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Friday, August 30, 2013

Financing Natural Catastrophe Exposure: Issues and Options for Improving Risk Transfer Markets

Rawle O. King
Specialist in Financial Economics and Risk Assessment

The federal government has an established institutional framework for disaster preparedness, reduction, prevention, and response—mainly disaster assistance. However, concerns have been expressed about the nation’s increasing exposure and vulnerability to natural hazards. The rising cost of financing recovery and reconstruction following natural disasters, reports of the nation’s increasing vulnerability to coastal hazards, questions concerning the capacity of state and local governments and private insurers to deal with the rising costs, and disagreements concerning the appropriate role of the federal government in dealing with these costs have all become major topics of congressional debate.

The financial consequences of catastrophic natural disasters, such as Hurricanes Katrina (2005) and Sandy (2012), are largely a result of increasing population growth and the rising concentration of property assets in vulnerable disaster-prone areas. According to the National Oceanic and Atmospheric Administration (NOAA), Hurricane Katrina caused more than $80 billion in economic losses (both insured and uninsured) to private property and infrastructure and, more recently, Hurricane Sandy caused more than $65 billion in economic losses. New York and New Jersey—two of the nation’s most populous states—were especially affected by Hurricane Sandy-induced storm surge and coastal flooding. Sandy also triggered a sustained and heightened policy interest in the potential effects of climate change and population growth on the National Flood Insurance Program (NFIP), the feasibility of innovative public-private sector catastrophe risk management and financing initiatives, and consideration of cost-effective and practical adaptation strategies to make society more financially resilient.

In the wake of Hurricane Sandy, a key policy question for Congress is whether the federal government should intervene in U.S. risk transfer markets to ensure the continued availability and affordability of homeowners’ insurance for all residents. Advocates of federal intervention in property catastrophe insurance markets argue that an inevitable mega-catastrophe event will exceed the financial capacity of private insurers and reinsurers, as well as state insurance programs. Thus, they argue, the federal government should consider establishing a national catastrophe risk-financing program to transfer diversified pools of risk to the capital markets to help states achieve better terms with regard to the cost of insurance protection.

In essence, advocates argue that state residual property insurance pools would benefit from global diversification by transferring government’s catastrophe risk to capital market partners through catastrophe swap or directly to capital market investors through (catastrophe) bond issuance, or the purchase options on their exposure to extreme weather events (weather hedge). These options would presumably reduce pressure on public budgets and help improve insurers’ access to capital to ensure adequate capacity and solvency of the insurance industry to meet consumer needs. Opponents of federal intervention argue that the insurance and reinsurance industry—with access to existing innovation for risk-financing transactions—has withstood unprecedented recent extreme natural disaster events with minimal disruption.

As will be discussed, several catastrophic risk-financing legislative options are before the 113th Congress. For example, H.R. 737, the Homeowners’ Defense Act of 2013, would establish a National Catastrophe Risk Consortium to facilitate multistate pooling of catastrophe exposures (covering a variety of event probabilities and types) and transferring such risk through catastrophe-linked securities and insurance derivatives directly to investors in the capital markets.

H.R. 240, the Homeowners Insurance Protection Act of 2013, would create the National Commission on Catastrophe Preparation and Protection to provide for reinsurance of state  disaster insurance programs. Under this proposal, the Treasury would auction excess-of-loss reinsurance contracts to public and private catastrophe risk-bearers, insurers, and state funds to improve the availability and affordability of coverage for homes. H.R. 549, the Homeowner Catastrophe Protection Act of 2013, would amend the Internal Revenue Code to allow insurers to establish pre-tax reserves by creating disaster protection funds for claims arising from future catastrophic events. Income allocated to the catastrophe reserves would be taxable as income only when withdrawn for the payment of losses. 

Date of Report: August 15, 2013
Number of Pages: 35
Order Number: R43182
Price: $29.95

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