CBO

A

S T U D Y

Federal Reinsurance

for Disasters

September 2002

The Congress of the United States ■ Congressional Budget Office 
Note

The photo on the cover is from the San Francisco Chronicle. It shows vehicles trapped on an

elevated section of Interstate 5 north of Sylmar, California, following the Northridge earthquake

of January 17, 1994.
Preface

This Congressional Budget Office (CBO) study, which was prepared at the request of the

Senate Budget Committee, analyzes proposals for federal reinsurance of risks from terrorism

and natural disasters. David Torregrosa of CBO’s Microeconomic and Financial Studies

Division wrote the paper, with contributions from Perry Beider, Kim Kowalewski, and

Marvin Phaup, under the direction of Roger Hitchner. Tim VandenBerg, formerly of CBO,

began the project.

Many other people contributed to the report. Rade T. Musulin of the Florida Farm Bureau

Insurance Companies; Richard Roth Jr., a consulting actuary; Howard Kunreuther of the

University of Pennsylvania’s Wharton School; and Ron Feldman of the Minneapolis Federal

Reserve reviewed several drafts. David Rafferty, formerly of the New Zealand Treasury, provided valuable information on New Zealand’s disaster insurance program. Barry Anderson,

Megan Carroll, Deborah Clay-Mendez, William Gainer, Mark Hadley, Arlene Holen,

Deborah Lucas, Angelo Mascaro, Robert Murphy, Allison Percy, and Tom Woodward, all of

CBO, made useful suggestions.

Amelie Cagle, Mark Puccia, Donald Watson, and David Weiss, all of Standard & Poor’s,

provided background information on the insurance industry and the implications of September 11. Anthony Mormino, Frank Nutter, and Mary Zetwick of the Reinsurance Association

of America provided information on the reinsurance industry. Jim Boyd of Resources for the

Future provided guidance on the effects of limiting damage awards.

The following people also contributed various forms of assistance or data: Dennis Kuzak of

EQECAT; Barbara Jacobik, Tim Mantz, and Rick Shiver of the Federal Emergency Management Agency; Herbert Mitchell and Joyce Northwood of the Small Business Administration;

Dan Kutzer of the Florida Windstorm Underwriting Association; J.D. Lester of the Florida

Residential Property and Casualty Joint Underwriting Association; Jack Nicholson of the

Florida Hurricane Catastrophe Fund; Stan Devereux of the California Earthquake Authority;

Richard Kerr and Michelle Kinlaw of MarketScout; Barry Meiners of the Council of Insurance Agents and Brokers; and John Rollins of the Florida Farm Bureau Insurance Companies.

Christine Bogusz edited the report, and Leah Mazade proofread it. Rae Wiseman produced

drafts of the manuscript, and Kathryn Winstead prepared the study for publication. Annette

Kalicki produced the electronic versions for CBO’s Web site. 

Dan L. Crippen

Director

September 2002

This study and other CBO publications

are available at CBO’s Web site:

www.cbo.gov

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2

3

CONTENTS

Summary and Introduction ix

The Market for Property Insurance 1

Supply 2

Demand 6

Regulation 7

The Insurance Market’s Response to Disasters 9

Recent Unanticipated Losses 9

Short-Run Market Adjustments 11

Long-Run Market Adjustments 13

States’ Responses to Reduced Supply

and Higher Prices for Coverage 14

Federal Assistance After Disasters 15

Proposals for Federal Reinsurance 19

Arguments For and Against Federal Intervention 19

How Would Federal Reinsurance of Risks

from Natural Disasters Work? 21

Cost to the Federal Government of Reinsuring

Risks from Natural Disasters 24

How Would Federal Reinsurance of Risks

from Terrorism Work? 25

Cost to the Federal Government of Reinsuring

Risks from Terrorism 26
vi FEDERAL REINSURANCE FOR DISASTERS

Advantages and Disadvantages of the Federal

Reinsurance Contracts 26

Other Federal Policies to Promote the

Supply of Insurance 28

Appendix A

State-Sponsored Insurance Programs in

Florida and California 35

Appendix B

Innovations in Capital Markets 43

Appendix C

Disaster Insurance Programs in Japan,

Great Britain, and New Zealand 49
CONTENTS vii

Tables

1. Operating Results for U.S. Property and

Casualty Insurers, 1990 Through 2001 5

2. Selected State-Sponsored Insurance Suppliers 6

3. Insured Losses from Hurricane Andrew 10

4. Annual Premiums for a $150,000 Frame Home

in California, 1993 Through 2000 14

5. Federal Financial Assistance After Selected Disasters 16

A-1. Arbitration Decisions in Florida 38

Figure

1. Catastrophe Reinsurance Price Index, 1984 to 2001 13

Box

B-1. USAA’s Catastrophe Bonds 45

Summary and Introduction

The terrorist attacks of September 11, 2001, inflicted

enormous personal and property losses on the United

States. Insurance payments for economic losses on that

day will surpass $30 billion and could top $50 billion.

Among the many adverse economic effects that resulted

from the attacks is a continuing shortage of insurance

against losses of property from terrorism. Coverage is

difficult to obtain, especially for buildings or sites that are

landmarks; where coverage is available, prices are high

and restrictions are numerous.

Policymakers have developed two types of federal proposals to increase the supply of property and casualty insurance. Under one set of options, which was created following Hurricane Andrew in August 1992 and the Northridge earthquake in January 1994, the federal government

would auction reinsurance contracts to primary insurance

companies and state-sponsored insurers. Reinsurance is

an established practice among private insurers. By buying

reinsurance, primary insurers spread the risk of loss more

widely and strengthen their ability to insure against catastrophes. The intent of those proposals is to offer federal

reinsurance when coverage is in short supply, at market

prices that are expected to cover the government’s costs.

By contrast, under proposals developed since September

11, the government would pay for most losses from a

terrorist attack directly, without reimbursement or with

only partial reimbursement. Even though one type of

proposal was created in response to natural disasters and

the other from an act of terrorism, both types could be

considered viable alternatives, whatever the source of catastrophic loss.

