Should the Government Provide Insurance For Catastrophes?

J. David Cummins

30th Annual Economic Policy Conference

Federal Reserve Bank of St. Louis

October 21, 2005

Outline of Presentation

Catastrophes: The Recent History Insurability of Catastrophic Losses

Natural catastrophes Is terrorism different?

Insurance Industry Resources Public and Private Sector Responses

Securitization Government programs

Evaluation of Government Mechanisms Conclusions

Catastrophes: The Recent History

Number of Insured Catastrophes

0

50

100

150

200

250

300

350

40019

7019

7219

7419

7619

7819

8019

8219

8419

8619

8819

9019

9219

9419

9619

9820

0020

0220

04

Bil

lion

s (2

004

$)

Natural Man-Made

No. Cats increases from < 150 per year to > 300 per year.

Worldwide Insured Catastrophe Losses

05

101520253035404550

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Bil

lion

s (2

004

$)

Natural Man-made

Cat loss increases from < $10B per year to > $20 per year.

15 Largest Insured Disasters Worldwide

0 10,000 20,000 30,000 40,000 50,000

H Katrina 05H Andrew 92WTC 9/11 01

Northridge 94H Ivan 04

H Charley 04Typh Mireille 91

Wstorm Daria 90Wstorm Lothar 99

H Hugo 89H Rita 05

H Frances 04Tsunamis 04

Storm: Eur 87Wstorm Vivian 90

Loss US$ Millions

Insurability of Catastrophe Losses

Criteria for Insurability

Risk averse buyers are willing to pay more than the expected loss for insurance, giving rise to gains from trade

Therefore, risks are insurable if insurance can be provided with Reasonably low probability of insurer default Reasonably low level of capital per policy Otherwise, the costs of capital may eliminate gains

from trade

Risk Charge Per Policy: Independent Risks

The central limit theorem implies a risk charge per policy for independent risks:

Such that λ → 0 as N → ∞

Nz z

N N

Risk Charge Per Policy: Correlated Risks

λr → Average pairwise covariance among risks.

Criteria for Insurability II

Insurance can be provided at reasonable cost if Risks are independent or if the average covariance among

risks is sufficiently small N is sufficiently large Loss volatility σ is sufficiently small (“thin tails”) Loss amounts are not “too large” Insurers can accurately estimate loss distributions for

heterogeneous policyholder types to avoid adverse selection Loss distributions are sufficiently stationary such that

parameter estimates from past data are predictive of future loss experience

Insurers can control costs of moral hazard

Degrees of Insurability

Depending upon their magnitude and characteristics, risks can be Locally insurable – insurable “locally” without much

international diversification, e.g., automobile insurance Globally insurable – insurable by diversifying globally

through reinsurance, e.g., most natural catastrophes Globally diversifiable – too large for the insurance

industry due to low frequency and high severity, but manageable through securitization

Globally undiversifiable – not insurable or securitizable

Insurability: Is Terrorism Different?

Mega-terrorism may be uninsurable and undiversifiable Difficult to estimate

Limited statistical data on WTC-magnitude events Data kept confidential by government for national security reasons Less subject to “scientific” modeling than natural cats, although

models are being developed and refined Loss distribution non-stationarity due to target-substitution and

changes in terrorist strategy and tactics

Losses affected by government homeland security, defense, and foreign policies

Potentially very large losses due to CBRN risks: $X trillions

Insurance Industry Resources

U.S. Property-Casualty Industry Resources

0

100

200

300

400

500

600

700

800

90019

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Bil

lion

s (2

004

$)

Equity Premiums

Deflated to 2004 real values using the CPI.

Global Reinsurers: Equity & CAT Losses

0

50

100

150

200

250

300

350

400

1999 2000 2001 2002 2003

Equ

ity

($U

S B

illi

ons)

0%2%4%6%8%10%12%14%16%18%

CA

T L

oss/

Equ

ity

(%)

Equity CAT Loss/Equity

Equity deflated to 2004 real values using the CPI.

