of state risk information that can be accessed by private-
market participant interested in underwriting risk-linked securities or entering
into reinsurance contracts...(and) use a catastrophe risk database to perform
research and analysis that encourages standardization of the risk-linked securities37
market.
The National Catastrophe Risk Consortium (“Consortium”) envisioned in H.R.
3355/S. 2310 would, therefore, work to allow states to pool large natural catastrophe
risks within the Consortium and then transfer it to the private capital markets through


36 H.R. 3355 and S. 2310 would also create: (1) a high-level liquidity protection program to
provide contingent loans to state catastrophe plans both prior to a disaster (liquidity loans)
and after a disaster (catastrophe loans); and (2) a Federal National Catastrophe Reinsurance
Fund that would serve as a reinsurance backstop for private catastrophe insurance and state
reinsurance programs that have a 0.5% probability of occurring (1-in-200 year return) or
lower.
37 Section 102, H.R. 3355.

the issuance of catastrophe bonds or the purchase of reinsurance.38 The Consortium
is premised on finding a low (or lowest) cost catastrophic risk financing solution that
generates market competition by exposing risk transfer opportunities in a way that
makes evident the cost savings for participants using the system, possibly in real (or
near real) time.
In theory, the Consortium would be set up to: (1) effectively induce usage by
providing economic incentives to insurers to underwrite catastrophe risk because the
risk could be transferred to investors at a lower cost of transmission; (2) facilitate
transparency in both standardized exchange-traded derivatives and heretofore highly
customized over-the-counter (OTC) contracts tailored for a specific buyer; (3) lead
to more individuals participating in catastrophe insurance programs; and (4) lower
the costs of insurance for the consumer.
Some are skeptical of the efficacy of a government solution, seeing no model
that convincingly reduces costs while increasing both competition and financial
innovation in the marketplace. Most economists would agree that it is important that
the economic benefit — the determining value proposition — be evident to users of
the Consortium in a manner that provides sufficient incentive for universal
participation.
There are several other possible options that would encourage the onshore
creation of catastrophe bonds and other ILS through tax exemption for income from
the underlying assets. These options would: (1) clarify and/or change GAAP
accounting rules for Special Purpose Reinsurance Vehicles; (2) encourage states to
amend reinsurance laws to give insurers credit on their financial statements for “other
risk transfer” or capital market instruments, provided there is a fully funded transfer
of risk; (3) amend federal tax law to allow insurers to deduct a “catastrophe
equalization tax” imposed by state governments in a segmented account for the
benefit of insurers for use in the event of a natural catastrophe; (4) grant insurance-
linked securities conduit status for federal tax purposes; (5) allow non-indemnity
reinsurance status of securities under state regulatory accounting rules; and (6) reduce
or eliminate the trust fund (collateral) requirements for non-U.S. reinsurers based on
a state insurance regulator’s determination of the adequacy of regulation of the
country of licensure and the financial strength of the assuming insurer.
Concluding Remarks
In recent decades, large-scale natural catastrophes have become increasingly
frequent and costly. The rising economic cost of compensating victims of disaster
and rebuilding has become a public policy issue which Congress may want to
address. Some maintain that private markets will not provide catastrophic risk unless
the government acts as reinsurer of the high end of the loss. Others believe the
private sector could handle a mega-catastrophe event, if the government removes tax,
accounting and regulatory barriers.


38 For more information see CRS Report RS22756, The Homeowners’ Defense Act: An
Overview, by Rawle O. King.

Several Members of Congress have focused attention on the nation’s significant
exposure to hurricane and earthquake risk and the claims-paying capacity of the
private sector, the effectiveness of emergency federal disaster relief assistance, and
whether the federal government should intervene in catastrophe insurance markets.
Based on both computer simulation models and historical data analysis of catastrophe
losses, economists have concluded that the average expected federal expenditure for
disaster relief outlays has been about $20 billion a year.39 Importantly, researchers
project that future catastrophic insured losses could exceed $100 billion.40 Given the
current approach of federal disaster relief spending in response to natural
catastrophes, researchers project an unfunded liability for natural disaster relief
assistance over the next 75 years comparable to that of Social Security.41
Due to a number of factors, including a lack of consensus on what will work and
concerns about adequate provisions for mitigation and avoidance of unnecessary
government intrusion into markets being served by the private sector, federal disaster
insurance legislation has not been acted upon. Congressional reluctance to establish
a federal disaster insurance program since the enactment of the 1968 flood insurance
statute has arguably been based on the premise that such a program could conflict
with economic and actuarial principles that emphasize the “true” cost of government
programs and the forgone benefits of a competitive insurance marketplace.
In response to higher property insurance prices and reduced availability of
homeowners insurance in several Gulf Coast and East Coast states, Members of the