A key consideration in Congressional deliberations about

disaster reinsurance is how the property and casualty

industry would respond without federal intervention.

That is, would the private supply of insurance rebound

quickly? A fast recovery would counter a potential slowdown in construction, an industry in which insurance is

often required for financing. Alternatively, is the risk of

terrorism uninsurable, such that supply could not recover

without the government’s assistance? Furthermore, given

that the Congress may need to act without fully understanding the industry’s ability to respond, are there policies that could avoid undermining private activity while

providing a backstop to private efforts if they proved

inadequate? How much would such policies cost taxpayers and the government? 

This Congressional Budget Office (CBO) study examines

the market for property and casualty insurance; the market’s response to recent large, unanticipated losses; and

policies that the Congress is considering to increase the

availability of insurance. In brief:

# Large insured losses that are unanticipated reduce the

supply of insurance and put pressure on private insurers to raise their prices, primarily by reducing insurers’

net worth and by increasing their uncertainty about

future losses.

# Higher prices for insurance eventually attract additional investment into the disrupted market. As a

result, insurers reassess their risks, supply increases,

and prices decline to levels that are consistent with
x FEDERAL REINSURANCE FOR DISASTERS

those revised perceptions of risk. But that adjustment

takes time, during which some property owners are

unable to get the insurance they want at prices they are

willing to pay.

# Proponents of a federal reinsurance program contend

that the government needs to add capital to the market

quickly during times of disruption and to withdraw it

as the market recovers. Those actions would moderate

fluctuations in the availability of insurance, address

the possibility that private insurance might prove incapable of surviving the “Big One” (usually defined as a

hurricane or earthquake costing in the $100 billion

range), and accomplish both without displacing private supply. Federal reinsurance might also reduce the

need for federal assistance after a disaster.

# A federal program to expand the supply of property

and casualty insurance would probably expose taxpayers to substantial risk—up to $100 billion in contingent liabilities for terrorism insurance and up to

$25 billion for natural disaster risk—and raise expected budget outlays. In addition, subsidies could

lead to fewer preventive actions by insured parties and

also to more risk taking, which could boost losses

from a disaster. A federal program could also delay

innovation by private insurers and the capital markets

that could increase private supply.

# States’ experience with regulations has shown that

controlling prices and requiring certain coverage can

delay the drop in supply and surge in prices that typically follow a large loss. It has also shown that insurance premiums can be reduced by shifting some costs

to taxpayers and to policyholders exposed to the smallest amount of risk. But those actions drive private

suppliers out of the market, tend to increase losses,

and may lead to higher prices over the long term.

# Since September 11, the supply of private insurance

against terrorism has grown, prices have fallen, and

coverage has become less restrictive. Experience with

natural disasters strongly suggests that this adjustment

will continue. However, private insurers may not be

able to pay claims and continue issuing coverage after

every contingency. Some imaginable events could

produce losses that were bigger than the industry

could afford. Also, another loss of unexpected size

could occur, temporarily halting insurers’ willingness

and ability to issue coverage.

# Under current proposals for federal reinsurance of

terrorism risks, the government would initially pay for

most of the losses from a terrorist attack. Insurers

would not pay any premiums up front for that coverage. However, CBO estimates that the government

would need to charge insurers about $3 billion annually to fully compensate taxpayers for the risks they

would assume under one of the proposals.

# As an alternative to providing reinsurance, the Congress could consider other measures to encourage the

private sector to supply reinsurance following catastrophic events. Those measures include offering property owners incentives to mitigate risks, reducing federal assistance after disasters, changing the tax treatment of loss reserves held by insurers, and limiting

damage awards.
CHAPTER

1

The Market for Property Insurance

The insurance market is usually divided into four

parts: life, health, marine, and property. Property and

casualty (P&C) insurers pay for losses of or damage to

homes, commercial buildings, motor vehicles and airplanes, business equipment, and personal and business income from causes including fire, wind, explosion, and

negligence. The terrorist attacks of September 11 hit

P&C insurers harder than other insurers. Payment of

claims for economic losses on that day will surpass $30

billion and could top $50 billion. Those losses exceed the

combined total of insured losses from what had been the

two largest single disasters in the United States—Hurricane Andrew, which struck south Florida in 1992, and

the Northridge earthquake, which shook the greater Los

Angeles area in 1994.

Property and casualty insurers do not sell “disaster”

insurance. Rather, they cover the insured economic losses

of individuals, businesses, and nonprofit organizations. A

single claimant’s losses would almost never amount to a

national disaster, nor even a financial disaster, for a wellmanaged insurer. Indeed, the insurance market operates

by pooling individual risks across a large and diverse

population. Each insured property owner is protected

against uncertain loss for the price of a pro rata share of

the expected losses, which is paid into a fund and used to

compensate the few owners who do suffer a loss. Thus,

under normal circumstances, property insurers use annual

premiums (and the investment income earned on

reserves, retained earnings, and capital) to cover losses

that would otherwise be personal catastrophes but not

national disasters. Insurance disasters occur when a single

event imposes losses on a large number of insured

properties.1

 Occurrences of that magnitude are rare,

which is why they are designated as happening, on average, once every 50 years (a 50-year loss) or once every 100

years (a 100-year loss).

Although P&C insurers have traditionally focused on

natural disasters, such as hurricanes and earthquakes,

manmade disasters also pose a large-scale threat to property. The challenge to insurers in providing disaster coverage is predicting the frequency and severity of any catastrophic event. Insurers have information and methods to

make satisfactory predictions for natural disasters and can

design and price insurance products to cover damage

from those events. Understanding the risk of loss from

willful acts is far harder because there is little basis for

predicting the frequency, kind, and severity of future

attacks.

Thus, when a new category of risk emerges, such as the

threat of terrorist attacks, P&C insurers may issue coverage that excludes such losses, at least until insurers obtain

more information and refine their methods of analysis

and prediction. Prior to September 11, terrorism insurance was provided only implicitly; that is, most existing

policies did not explicitly include or exclude losses from

terrorism. After the attacks on the World Trade Center,

insurers began to exclude terrorism from coverage under

new policies and renewals.