Underwriting Cycles

Insurance markets subject to underwriting cycles “Hard” markets – rising prices and supply restrictions “Soft” markets – falling prices and ample supply

Why cycles exist Information asymmetries between capital markets and

insurers about reserve adequacy and exposure to loss Cost of capital rises after loss shocks Insurers don’t pay out excess capital in soft markets due

to difficulty in raising it again after next loss shock The result: Inconsistent availability and periodic

price fluctuations

U.S. P-C Insurance Underwriting Cycle

-20%

-15%

-10%

-5%

0%

5%

10%

15%

1977 1980 1983 1986 1989 1992 1995 1998 2001 2004

Underwriting Profit OOR

World Rate on Line Index: Cat Reinsurance

0

50

100

150

200

250

300

350

40019

91

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Ind

ex:

1990

= 1

00

Conclusions: Insurance Industry Capacity

Industry resources have increased US insurers

Equity increased by 61% and premiums by 38% since 1990 $750 billion in total resources in 2004

Global reinsurers Equity increased by 34% Equity of $338 billion and premiums of $164 billion in 2004

However, insurance markets experience price and availability cycles – capacity inconsistently available especially for mega-events

Private Sector Solutions: Securitization

Why Securitization Can Help

Insurance markets can cover most natural catastrophes Subject to cycles and crises Questionable capacity for the largest potential Cats

Securitization of Cat-risk could help to complete the market and smooth out cycles $100 billion loss would be

Equivalent to about 30% of equity capital of the global reinsurers Less than 0.33 of 1% of US stock and bond market capitalization

Cats have low correlations with other events that move markets (zero or low-beta securities)

Markets reveal information – smooth out underwriting cycles

CAT Bond With Single Purpose Reinsurer

S in g leP u r p o se

R e in su r e r

P rin cip al

In v e sto r sC on tin g en t P aym en tP rin cip al & In teres t

In su r e r

P rem iu m + X

C all O p tion

S P R P roceed s

S wapC o u n te r p ar ty

F ix edIn teres tR etu rn

L IB O R - X

CAT Bonds: New Issue Volume & Deals

0200400600800

1,0001,2001,4001,6001,8002,000

Pre

-98

1998

1999

2000

2001

2002

2003

2004

Vol

ume

($ U

S M

illi

ons)

0

5

10

15

20

25

30

Num

ber

of D

eals

Volume No. Deals

CAT Bonds: Absolute & Relative Yields

0

1

2

3

4

5

6

7

Yie

lds

and

E(L

) (%

)

0

1

2

3

4

5

6

7

8

Yie

ld/E

( L

)

Yields Expected Loss Yield/E(L)

CAT Bond Investors: 1999 vs. 2004

1999, 30%

1999, 5%

1999, 5%

1999, 5%

1999, 25%

1999, 30%

2004, 40%

2004, 33%

2004, 16%

2004, 4%

2004, 4%

2004, 3%

0% 10% 20% 30% 40% 50%

Money Manager

Cat Fund

Hedge Fund

Bank

Reinsurer

Primary Insurer

CAT Bonds: Barriers to Growth

NAIC does not allow reinsurance accounting treatment for non-indemnity CAT bonds

Uncertainty about consolidation under GAAP accounting rules

Bonds do not have “conduit” status for Federal tax purposes

CAT Bonds: Conclusions

Risk-capital raised is small relative to reinsurance Spreads have been declining Bonds have attracted broad market interest –

dedicated CAT funds have developed Regulatory and accounting barriers exist Without regulatory barriers, market might develop

“critical mass” Increasing liquidity and declining spreads CAT bonds could “complete the market” for natural cats

CAT Bonds: Conclusions II

CAT bonds for terrorism? Issues that hinder insurability may block wide-scale use

of terrorism bonds Potentially large scale of risk Difficulty in estimating probability distributions Lack of stationarity Confidentiality of information on terrorism Interaction with government policies

Existence of bonds might influence actions of terrorists Target selection Trading in bonds to manipulate market

