Category Archives: Catastrophes

Terrorism risk insurance

Clearly insurance is an enabling technology; without insurance many if not most large-scale commercial activities would grind to a halt. In a Business Week article entitled “The Unexpected Threat to Super Bowl XLIX“, Wharton professors Howard Kunreuther and Erwann Michel-Kerjan point out that that if Congress decides not to renew the Terrorism Risk Insurance Act (TRIA) (set to expire on Dec. 31), there is a chance that the Super Bowl might not be played. Will Warren Buffet step in as an insurer of last resort if TRIA is not reauthorized?  Also, Gordon Woo raises some excellent points about possible private sector alternatives to TRIA in his blog posting entitled “RMS and the FIFA World Cup: Insuring Against Terrorism“.

Finance to the Rescue

For what it’s worth, I am one of four people (along with Jeff Holland, Liongate Capital Management founder, John W. Howton Rockbrook Capital founder, and John C. Bogle, founder and former CEO of the Vanguard) interviewed in “Finance to the Rescue”, an article that appears in the Fall 2005 issue of Baylor Business Review.  My interview is on the topic of cat bonds, which is a topic that I have previously blogged about.

Bush’s avian flu initiative (AKA the International Partnership on Avian and Pandemic Influenza)

The White House posted the transcript of President Bush’s speech today to the United Nations.  Of particular significance is the President’s announcement concerning the International Partnership on Avian and Pandemic Influenza (see for the complete transcript):

“As we strengthen our commitments to fighting malaria and AIDS, we must also remain on the offensive against new threats to public health such as the Avian Influenza. If left unchallenged, this virus could become the first pandemic of the 21st century. We must not allow that to happen. Today I am announcing a new International Partnership on Avian and Pandemic Influenza. The Partnership requires countries that face an outbreak to immediately share information and provide samples to the World Health Organization. By requiring transparency, we can respond more rapidly to dangerous outbreaks and stop them on time. Many nations have already joined this partnership; we invite all nations to participate. It’s essential we work together, and as we do so, we will fulfill a moral duty to protect our citizens, and heal the sick, and comfort the afflicted.”

Hurricane Katrina and the Great New Orleans Flood

Here is a collection of readings that I have been wading through (pardon the pun) in order to try to gain some perspectives on the tragedy that we see unfolding in the Gulf Coast generally and in New Orleans in particular:

1. Katrina, Cost-Benefit Analysis, and Terrorism, by Richard Posner, Senior Lecturer in Law, University of Chicago.
2. Major Disasters and the Good Samaritan Problem, by Gary Becker, 1992 Nobel Laureate in Economics, Professor of Economics at the University of Chicago and Senior Fellow at the Hoover Institution, Stanford University.
3. Rebuilding New Orleans — and America, by Thomas Sowell, Rose and Milton Friedman Senior Fellow, The Hoover Institution, Stanford University.
4. A Fuller Picture: Beginning to understand what we are seeing in New Orleans, by Michael Novak, George Frederick Jewett Scholar in Religion, Philosophy, and Public Policy at the American Enterprise Institute.

In retrospect, it would appear that the man-made aspects of the disaster are by far and away much worse than the storm itself.  The initial damage report from risk modeling firm Risk Management Solutions (RMS) was $20–$35 billion.  Later that same day (September 2), the levees failed in New Orleans and RMS immediately revised its estimate to $100 billion.  On September 7, the Wall Street Journal published a page 1 article entitled “First Estimates on Katrina Costs For Washington Hit $200 Billion”.  The biggest long term problem (at least from a loss prevention standpoint) has been a chronic underinvestment in levee protection for most of the history of the city of New Orleans.  Interestingly (as noted in John Berlau’s piece entitled Greens vs. Levees), the Army Corps of Engineers was sued sometime back in the mid-90’s in order to prevent them from raising and fortifying Mississippi River levees.  The Corps’ rationale for this project at the time was that it was needed “…because a failure could wreak catastrophic consequences on Louisiana and Mississippi which the states would be decades in overcoming, if they overcame them at all.”

Late today (September 8), Congress approved $51.8 billion in emergency spending to pay for Hurricane Katrina recovery efforts, and thankfully this will be directed through channels other than Louisiana public officials (see Congressman Tom Tancredo (R-CO)’s letter to Speaker Dennis Hastert (R-IL) on the problem of public corruption in Louisiana).

Cat bonds

The very concept of insurance is based on risk. So it’s no surprise that important innovations in risk management and finance often come from the insurance industry. One such innovation that is growing in popularity is the so-called catastrophe bond, or “cat bond.”

Common sense as well as theory suggests that proper diversification of any risk involving a remote possibility of enormous loss (such as a natural or man-made catastrophe) makes such a risk more manageable. Traditionally, catastrophe, or “cat” risk was transferred and shared through the insurance and reinsurance markets. However, in spite of the dramatic growth in the magnitude of human and economic losses from natural and man-made catastrophes in recent years, it is surprising how little cat risk transfer actually occurs. Property owners fail to adequately insure catastrophe risk, and even when they purchase insurance, their insurers tend to retain most (as much as 70 percent) of this risk rather than distribute it more broadly through the reinsurance market. The reason why cat reinsurance is so limited is due to inadequate global capacity and correspondingly high reinsurance premiums.

Cat bonds came into existence due to this lack of capacity in the reinsurance market. Although they have been used primarily as an alternative to cat reinsurance, there are examples of corporations and other non-insurance entities issuing cat bonds. For example, during the summer of 1999, Tokyo Disneyland issued cat bonds because management found at the time that it was cheaper to have the capital markets insure its earthquake exposure than the insurance markets. More recently, the Fédération Internationale de Football Association (FIFA) issued a $260 million cat bond to protect itself against (a terrorism-related) cancellation of the 2006 World Cup in Germany.