1. See Christian Gollier, “Insurability” (paper presented at the National Bureau of Economic Research Conference on Insurance,

Cambridge, Mass., February 1, 2002).
2 FEDERAL REINSURANCE FOR DISASTERS

Overall, the market for property and casualty insurance is

highly competitive and adaptive to new circumstances. It

is also tightly regulated, especially for personal lines of

insurance, such as homeowners and automobile. Traditionally, P&C insurers have experienced periodic increases and decreases in net income from underwriting

activities.2

 However, the industry has always recovered

from periods of heavy losses. A useful approach to understanding the market’s performance is to examine the principal forces that affect it—supply, demand, and regulation. 

Supply

More than 100 companies sell property and casualty

insurance in the United States. The names of the largest

national operators—State Farm, Allstate, and American

International Group—are familiar to most consumers.

But many insurers specialize regionally.3

 Also, some states

sponsor insurance programs, especially to cover high-risk

properties.

The market for P&C insurance appears to be competitive

nationally, with the three largest companies dividing a 23

percent market share and the top 10 firms collecting 44

percent of total premiums in 2000.4

 The industry relies

heavily on information and capital, needing the former to

assess risk and the latter to ensure the capacity to pay

claims.

Risk Assessment and Capital Holdings 

Perhaps the easiest part of providing insurance is when a

company’s agent says to a property owner, “You’re covered.” For an insurer, agreeing to a binding contract to

protect against specified losses is the final step in a process

that includes establishing premiums that are actuarially

sound and obtaining sufficient capital to pay claims. Insurance premiums must cover insured losses, administrative expenses, and a return on the capital that would be at

risk if losses exceeded annual premiums and investment

income. 

To set premiums that are sound, insurers must allow for

the uncertainty of the “true” distribution of future losses,

especially for infrequent events that result in large losses.

Even though many hurricanes, earthquakes, and manmade acts of destruction occur each year, catastrophes are

rare. In the past century, only three of the most powerful

hurricanes (Category 5 on the Saffir-Simpson scale, which

measures hurricane strength on the basis of wind speed)

have made landfall in the United States. Similarly, only

four earthquakes exceeding 8.0 on the Richter scale are

known to have struck the United States, and none affected a densely populated area.5

 (Of course, less powerful

earthquakes and hurricanes can cause extensive damage

and loss of life if they strike an area that is densely populated.) And although a number of incidents of terrorism

have occurred in the United States in recent years, none

approached the attacks of September 11 in magnitude or

in severity. With such infrequent catastrophes, insurers

cannot be sure that they have reliably estimated expected

losses.6

 Moreover, the underlying probabilities of catastrophic events can change as a result of variations in

climate, geology, and the global political environment.7

Because insurance losses may vary widely, insurers must

hold sufficient capital reserves to bridge the gap between

2. Congressional Budget Office, The Economic Impact of a Solvency

Crisis in the Insurance Industry (April 1994).

3. Martin W. Grace and others, Catastrophe Insurance: Supply, Demand, and Regulation, Working Paper No. 01-38-pk (Philadelphia: Wharton Catastrophic Risk Management Project, December

2001).

4. Data are from A.M. Best Company as reported in Insurance Information Institute, The Fact Book 2002 (New York: Insurance Information Institute, 2002), p. 8.

5. Letter from Paul G.J. O’Connell, Chairman, Catastrophe Work

Group, American Academy of Actuaries, to the General Accounting Office, May 7, 1997.

6. Howard Kunreuther, “The Role of Insurance in Managing Extreme Events: Implications for Terrorism Coverage,” Business Economics, National Association for Business Economics, April 2002.

7. In the extreme, some risks may have loss distributions that cannot

be observed or identified. See Nomura Fixed Income Research,

How the Events of 9/11 Affect Thinking About Risk (New York:

Nomura Securities International, January 3, 2002); and Howard

Kunreuther, Robin Hogarth, and Jacqueline Meszaros, “Insurer

Ambiguity and Market Failure,” Journal of Risk and Uncertainty,

vol. 7, no. 1 (1993), pp. 71-87.
CHAPTER ONE THE MARKET FOR PROPERTY INSURANCE 3

annual premiums and actual losses. When catastrophic

events occur, they adversely affect many properties and

people. Individual losses are thus “bunched” in space and

time, or correlated with one another. The variance of an

insurer’s losses—the distribution around the mean—is

higher for correlated than for uncorrelated risks and requires larger reserves.

The added cost of holding larger amounts of capital

means that insurers must charge a higher premium for

correlated risks than for independent risks.8

 That difference can be seen in an example of two insurance portfolios: one for hurricane coverage (correlated risks) and one

for fire (independent risks).9

 The hurricane portfolio

exposes the insurer to a $100 million loss once every 100

years, whereas losses from fire alternate between $0.8

million and $1.2 million each year. Annual premiums of

$1 million would cover the expected costs of each hazard.

But to ensure its ability to pay claims every year, a fire

insurer would need to hold only about $200,000 in capital reserves for those years in which losses were $1.2 million. An insurer covering losses from hurricanes, in contrast, would need to hold capital of $99 million for the

$100 million loss that would occur, on average, once

every 100 years. (Bond-rating agencies generally require

that insurers have enough capital to pay off at least a 100-

year loss. To attain a top rating, insurers may need to

hold capital against a 250-year loss.)

With either portfolio, insurers would expect to lose a

certain amount of capital each year, and that loss must be

incorporated in the price of the insurance. The price must

also reflect other costs to capital reserves. One such cost is

the competitive return that investors must earn on their

capital. The cost of capital is the opportunity cost of not

investing the money in the most profitable alternative

activity (after adjusting for risk). Insurers invest most of

their capital in relatively safe, liquid assets (such as bonds)

to assure policyholders and rating agencies that they can

pay claims in the event of a disaster.