Existing Public Sector Solutions: Government Role

In Catastrophe Insurance

Government Role: Natural Catastrophes

Following Northridge earthquake in 1994, California earthquake insurance market collapsed

State legislature created the California Earthquake Authority (CEA) to provide insurance Quasi-public entity, no government backing Capitalized by private insurers Issues earthquake “mini-policies,” sold at actuarial rates

with “tempering” Has issued CAT securities Claims-paying ability of $6.9 billion in 2004

Government Role: California (continued)

Private insurers have reentered the market – in 2004, CEA wrote 47.3% of earthquake premiums

Demand for coverage has declined In 1996, 33% of homeowners had earthquake coverage In 2003, only 13.6% had coverage Reason: Buyers consider price too high for coverage

provided even though rates are close to actuarially fair (Jaffee 2005)

Market exists but would not finance a major quake

Government Role: Florida

Following Hurricane Andrew in 1992, insurers tried to raise prices and withdraw coverage for windstorm in Florida

Florida responded by restricting price increases and rates of non-renewal

Florida created 2 quasi-governmental entities (no government financial backing) Citizens Property Insurance Corp – residual market facility Florida Hurricane Catastrophe Fund (FHCF) – state-run

catastrophe reinsurance fund

Government Role: Florida II

FHCF No state backing but exempt from Federal income tax Can assess member insurers if funds inadequate Can issue tax exempt bonds Claims paying ability of $15 billion XS of $4.5 billion

Windstorm insurance widely purchased in Florida with 34% provided by Citizens

Conclusion: Government can play “make-available” role without taxpayer funding

Need for Federal Role: Lessons From Natural Catastrophes

Insurance is available in California, Florida, and other states The market for private reinsurance against natural catastrophes

has stabilized Prices initially rose dramatically but have declined sharply in recent

years (Guy Carpenter, Inc. 2005) Substantial new capital entered the CAT reinsurance industry following

Andrew and Northridge Some market anomalies remain

Market for mega-catastrophes remains thin Coverage skewed towards relatively small events

Conclusion: with some government encouragement (but not funding), “2nd-best” solutions have developed

Government Role: Terrorism Insurance

Prior to 9/11 terrorist attacks, terrorism insurance was included in commercial policies for 0 premium

Following 9/11, world reinsurers excluded terrorism from reinsurance policies

US primary insurers convinced regulators in 45 states to permit terrorism exclusions Did not apply to workers’ compensation Did not apply to personal insurance, only commercial Nevertheless, terrorism coverage availability declined

significantly

Government Role: Terrorism Insurance II

Congress responded to lack of commercial terrorism insurance by passing the Terrorism Risk Insurance Act of 2002 (TRIA) (11/20/2002) Nullified terrorism exclusions & requires insurers to “make-

available” terrorism insurance to commercial buyers Allows market to determine prices subject to state regulation Created Federal terrorism reinsurance backstop with

maximum limit of $100 billion Federal reinsurance provided at no cost TRIA set to expire at end of 2005

Reinsurance Coverage Under TRIA

Overall Liability Limit

$100 Billion

Federal Share:

90% with Discretionary Recoupment

Price of Federal Share = 0

Ins

urer

Sha

re: 1

0 %

Deductible and Mandatory Recoupment

$10B 2003, $12.5B 2004, $15B 2005*

*Aggregate deductibles, individual insurer deductibles are 7% of premiums in 2003, 10% in 2004, and 15% in 2005.

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

-10%

-8%

-6%

-4%

-2%

0%

2%

4%P

&C

Lif

e

Ag

en

ts

RE

IT

Co

nst

Tra

ns

Uti

liti

es

Ban

ks

(-1,+1)

(-5,+5)

(-10,+10)

Significant negative effect for at least one window for all industries except construction.

Why the Negative Reaction?