Cat bonds represent a form of insurance securitization in which risk is transferred to investors rather than insurers or reinsurers. Typically, an insurer or reinsurer will issue a cat bond to investors such as life insurers, hedge funds and pension funds. The bonds are structured similarly to traditional bonds, with an important exception: if a pre-specified event such as a terrorist attack or hurricane occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or the principal value of the bonds.

Although the cat bond market is still relatively small compared with the traditional insurance and reinsurance markets, it is already having a particularly important effect on reinsurers. Since the cat bond market provides insureds with a credible alternative to traditional reinsurance, the cat bond market has forced reinsurers in particular to become more competitive in their pricing and underwriting practices. Furthermore, investors value cat bonds in part because returns on these securities tend not to be very highly correlated with returns on other asset classes such as stocks, conventional bonds, commodities and real estate.

Given the benefits that cat bonds offer both insureds and investors, the market for cat bonds is expected to continue to grow and exert an important check and balance upon pricing and underwriting practices in conventional insurance and reinsurance markets. Ironically, as documented by a recent Wall Street Journal article, the growth of the cat bond market is in turn fueling the growth prospects of the reinsurance industry, as a number of hedge funds that were early cat bond investors are now starting to launch their own reinsurance firms.

Catastrophe risk summary and recommended reading

Here is a summary of the various articles I have written concerning public policy in the context of the disastrous hurricane season suffered by the state of Florida:

  • 09.07.04: Financial Implications of Hurricanes – This article provides some insight concerning the evolution of public policy in the post-Andrew world. Because of persistent regulatory suppression of insurance rates, economic theory suggests that over time, product quality will likely deteriorate and insurers can be expected to exit the market. For all practical purposes, this is what has occurred in the Florida homeowners insurance market. Clearly, there has been a shifting of risk away from private insurers and toward government and policyholders. What has resulted is a rather ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.
  • 09.08.04: Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk – This article explains why public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select “economically efficient” levels of private insurance and loss mitigation.
  • 09.09.04: The double deductible problem in Florida – Here, you will find my “proposal” concerning policy regulation reform; i.e., why not offer consumers a choice between the status quo policy form and an alternative policy form that enables consumers to insure against aggregate losses? This is a workable reform, assuming that the rate suppression problem can also be properly addressed.
  • 09.10.04: Reinsurance reinstatement option – This article discusses an important contractual issue that is looming in the market for catastrophe reinsurance which may end up being considerably more significant economically than the “double deductible” problem (i.e., given the amount of catastrophe exposure this season, this important aspect of “fine print” may result in quite a few insolvencies).
  • 09.17.04: More on double deductibles – This article argues that in order to “fix” the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms. Specifically, 1) the rate suppression problem needs to be properly addressed so that rates accurately reflect the expected cost of risk, and 2) consumers ought to have a broader set of choices concerning policy forms.

For people who are interested in reading more about public policy as it pertains to catastrophe risk, I highly recommend two books: 1) Catastrophe Insurance: Consumer Demand, Markets, and Regulation, and 2) When All Else Fails: Government As the Ultimate Risk Manager. Finally, I also highly recommend Martin Grace’s weblog.

More on double deductibles

Professor Martin Grace argues that the so-called “double deductible” problem in Florida is more of a problem of high deductibles, where doubling just worsens the problem.  Why are deductibles high?  Professor Grace notes that for some time now, insurers have not been allowed to charge adequate rates, so rate regulations have provided the incentive for the private insurance industry to reduce their Florida windstorm exposure.  Since less risk is privately insured, more risk is borne by policyholders and government in various forms, including higher deductibles and state run risk pools.

Florida provides an interesting case study of dysfunctional regulatory policy.  As Professor Grace so capably documents, the regulatory process has effectively undermined the viability of private insurance and substituted in its place an ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.  Unfortunately, it appears that things may get worse before they get better.  The New York Times published an article about the “double deductible” problem the other day which enumerates some of the short term measures and longer term reforms that are under consideration.  One idea which has been floated is to provide a cash grant of $500 to everyone who has suffered unpaid insurance losses during the course of this hurricane season.  While such a measure may alleviate some of the short term financial “pain” for affected consumers, from a longer term perspective this is not sound public policy, since policies like this undermine consumer incentives to make prudent risk management decisions (see “Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk“).  Actually, this is a classic case of a policy which may have favorable political implications but carries with it rather undesirable economic consequences.  Furthermore, Mr. Tom Gallagher, who is the head of the state’s Department of Financial Services, wants to get rid of multiple deductibles and substitute an alternative policy that would enable consumers to insure against aggregate losses and therefore only pay one deductible.  There’s nothing wrong with this idea so long as insurers are able to charge a premium which reflects the added risk and cost associated with such a policy. However, why stop there? Why not provide consumers with the option to choose between a policy based upon the current policy form, and the alternative policy proposed by Mr. Gallagher? This would encourage self selection, and therefore allow for more efficient and fair pricing. Besides offering consumers greater choice, such a policy reform would also promote market efficiency and enhance the insurability of Florida windstorm risk. In order to “fix” the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms.  If not, then over time consumers and the state will continue to suffer from an insurability problem.

Reinsurance reinstatement option

With the entire furor over the so-called “double deductible” problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.
Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the “option to default” conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.
I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.