Taxes represent another cost to capital reserves. The interest on the bonds held by an insurance company is subject

to corporate income taxes, which reduce the earnings

available for return to the owners who provided the capital.10 That taxation pushes up the premium that insurers

must charge on catastrophic risk. If taxes absorb onefourth of investment income, then an insurer’s 8 percent

market return on investments is reduced to 6 percent

after taxes. Because shareholders could instead invest directly in a mutual fund that returned 8 percent, insurers

would need to collect an additional 2 percentage points in

premiums ($1.98 million in the previous example) to

compensate providers of capital for hurricane exposure.11

For fire risks, however, insurers would need to collect

much less (only $4,000) to compensate stockholders for

the cost of their capital. Thus, an insurer would need to

charge policyholders nearly $3 million per year for the

hurricane insurance but just over $1 million for the fire

8. Howard Kunreuther, “Insurability Conditions and the Supply of

Coverage,” in Kunreuther and Richard J. Roth Sr., eds., Paying the

Price: The Status and Role of Insurance Against Natural Disasters in

the United States (Washington, D.C.: Joseph Henry Press, 1998),

pp. 37-38. Prices for catastrophe coverage must include a markup

(or load) over expected losses even when competition is strong.

Consequently, high prices for catastrophe coverage should not

necessarily be interpreted as a market failure. See George Zanjani,

“Pricing and Capital Allocation in Catastrophe Insurance” (working paper, Federal Reserve Bank of New York, May 21, 2001).

9. This example is based on one presented in Rade T. Musulin, “Can

Our Children Afford ‘Affordable’ Insurance?” Emphasis, Tillinghast-Towers Perrin (1997), pp. 2-5. 

10. Scott E. Harrington and Greg Niehaus, “Government Insurance,

Tax Policy, and the Affordability and Availability of Catastrophe

Insurance,” Journal of Insurance Regulation, vol. 19, no. 4 (Summer 2001), pp. 591-612.

11. The restrictions precluding some risky investments do not represent a significant cost to insurers or investors. As long as investors

get a fair risk-adjusted return on their investment, they do not

need to receive an equity return on what is essentially a bond fund.

An investor who chose a bond mutual fund would be satisfied with

the returns passed through by an insurance company if it were not

for the unfavorable tax treatment those returns received. Moreover,

investors may not need to receive a higher return on their capital

because of the risk of insurance losses. Risks that are not correlated

with the rest of the market can be reduced through diversification

and thus do not require a premium. Catastrophes such as hurricanes have very low correlation with the market and, hence, do not

represent priced risk. In practice, investors might require some

additional compensation for the great uncertainty of disasters, for

example, or for the possibility of fraud.
4 FEDERAL REINSURANCE FOR DISASTERS

insurance, even though both portfolios have the same

expected overall loss.

To pay claims in the event of a disaster, insurers have options other than holding costly reserves. One option is to

borrow the money, but that may not be possible because

policyholders are not contractually obligated to purchase

multiyear policies. If they were, their future premiums

might serve as collateral. Also, borrowing may become

more difficult after a disaster because insurers have the

option of declaring bankruptcy.

Insurers can substantially reduce their cost of capital

through risk diversification. By combining insurance

pools whose losses have different causes and hence are

likely to occur at different times (hurricanes in Florida,

earthquakes in Japan, and terrorism in Europe, for example), insurers can narrow the gap between overall expected

losses and the maximum probable loss in any one year,

reducing their need for capital. Diversification can occur

through a single insurer’s underwriting different hazards

(automobile, fire, and workers’ compensation, for instance) in various locations. Alternatively, it can happen

through reinsurance, a process in which one insurer sells

some of its business and the associated income from premiums to another insurer. Through such sales, even specialized regional insurance companies can reduce their

risks and need for capital.

Most reinsurers are large, well-capitalized companies. By

operating in international markets, they are able to raise

large sums of capital and diversify risks broadly. The four

largest reinsurers in 2000 were Munich Re, Swiss Re,

General Electric Global Insurance Holdings, and Berkshire Hathaway Reinsurance Group.

Industry Earnings

Insurers’ capacity to pay claims depends on their net

worth. And insurers’ net worth hinges at least in part on

their ability to charge appropriate premiums so as to generate earnings and attract capital. In 2000, the U.S. property and casualty industry earned $9.5 billion in pretax

operating income on $301 billion in net premiums (see

Table 1). Earnings were down significantly from the peak

years of the mid-1990s, a pattern that is consistent with

the industry’s so-called underwriting cycle (several years

of rising earnings followed by several years of falling earnings).12 For 2001, the industry reported its first overall

loss since 1992.

The 1990s was a period of volatile underwriting losses.

Although a certain level of underwriting losses is normal

for insurers, they will lose money and may become insolvent if losses grow too large. But the 1990s also saw the

property and casualty industry add capital (also called

policyholders’ surplus) at a rapid rate; the ratio of capital

to premiums nearly doubled between 1990 and 1998.

Since then, capital holdings have fallen by about $45

billion, primarily because of the high level of underwriting losses and declining returns on investments. At the

end of 2001, domestic insurers’ net worth stood at $290

billion.13 The surplus for reinsurers was similarly large; at

the end of 2000, the top 25 global reinsurers, with more

than 80 percent of the market, had $208 billion of surplus.14 Industrywide measures of insurers’ ability to pay

can be misleading, however, if claims from disasters are

concentrated in relatively few firms.15

12. Several explanations exist for the underwriting cycle. Some analysts

emphasize capital market imperfections; see Kenneth A. Froot and

Paul G.J. O’Connell, On the Pricing of Intermediated Risks: Theory

and Application to Catastrophe Reinsurance, Working Paper No.

6011 (Cambridge, Mass.: National Bureau of Economic Research,

April 1997). Other analysts are less certain of the causes of price

fluctuations; see Anne Gron and Deborah Lucas, “External Financing and Insurance Cycles,” in David F. Bradford, ed., The

Economics of Property-Casualty Insurance (Chicago: University of

Chicago Press, 1998), pp. 5-27. 