P-C insurers – required to offer coverage and exposed to deductibles and co-payments

Other industries Samaritan’s dilemma – substitution of limited Federal

reinsurance for more open-ended post-disaster aid Market wanted more substantial “Federalization” TRIA prevented reemergence of more efficient private

market solutions TRIA excludes CBNR hazards

Terrorism Insurance Take-Up Rates: US Treasury Estimates

0%

10%

20%

30%

40%

50%

60%

2002 2003 2004

Tak

e-U

p R

ate

(%)

Terrorism Premiums: % of Total Property Premiums

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

2002 2003 2004

Ter

rori

sm P

rem

% o

f T

otal

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

% C

harg

ing

Pre

miu

m =

0

Overall % With Premium > 0 % With Premium = 0

Source: U.S. Treasury (2005).

Percent of Insurers Writing Terrorism Coverage: US Treasury Estimates

0%10%20%30%40%50%60%70%80%90%

100%

2002 2003 2004

% o

f In

sure

rs W

riti

ng

% Writing Certified % Writing Non-Certified

Source: U.S. Treasury (2005).

TRIA: Conclusions

Stock market responded negatively to TRIA However, TRIA has made coverage widely available

at reasonable prices Take-up rates fairly high, approximately 50% Terrorism small proportion of total premium, but Federal

reinsurance is free

Availability of coverage will decline and price will rise, at least temporarily, when TRIA expires Shown by limited availability of “non-certified” coverage

Terrorism Insurance In Other Countries

Government terrorism programs exist in 8 OECD countries – Australia, Austria, France, Germany, Netherlands, Spain, U.K., and U.S.

All established after 9/11/2001 except Spain where terrorism is covered by CCS The U.K. where Pool Re created in 1993 in response to

IRA terrorism

Terrorism Insurance In Other Countries II

Generalizations 7 of 8 programs have some government reinsurance

Unlimited in France, Spain, and U.K. Of programs with limits, the U.S. is highest ($100 billion)

Of the 7 government backed programs, 5 are temporary and 4 have fixed sunset dates

Only the U.S. program does not charge a premium for government reinsurance

But Treasury can seek recoupment ex post Has “crowding-out” effect on private reinsurance – cannot

compete with free reinsurance

Need for Federal Role: Lessons From Terrorism Insurance

Is terrorism different from natural cats? Estimation difficulties Potential magnitude Relationship with government policies Are CBNR hazards inherently uninsurable and

undiversifiable?

Conclusion: Terrorism is different but useful to distinguish between “Mega” events, where government possibly has a role Smaller events, where private solutions will emerge

Mechanisms for Government Involvement: An Evaluation

Theories of Government Intervention

Laissez-faire: Government should not intervene Even 2nd best market solutions better than government programs Government intervention generally results from rent-seeking by

private interests (Stigler, Peltzman, etc.) Public-interest theory: Government intervention can

correct market failures that lead to sub-optimal resource allocation (Musgrave) Government’s ability to “time-diversify” gives it an advantage in

financing low frequency, high severity events Market-enhancing rationale: Public intervention can

facilitate the development of new private sector solutions – e.g., mortgage-backed securities markets

Government Role: Natural Cats

Given the state of the private insurance and reinsurance markets, laissez faire theory should apply, i.e., a 2nd best solution has emerged

Therefore, government should play a market enhancing role: Remove regulatory and accounting impediments to CAT

bonds Work with insurers to improve the market for

earthquake insurance and windstorm coverage

Government Role: Terrorism Insurance

Great uncertainty exists about the insurability and diversifiability of terrorism risk

Therefore, guiding principle of any government role should be to encourage the emergence of private sector solutions. Any program should be Priced at greater than the expected government loss Voluntary (reinsurance part) – “make available” provision

in primary market may need to be mandatory Temporary with explicit sunset date, subject to renewal by

Congress

Government Role: Terrorism Insurance II

Federal XOL (“excess of loss”) reinsurance contracts (Lewis and Murdock 1999) Government would periodically auction XOL reinsurance

contracts in loss layers where private coverage not available Priced at expected loss + risk premium to encourage private

market “crowding out” If loss occurs, government would issue bonds at risk-free

rate to pay claims, exploiting ability to time-diversify Mandatory “make-available” in primary market subject to

an aggregate limit on insurer liability

Government Role: Terrorism Insurance III

Renewal of a TRIA-like program With a positive price equal to expected loss plus risk

premium to encourage private reinsurers to reenter market Models of terrorism losses now exist that could be used to

estimate premiums, e.g., Risk Management Solutions (RMS)