110th Congress might choose to focus on:


!the current condition of, as well as the outlook for, the availability
and affordability of property insurance in disaster-prone regions of
the country;
!investigation of alternative risk-financing approaches to address the
increased prices and reduced availability of catastrophe property
insurance;
!determination of the extent to which a greater reliance on insurance
could reduce federal disaster costs and reduce the likely insolvency
of insurance companies in a catastrophic event;
!the ability of states-sponsored residual market mechanisms designed
to provide adequate insurance coverage and increased underwriting
capacity to insurers and reinsurers in constrained markets;


39 J. David Cummins, Michael Suher, and George H. Zanjani, “Federal Financial Exposure
to Natural Catastrophe Risk,” Federal Reserve Bank of New York, November 30, 2007,
located at:[http://www.nber.org/chapters/c3036.pdf].
40 Ibid.
41 Ibid.

!the capacity of the private insurance market to cover losses inflicted
by natural catastrophes;
!deciding whether it is possible to develop an actuarial basis for
determining viability of a federal all-hazard insurance program; and
!finding ways to create a transparent marketplace capable of properly
assessing, transacting, and clearing risk transfer in a manner that
confirms free market principles.



Appendix A. Legislative Options
Table 4. Major Federal Disaster Insurance
Legislation in the 110th Congress
Bill Number
(Sponsor)Bill TitlePurpose
Bi-Partisan Study Commissions
H.R. 537/S. 292Commission on CatastrophicWould establish a bipartisan commission on
(Meek/Nelson)Disaster Risk and Insurancecatastrophic disaster risk to study the financial
Act of 2007condition of the property and casualty
insurance and reinsurance markets.
H.R. 3644/S. 2286Commission on NaturalWould establish a bipartisan commission to
(Shays/Dodd)Catastrophe Risk Managementexamine the risks and recommend possible
and Insurance Act of 2007solutions for Americans living in disaster-prone
areas.
Tax-Policy Incentives
H.R 164/S. 926Policyholder DisasterWould amend the federal tax code to allow to
(Jindal/Nelson)Protection Act of 2007set aside a portion of premium income in tax-
exempt policyholder disaster protection funds.
H.R. 1787/S. 927Catastrophe Savings AccountsWould amend the Internal Revenue Code (IRC)
(Feeney/Nelson)Act of 2007to allow homeowners to create tax-exempt
catastrophe savings accounts similar to health
savings accounts, which could be used to pay
hurricane deductibles and the costs of
retrofitting properties.
S. 2327Homeowners InsuranceWould amend the IRC to provide tax credits to
(Dodd)Assistance Act of 2007homeowners to offset the cost of their
premiums, up to $250 annually.
All-Peril Homeowners Insurance Policy
H.R. 3121/S. 2284Flood Insurance Reform andWould amend the National Flood Insurance
(Waters/Dodd)Modernization Act of 2007Program (NFIP) to restore the financial
solvency of the flood insurance program.
H.R. 920Multiple Peril Insurance Act ofWould amend the NFIP to give policyholders
(Taylor)2007the option of purchasing windstorm coverage.
H.R. 3959Flood Insurance Reform Would phase in actuarial rates for certain
(Garrett)single-family properties valued at $600,000
and above, built before 1974 and used as a
principle residence.
Reinsurance for State Catastrophe Funds
H.R. 91Homeowners InsuranceWould establish a federal reinsurance program
(Brown-Waite)Protection Act of 2007to allow state catastrophe insurance programs
to purchase reinsurance through a national
catastrophe fund.
H.R. 330Homeowners’ InsuranceWould establish a federal reinsurance program
(Brown-Waite)Availability Act of 2007to provide reinsurance to improve the
availability of homeowners’ insurance.



Bill Number
(Sponsor)Bill TitlePurpose
S. 928Homeowners Protection Act ofWould establish a commission to advise the
(Nelson)2007Treasury Secretary regarding estimated loss
costs associated with federal contracts for
reinsurance coverage and develop mitigation
plans.
Insurance-Risk Securitization
H.R. 3355/S. 2310Homeowners’ Defense Act ofWould establish a multi-state-operated
(Klein/Clinton)2007corporation to pool catastrophe risks and
transfer this to investors in the capital market.
Risk Retention Group for Commercial Property Coverage
H.R. 5792Increasing Insurance CoverageWould amend the Liability Risk Retention Act
(Moore)Options for Consumers Act ofof 1986 to expand the program to include
2008coverage for commercial property insurance.
Source: Congressional Research Service