13. As of March 31, 2002, capital holdings of domestic reinsurers were

$25.3 billion, a drop of just $1.3 billion since June 30, 2001. For

data on reinsurers, see the statement of Franklin W. Nutter, President, Reinsurance Association of America, before the Senate Commerce, Science, and Transportation Committee, October 30,

2001; updated data are available at www.reinsurance.org. 

14. Those figures also include the companies’ primary insurance operations. See Standard & Poor’s, “Reinsurance Outlook 2002: Price

Surge Bullish for Earnings,” Commentary in Ratings Direct,

December 18, 2001.

15. J. David Cummins, Neil Doherty, and Anita Lo, Can Insurers Pay

for the ‘Big One’? Measuring the Capacity of the Insurance Industry to

Respond to Catastrophic Losses, Working Paper No. 98-11-B (Philadelphia: Wharton Financial Institutions Center, June 24, 1999),

available at http://fic.wharton.upenn.edu/fic/papers/98/9811.pdf.

Also see General Accounting Office, Insurers’ Ability to Pay Catastrophe Claims, GAO/GGD-00-57R (February 8, 2000).
CHAPTER ONE THE MARKET FOR PROPERTY INSURANCE 5

Table 1.

Operating Results for U.S. Property and Casualty Insurers, 1990 Through 2001

(In millions of dollars)

Year

Net

Premiums 

Net

Underwriting Lossa

Pretax

Operating Incomeb

Policyholders’

Surplusc

1990 218,100 -21,652 11,249 138,401

1991 223,243 -20,458 13,789 158,658

1992 227,751 -36,260 -2,526 163,080

1993 241,691 -18,094 14,551 182,275

1994 250,709 -22,083 11,604 193,346

1995 259,803 -17,375 19,459 230,001

1996 268,730 -17,162 20,801 255,527

1997 276,568 -6,030 35,469 308,479

1998 281,621 -16,572 23,354 333,327

1999 286,934 -24,429 14,426 334,348

2000 301,000 -32,300 9,500 319,000

2001 323,977 -52,990 -15,164 289,649

Source: Congressional Budget Office based on A.M. Best Company, Best’s Aggregates & Averages: Property-Casualty (Oldwick, N.J.: A.M. Best Company, 2000);

A.M. Best Company, “2000 Property/Casualty Results: Insurers Not Out of the Woods” (Oldwick, N.J.: A.M. Best Company, April 16, 2001) for 2000 data;

and Insurance Services Office, Inc., “Property/Casualty Industry Suffers First-Ever Net Loss in 2001; Surplus Drops as Terrorist Attack and Poor Investment

Results Pummel Earnings” (press release, Jersey City, N.J., April 15, 2002), available at www.iso.com (for 2001 data).

Note: Data are for private insurance companies, so they exclude state funds.

a. Includes payments of dividends to policyholders. In 2001, dividends were $2.3 billion. See Ruth Gastel, ed., “Financial and Market Conditions,” in Insurance

Issues Update (New York: Insurance Information Institute, May 2002).

b. Excludes the realization of capital gains or losses.

c. Insurers’ capacity to issue insurance depends on their net worth (assets minus liabilities), or capital and surplus. The largest component of net worth is surplus,

which is an insurer’s accumulated stock of retained earnings. Capital is shareholders’ equity of a publicly owned insurance company.

State-Sponsored Programs

A few states, notably Florida and California, actively

supply property and casualty insurance (see Table 2).

Florida has established three programs: a residential insurer of last resort; an insurer that provides only hurricane

coverage; and a reinsurer. Following the Northridge

earthquake, California created the California Earthquake

Authority (CEA) to issue earthquake insurance to homeowners. And Hurricane Iniki in 1992 prompted Hawaii

to establish the Hawaii Hurricane Relief Fund to sell

insurance that covered hurricane damage.16 In addition,

the states of Alabama, Florida, Louisiana, Mississippi,

North Carolina, South Carolina, and Texas have initiated

“beach plans,” risk-sharing pools specifically designed to

provide homeowners’ insurance in coastal areas. (See

Appendix A for a more complete discussion of statesponsored insurance programs in Florida and California.)

Rates in Florida’s programs are generally set below market

levels and at costs lower than expected losses, whereas

rates in California typically reflect expected losses.17 All

insurers operating in Florida are residually liable for fund16. The recovery of the private market for hurricane insurance enabled

the Hawaii Fund to cease issuing and renewing policies as of December 1, 2000.  

17. Personal communication from Richard J. Roth Jr., a consulting

actuary, to the Congressional Budget Office, January 8, 2002. Although the California Earthquake Authority’s rates may be actuarially sound overall, critics charge that rates for the riskiest properties are capped to promote affordability. In addition, unlike private

companies, the CEA imposes no load for the cost of its capital. See

Tillinghast-Towers Perrin, “CEA Consulting Team Report” (New

York, July 5, 2001), pp. 65-73.
6 FEDERAL REINSURANCE FOR DISASTERS

Table 2.

Selected State-Sponsored Insurance Suppliers

State-Sponsored Insurer Type of Coverage 

Payment Capacity 

(Billions of dollars)

California Earthquake Authority Supplemental earthquake coverage 7.36a

Florida Hurricane Catastrophe Fund Reinsurance for hurricane losses 11.0b

Florida Residential Property and Casualty 

Joint Underwriting Association Standard homeowners’ coverage 1.86

Florida Windstorm Underwriting Association Coverage for residential losses from wind perils 5.8

Hawaii Hurricane Relief Fund Hurricane coverage for commercial and 

residential buildings 1.49c

Source: Congressional Budget Office based on information from the insurance suppliers.

a. As of November 30, 2001.

b. As of December 31, 2001. The payment capacity to cover the first hurricane season is $11 billion. The payment capacity for the following year’s hurricane season

would be $7.9 billion.

c. Should claims exceed this sum, the Hawaii Hurricane Relief Fund can impose assessments on all property and casualty premiums written in the state to raise

additional funds.

ing future deficits incurred by the state funds, which

appear to be undercapitalized. Such losses would be

passed on to policyholders through postdisaster assessments. Thus, the current low prices of the Florida programs do not represent the full cost of the insurance.