Allowing insurers to accumulate catastrophe reserves out of pre-tax income is a bad idea Reduces Federal tax revenues No way to prevent insurers from substituting tax favored

reserves for other hedging mechanisms, with little or no net gain in capacity

Conclusions

Conclusions

Frequency and severity of catastrophic losses continues to increase significantly More and bigger natural catastrophes Distributional shift in man-made catastrophes with 9/11

Second-best private market solutions have emerged for natural cats, with some government encouragement (but not funding) California and Florida experience Growth in capacity of world reinsurance market Decline in reinsurance prices over time, pre-Katrina

Conclusions II

Federal government should not provide insurance for natural cats Should play market-enhancing role by forming Federal

task force to remove barriers to CAT bonds

States should continue to work with insurers to improve markets for natural cat insurance Solving the low market penetration problem in California Increasing capacity of CEA and FHCF

Conclusions III

Federal government possibly should play a role in providing terrorism reinsurance

Any Federal program should be designed to encourage reentry of private reinsurers by being priced at expected loss plus a risk premium

Mechanisms for Federal involvement Terrorism XOL reinsurance contracts TRIA-like program with positive premiums that permits

competition from private reinsurers No tax-deductible reserves

CAT Losses Versus U.S. & World GDP

0.00%0.05%0.10%0.15%0.20%0.25%0.30%0.35%0.40%0.45%0.50%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

CA

T L

osse

s/G

DP

(%

)

CAT/World GDP CAT/U.S. GDP

“Cat losses are manageable on a macro-scale.”

Top 15 Insured CAT Losses Through 2005

Amount Date Event Country

50,000 29/8/2005 Hurricane Katrina US21,542 23/8/1992 Hurricane Andrew US, Bahamas20,035 11/9/2001 Terrorist attacks US17,843 17/1/1994 Northridge earthquake (M 6.6)US11,000 2/9/2004 Hurricane Ivan US, Caribbean

8,000 11/8/2004 Hurricane Charley US, Caribbean7,831 27/9/1991 Typhoon Mireille Japan6,639 25/1/1990 Winterstorm Daria France, UK et al 6,578 25/12/1999 Winterstorm Lothar France, CH et al 6,393 15/9/1989 Hurricane Hugo Puerto Rico, US6,000 24/9/2005 Hurricane Rita US5,000 26/8/2004 Hurricane Frances US, Bahamas5,000 26/12/2004 Seaquake (MW 9.0), tsunamis in Indian OceanIndonesia, Thailand 4,988 15/10/1987 Storm & floods France, UK et al 4,613 25/2/1990 Winterstorm Vivian W./Central Europe

U.S. P-C Insurance: Premiums-to-Surplus

0.6

0.7

0.8

0.9

11.1

1.2

1.3

1.4

1.5

1.6

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Failure of Diversification

High-Frequency, Low-Severity Diversify across risk pool at a point in time

Low-Frequency, High-Severity Cannot diversify across pool at any given time Diversification across time fails Through capital markets, can diversify across the entire

economy not just insurance/reinsurance market

Why Use a Special Purpose Vehicle?

Insulate investors from sponsor’s credit risk Insulate investors from agency costs of issuer,

creating a “pure play” security Provide transparent servicing of asset/liability Structure tranches of debt to appeal to different

classes of investors Provide tax and accounting benefits to sponsor

ME

NH

MA

CT

PA

WVVA

NC

LA

TX

OK

NE

ND

MN

MI

IL

IA

ID

WA

OR

AZ

HI

NJ

RI

MDDE

AL

VT

NY

DC

SC

GA

TN

AL

FL

MS

ARNM

KYMOKS

SDWI

IN

OH

MT

CA

NV

UT

WY

CO

PR

Terrorism Exclusions

Exclusions Approved,Mandatory Fire Following

No Terrorism Exclusion

Exclusions Approved,Fire Following NOT Mandatory

Terror exclusions approved in 45 states + DC and PR

Terrorism Insurance Prices As % of Property Insurance Premiums

0%

1%

2%

3%

4%

5%

6%

< 100 100 to 500 501-1000 > 1000

Total Insured Value ($ Millions)

% o

f P

rem

ium

s

2003 2004

Source: Marsh & McLennan.