Some state-sponsored funds, including the CEA and the

Florida Hurricane Catastrophe Fund, also enjoy significant tax advantages, enabling them to charge lower prices.

Florida’s other two state-sponsored funds (the Florida

Windstorm Underwriting Association and the Florida

Residential Property and Casualty Joint Underwriting

Association) are being restructured and merged into a

single fund to qualify for tax-exempt status. The tax exemptions shift costs from the states to federal taxpayers. 

None of the state-sponsored insurers has been tested by a

disaster on the scale of Hurricane Andrew, although some

have paid out claims for smaller events. Hurricanes that

struck Florida in 1994, 1995, and 1998 led to several

hundred million dollars in disbursements by that state’s

sponsored insurers. Those payments were funded by assessments imposed on private insurers and policyholders.

The CEA has paid out only 695 claims, totaling roughly

$473,000, since its inception.18

States sometimes require private insurers to provide disaster coverage. California has required all firms offering

homeowners’ insurance in the state to also provide earthquake coverage at the option of the buyer, for example,

since 1985.

Demand

Consumers buy property and casualty insurance for a

variety of reasons. Many property owners prefer the certainty of a fixed annual premium to the risk of uninsured

catastrophic loss. Others with mortgages buy coverage

because lenders require insurance on assets used as collateral. Most consumers’ insurance needs are met through

standard homeowners’ policies, which cover losses from

hurricanes but not from floods or earthquakes. Flood

insurance is available from the federal government, and its

purchase is mandatory in most high-risk areas. Mortgage

18. Personal communication from Stan Devereux, Legislative and

Public Affairs Director, California Earthquake Authority, February 13, 2002. 
CHAPTER ONE THE MARKET FOR PROPERTY INSURANCE 7

lenders rarely require earthquake insurance, but some

households insure against quakes through a separate policy option.19

Self-insurance plans are the most widespread substitutes

for purchased P&C insurance. Many large businesses,

nonprofit organizations, and state and local governments

with numerous and diversified risks choose to forgo coverage from an insurer and instead absorb losses as they

occur. The owners of a large commercial property that is

a landmark can self-insure by spreading ownership among

several million stockholders. Indeed, they may have little

practical choice but to do so. Individuals and small businesses can partly self-insure by purchasing insurance with

high deductibles or coinsurance. 

Consumers increasingly decide to self-insure as premiums

for purchased insurance rise and as coverage terms become more restrictive. In California, complaints persist

that prices for earthquake insurance sold through the

state-sponsored program are too high. The program’s

large deductibles, numerous exclusions, and tight caps on

contents and living expenses mean that homeowners with

policies would bear substantial uninsured loss after a

quake.20 As a result, about 16 percent of California residences now have earthquake insurance, down from

30 percent before the Northridge earthquake.21 However,

homeowners’ willingness to pay for disaster insurance

may be affected by misperceptions about the frequency of

rare events and the availability of federal aid after a disaster.22

Most state and local governments do not buy P&C insurance, especially for infrastructure such as streets and highways, bridges, and public buildings. Separate coverage

may be unnecessary because the Federal Emergency Management Agency provides state and local governments

with public assistance grants to repair infrastructure that

is damaged from a disaster. 

Regulation

Most states regulate premiums for property and casualty

insurance, including homeowners’ and automobile coverage, that is sold to individuals. The goal of price regulation is to keep insurance affordable. During the 1990s,

requests by Florida’s insurers to increase premiums for

homeowners’ insurance were often denied, delayed by the

appeals process, or granted only in part.23 As a result, rates

for homeowners’ insurance in Florida are at or below

rates in nearby coastal states, even though the risk of

hurricane-related losses is higher in Florida.24

19. There is an exception: Freddie Mac requires earthquake insurance

for some condominiums in California. Apparently, single-family

homes are more resistant to earthquake damage than are multifamily properties. Also, any losses from the fires that often accompany

earthquakes are covered under standard homeowners’ policies. See

Morgan Stanley Dean Witter, “Fannie Mae: Tremble Not Over

Trembler Risk” (New York: Morgan Stanley Dean Witter,

August 9, 2001).

20. For instance, there is typically a 15 percent deductible of the value

of the property. Consequently, policyholders more than 20 miles

from a fault line, and thus less exposed to losses, are unlikely to

receive any reimbursement for claims. In addition, individuals may

underestimate their exposure to low-probability, high-loss events.

See Howard Kunreuther and Mark Pauly, Ignoring Disaster: Don’t

Sweat the Big Stuff, Working Paper No. 01-16-HK (Philadelphia:

Wharton Risk Management and Decision Processes Center, October 11, 2001), available at http://grace.wharton.upenn.edu/risk/

wp/wplist01.html.

21. Price increases may explain some of the drop in coverage rates.

Some research indicates that consumers—at least those in Florida

and New York—are more responsive to changes in price for catastrophe coverage than for noncatastrophe coverage. See Martin

Grace, Robert W. Klein, and Paul R. Kleindorfer, The Demand for

Homeowners Insurance with Bundled Catastrophe Coverage, Working Paper No. 02-06 (Philadelphia: Wharton Project on Managing

and Financing Extreme Risks, January 2002).

22. See Risa Palm, “Demand for Disaster Insurance: Residential Coverage,” in Kunreuther and Roth, eds., Paying the Price, pp. 51-66.

23. Robert Klein, “Regulation and Catastrophe Insurance,” in

Kunreuther and Roth, eds., Paying the Price, pp. 196-201.

24. Collins Center for Public Policy, Final Report of the Academic Task

Force on Hurricane Catastrophe Insurance (Tallahassee, Fla.: Collins Center for Public Policy, 1995), pp. 43-46. Since 1995, rates

for homeowners’ insurance in Florida have approached those in

other coastal states.
8 FEDERAL REINSURANCE FOR DISASTERS

Price regulation can make coverage more affordable in the

short run. But regulation reduces the availability of and

boosts prices for private insurance in the long run by

pricing private suppliers out of the market (they cannot

compete as claims rise and premiums stay the same).

Markets in which regulatory intervention has been consistently minimal, such as the market for commercial property insurance, have performed reasonably well over the

long term. For example, as a share of property at risk, the

market for commercial earthquake insurance in California, which is unregulated, is several times larger than the

residential market, which is regulated. Primary insurers

are better able to attract capital and reinsure commercial

risks because they can charge higher premiums.25 Also

contributing to the willingness of insurers to issue policies

in the commercial market may be commercial structures’

enhanced ability to withstand disasters, either because of

their location or because of significant investments in loss

prevention.

Terrorism insurance and other commercial coverage is

generally sold at unregulated market prices. For primary

insurers, most states have approved some exclusions of

coverage for terrorism losses. Primary insurers can also

use surplus lines (coverage that is not available from insurers licensed or “admitted” by a state) to exclude terrorism coverage. In addition, because state insurance commissioners cannot compel reinsurers to issue coverage,

many reinsurers will choose to exclude terrorism risk

from their P&C policies. Some states, however, do not

allow terrorism claims to be excluded from commercial

P&C coverage.26 Consequently, primary insurers in those

states (New York, California, Florida, Georgia, and

Texas) must weigh the risk of being overexposed to losses

from terrorism against the loss of revenue from not issuing policies.

25. For detailed information on coverage and comparisons of residential and commercial markets prior to the creation of the CEA, see

California Department of Insurance, California Earthquake Zoning

and Probable Maximum Loss Evaluation Program: An Analysis of

Potential Insured Earthquake Losses from Questionnaires Submitted

by Property/Casualty Insurers in California (Los Angeles: California

Department of Insurance, 1998), especially Tables 7 and 8, pp.

12-14.

26. Exclusions of terrorism coverage cannot be part of workers’ compensation coverage. Fires that may follow a terrorist attack also

must be covered under standard homeowners’ policies in about 30

states. Terrorism coverage is not an issue in the residential market

because houses are not considered likely targets. See American

Academy of Actuaries, Terrorism Insurance Coverage in the Aftermath of September 11th: A Public Statement by the Extreme Events

Committee of the American Academy of Actuaries (April 17, 2002),

available at www.actuary.org/pdf/casualty/terrorism_ 17apr02.pdf;

and Standard & Poor’s, “Commercial Insurers to Cut Coverage for

Losses Caused by Terror Attacks,” Ratings Direct, January 9, 2002.

As of January 2002, blanket exclusions of terrorism risk were not

being imposed on small business and personal lines of insurance.

Instead, exclusions for those lines cover only losses from nuclear,

chemical, or biological terrorism. Personal communication from

Rade T. Musulin, Vice President, Florida Farm Bureau Insurance

Companies, January 18, 2002.
CHAPTER



The Insurance Market’s

Response to Disasters

oth natural and manmade disasters trigger a

predictable sequence of financial events for insurers and

reinsurers. In the short run, big and unanticipated losses

lead to large insurance payouts, which reduce insurers’

capital reserves and heighten their uncertainty about

losses from future events. Those effects lessen insurers’

ability and willingness to provide coverage at existing

prices. As the supply of insurance dwindles, sometimes

simultaneously with an increase in demand, prices climb.

Higher premiums in turn raise concerns about affordability. In the long run, the higher premiums will attract

new capital and spur urgent assessments of unfamiliar

risks. As a result, supply will begin to recover; prices will

stabilize and then fall, although not necessarily to predisaster levels because of insurers’ higher perceived risk of

loss. 

Recent Unanticipated Losses

Hurricane Andrew, the Northridge earthquake, and the

terrorist attacks of September 11 resulted in major losses

for property and casualty insurers.

The destruction from Hurricane Andrew—which swept

ashore 20 miles south of Miami on August 24, 1992—set

a new record for insured losses. Property damage from the

Category 5 hurricane totaled $34 billion (in 1999

dollars), $17 billion of which was insured (see Table 3).1

Almost two-thirds of the dollar amount of all claims,

approximately $11 billion, was paid to holders of homeowners’ policies.2

 Commercial policies accounted for

most of the remainder.

On January 17, 1994, an earthquake measuring 6.7 on

the Richter scale occurred at a previously unknown fault

beneath California’s San Fernando Valley, 20 miles

northwest of downtown Los Angeles.3

 Peak ground

movement during the 15-second quake was among the

most rapid ever recorded in the United States. Damage

from the Northridge earthquake totaled $43 billion (in

1999 dollars), $16.6 billion of which was insured. Claims

on homeowners’ policies constituted more than three1. The National Hurricane Center recently changed the classification

of Hurricane Andrew from Category 4 to Category 5. Scientists

 

determined that maximum sustained wind speeds during the hurricane were 165 miles per hour—or 20 miles per hour faster than

they had previously estimated. See National Oceanic and Atmospheric Administration, “After 10 Years, Hurricane Andrew Gains

Strength” (press release, Washington, D.C., August 21, 2002),

available at www.nhc.noaa.gov.

2. Eugene Lecomte and Karen Gahagan, “Hurricane Insurance Protection in Florida,” in Howard Kunreuther and Richard J. Roth

Sr., eds., Paying the Price: The Status and Role of Insurance Against

Natural Disasters in the United States (Washington, D.C.: Joseph

Henry Press, 1998), p. 105.

3. Richard J. Roth Jr., “Earthquake Insurance Protection in California,” in Kunreuther and Roth, eds., Paying the Price, pp. 67-95.
10 FEDERAL REINSURANCE FOR DISASTERS

Table 3.

Insured Losses from Hurricane Andrew

Type of Insurance

Insured Losses 

(Millions of 1999 dollars)

Percentage of

Total Insured Losses

Number of

Direct Claims

Homeowners 11,111 65.0 280,000

Commercial Multiperil 3,767 22.0 50,517

Fire and Allied Lines (Commercial)a 1,062 6.2 24,467

Automobile, Physical Damage 365 2.1 161,400

Mobile-Home Owners 204 1.2 11,779

Farmowners 16 0.1 1,245

Other Typesb 559 3.3 17,177

Total 17,084 100.0 546,585

Source: Congressional Budget Office based on data from the Florida Department of Insurance, cited in Eugene Lecomte and Karen Gahagan, “Hurricane Insurance

Protection in Florida,” in Howard Kunreuther and Richard J. Roth Sr., eds., Paying the Price: The Status and Role of Insurance Against Natural Disasters

in the United States (Washington, D.C.: Joseph Henry Press, 1998), p. 105.