Terrorism Insurance Prices: Median Rates(% of Total Insured Value)

0.000%

0.002%

0.004%

0.006%

0.008%

0.010%

0.012%

< 100 100 to 500 501-1000 > 1000

Total Insured Value ($ Millions)

% o

f P

rem

ium

s

2003 2004

Source: Marsh & McLennan.

CAT Bond: Hartford Fire Foundation Re

Value of bond issue = $750 million shelf registration, 2 tranches issued = $256.4 million

Issue date: November 2004 Expiration date, Tranche A: November 2008 Single purpose reinsurer: Foundation Re Covers: Tranche A: Gulf and East coast wind Spread over LIBOR: Tranche A = 410 bps Expected loss: 0.78%

Percent of Marginal Exposure to CAT Loss Reinsured (By Event Size)

0%

10%

20%

30%

40%

50%

60%

Loss (US$ Billions)

Mar

gina

l % R

eins

ured

Reinsurance is inadequate for the largest events.

U.S. Property-Casualty Industry Resources

0

100

200

300

400

500

600

700

800

90019

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Bil

lion

s (2

004

$)

Equity Premiums

Global Reinsurers: Equity & CAT Losses

0

50

100

150

200

250

300

350

400

1999 2000 2001 2002 2003

Equ

ity

($U

S B

illi

ons)

0%2%4%6%8%10%12%14%16%18%

CA

T L

oss/

Equ

ity

(%)

Equity CAT Loss/Equity

Measures of Insurer Performance

Combined ratio (CR) = Losses/Premiums + Expenses/Premiums CR < 1 implies underwriting profit CR > 1 implies underwriting loss

Overall operating ratio (OOR) = Combined ratio – Investment Income/Premiums OOR < 1 implies overall profit OOR > 1 implies overall loss

Global Non-Life Reinsurers Performance

0

20

40

60

80

100

120

140

Com

bin

ed R

atio

-10

-5

0

5

10

15

Ret

urn

on

Rev

enu

e (%

)

Government Catastrophe Insurance In Other Countries

Several countries have government programs for natural catastrophes

Spain: CCS, a public corporation, provides coverage for “extraordinary risks” Coverage is mandatory for all property policies Premium is collected and remitted to CCS CCS backed by unlimited government guarantee

Government Catastrophe Insurance In Other Countries II

France: CAT NAT covers catastrophe risk Coverage is mandatory in all non-life policies Backed by unlimited government reinsurance through

CCR, reinsurer of last resort Premium surcharges collected for the coverage Premiums set by French government

Terrorism Insurance In Other Countries II

Spain – terrorism an “extraordinary risk” covered by CCS Coverage mandatory Unlimited government reinsurance Premium is charged for the reinsurance coverage

France – established GAREAT to reinsure terrorism insurance written by private insurers Coverage mandatory Unlimited government reinsurance through CCR Premium is charged for government reinsurance

Terrorism Insurance In Other Countries III

Germany – specialist insurer, EXTREMIS, established in 2002 to provide terrorism insurance Coverage not mandatory Reinsurance of Euro 8 billion XS of Euro 2 billion in

government reinsurance coverage Premium charged for government coverage Demand very low, program will sunset at end of 2005

U.K. coverage provided by Pool Re, a private mutual reinsurance company Coverage not mandatory Unlimited government reinsurance for events that

exhaust resources of Pool Re

Terrorism Insurance:Commercial-Multifamily Mortgage Market

$656

$616

$548

$132

0 100 200 300 400 500 600 700

Total LoanBalance

Terrorism InsRequired

Terrorism Ins InPlace

Balance With InsEx-TRIA

$ Billions

Theories of Government Intervention

Laissez-faire: Government should not intervene Any market-based solution, even second-best, will be better

than governmental intervention Government intervention generally results from rent-seeking

by private interests (Stigler, Peltzman, etc.) Public-interest theory: Government intervention can

correct market failures that lead to sub-optimal resource allocation (Musgrave) Information asymmetries and bankruptcy costs associated

with low frequency, high severity events create the need for government to “complete” the market

Government’s ability to “time-diversify” gives it an advantage in financing low frequency, high severity events

Theories of Government Intervention

Market-enhancing rationale: Public intervention can facilitate the development of new private sector solutions but government should not substitute for private sector mechanisms, e.g., Mortgage securitization Federal flood mapping program

Government Role: Natural Cats

Given the state of the private insurance and reinsurance markets, laissez faire theory should apply, i.e., a 2nd best solution has emerged

Therefore, government should play a market enhancing role by removing impediments to development of CAT bond market GAAP accounting should allow bonds off balance sheet State regulators should allow reinsurance accounting

treatment of non-indemnity bonds Bonds should be given conduit status

Criteria For Insurability

Analysis of insurability Rests on the law of large numbers

Law of large numbers: Let Xi, i = 1, . . . , N be i.i.d. random variables with

mean μ and variance σ2, whereXi = losses of policy i

Law of large numbers states that

Therefore, in a large risk pool, the insurer can be very certain about the expected loss

lim Pr[| | ] 1N

X

Criteria For Insurability II

The central limit theorem (CLT) can be used to illustrate the criteria for insurability. The CLT states that the following variable approaches a standard normal distribution as N → ∞

where

1

N

ii

N

X Nz

12 2

1 2 12

jN N

N i iji j i

Globally Insurable Risks

Risk charge is too large locally but goes to zero through global diversification (reinsurance).

Locally Insurable Risks

“Risks that can be effectively pooled at the ‘local’ level.”

Numerous exposure units “Small” mean and standard deviation of loss Statistically independent or low covariance

Result: Insurance provided at approximately the expected value of loss λ → 0 “locally”.

Globally Insurable Risks

“Risks that cannot be effectively pooled by insurers at the ‘local’ level but can be pooled by insurers globally.”

Relatively small number of exposure units “Large” mean and standard deviation of loss Statistically dependent locally

Result: Reinsurance allow premium to approach the expected value of loss.

Globally Diversifiable Risks

“Risks that cannot be effectively pooled by the global insurance industry but can be diversified through securitization.”

Loss magnitude large relative to the resources of insurers and reinsurers but small relative to capital markets

Low frequency, high severity

Top 15 Insured Catastrophes Since 1970

All have occurred since 1987 (in 2004 prices) 13 occurred since 1990 7 occurred since 2000 Only one was a man-made catastrophe (the

September 11, 2001 terrorist attacks)

Terrorism Insurance Take-Up Rates:Marsh & McLennan Estimates

0% 10% 20% 30% 40% 50%

2003 Q2

2003 Q3

2003 Q4

2004 Q1

2004 Q2

2004 Q3

2004 Q4

Commercial P-C Rate Changes By Line

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

4Q99

2Q00

4Q00

2Q02

4Q01

2Q02

4Q02

2Q03

4Q03

2Q04

4Q04

2Q05

Comm Property General Liab

Terrorism Umbrella

CAT Bonds: Why Are Spreads So High?

Investor unfamiliarity: “Novelty premium” Uncertainty about accuracy of loss estimates:

“Modeling premium” Low volume so far: Liquidity premium Uncertainty about correlation of events with

securities markets: “Stealth beta premium”

Globally Undiversifiable Risks

Mega-catastrophes Estimated damages from a return of the 1923 Tokyo

earthquake $2.1 to 3.3 trillion 45-70% of GDP of Japan

Mega-terrorism risk – use of chemical, biological, radiological, or nuclear weapons (CBRN)

War risk