Note: Numbers may not add up to totals because of rounding.

a. Includes coverage for losses caused by fire, lightning, wind and water damage, and vandalism.

b. Includes coverage for boat owners, as well as other insurance lines.

quarters of the total dollar value of insured claims.4

Claims might have been far higher, but only 40 percent

of homeowners in the Northridge area carried earthquake

coverage.5

The September 11, 2001, terrorist attacks on the World

Trade Center completely destroyed the New York City

landmark. Financial losses from the attacks will be the

largest ever for a single event in the United States. Current estimates of insured losses exceed $30 billion.6

 Prior

to the attack, insurers had collected almost no premiums

for terrorism risks. Moreover, none of the insurers anticipated any scenario that would result in the complete destruction of the 110-story twin towers. In setting commercial policy premiums, insurers largely ignored the

February 1993 bombing of the World Trade Center, even

though that event caused roughly $725 million in insured

property losses (in current dollars), 1,000 injuries, and six

deaths. 

4. The Northridge earthquake was unusual in that most of its insured

losses were residential rather than commercial. (About 80 percent

of the insured coverage in California today is commercial coverage.) After the earthquake, the California Department of Insurance

raised the probable maximum loss for residences in the Los Angeles and San Francisco areas by 25 percent but made no changes

to the probable maximum loss for commercial structures. See California Department of Insurance, California Earthquake Zoning and

Probable Maximum Loss Evaluation Program: An Analysis of Potential Insured Earthquake Losses from Questionnaires Submitted by

Property/Casualty Insurers in California (Los Angeles: California

Department of Insurance, 1998). 

5. Insurance Services Office, Catastrophes: Insurance Issues Surrounding the Northridge Earthquake and Other Natural Disasters (New

York: Insurance Services Office, 1994), p. 14.

6. Statement of Matthew C. Mosher, Group Vice President, A.M.

Best Company, before the House Committee on Financial Services, September 26, 2001. As of October 2, 2001, industry estimates of insured losses from the terrorist attacks ranged from $30

billion to $70 billion. See David Pilla, “The Cost of Terror,” Best’s

Review, A.M. Best Company (October 2001). Business-interruption claims are still being decided, and concerns about asbestosrelated claims—possibly totaling as much as $7 billion—have been

voiced. However, the loss of life from the attacks is less than was

originally feared, which reduces claims for life insurance and workers’ compensation. See Standard & Poor’s, “Commercial Lines

Outlook for 2002: Negative Fundamentals Persist Despite Surging

Prices,” Ratings Direct, January 31, 2002.
CHAPTER TWO THE INSURANCE MARKET’S RESPONSE TO DISASTERS 11

Short-Run Market Adjustments

Andrew, Northridge, and September 11 each set off a

“supply shock” in insurance markets. Unanticipated losses

from major disasters reduce insurers’ net worth and increase their uncertainty about the level and variance of

future losses. Both factors tend to rein in the supply of

coverage and elevate prices in the short term.

Reduced Income and Capital

After each of the three disasters, the affected property and

casualty insurers saw their earnings fall and their capital

initially drop in value. Of the two natural disasters, Hurricane Andrew was the more damaging to the industry.

The year-over-year increase in underwriting losses nearly

doubled in 1992, the year that Andrew struck, and the

industry recorded its first operating loss of the decade (see

Table 1 on page 5). Three insurers each paid claims in

excess of $1 billion, and 11 small insurance companies

filed for bankruptcy.7

 (The Florida State Guaranty Fund

paid claims made against those insolvent firms only up to

the $300,000 statutory limit.)

Despite the magnitude of the industry’s financial losses,

however, capital grew by more than $4 billion in 1992.

That anomalous result in part reflects the weakness of

overall industry data on capital, which fail to show the

wide dispersion of capital across the industry. While some

firms were collapsing into insolvency, others were profitably able to attract new sources of revenue. That result

also shows that the flow of capital into the industry is not

merely the remainder left after expenses are paid and

dividends are distributed. Capital flows are strongly affected by investors’ perceptions of future rates of return;

likewise, earnings are affected by the returns that insurers

receive on the capital they invest. The unusually strong

stock market of the 1990s bolstered insurers’ income and

capital during that decade.

The Northridge earthquake significantly drained the

financial resources of many insurers, but none went bankrupt as a result. (Technically, one insurer, 20th Century,

did become insolvent from Northridge quake claims.

However, a capital infusion from its parent company

enabled the firm to pay all its claims without activating

the California Insurance Guarantee Fund.) Underwriting

losses for the industry grew by just over 20 percent in

1994, but they do not reflect the full cost of the quake

because many claims were paid over the following years as

the full extent of damages became apparent.8

 Industry

capital continued to grow in 1994 but at a slower rate.

Despite their severity, the financial shocks from Andrew

and Northridge pale in comparison with the losses from

September 11. That one day shattered the industry’s expectations about maximum insured losses from a single

event as annual earnings were wiped out and global capital was effectively reduced by more than $30 billion (before taxes). Two insurers—one in Denmark, the other in

Japan—failed as a result of the attacks. According to

Standard & Poor’s, losses from the Trade Center bombings would have to exceed $50 billion before they threatened the solvency of the U.S. insurance system.9

 (The

effect on domestic insurers is dampened somewhat because more than half of the total losses will probably be

covered by reinsurers.) So far, no U.S. insurers or major

international reinsurers have failed because of the attacks,

but rating agencies have downgraded the credit of several

insurance companies.10

7. U.S. Senate, Bipartisan Task Force on Funding Disaster Relief,

Report of the Senate Task Force on Funding Disaster Relief, Document No. 104-4 (March 15, 1994), p. 31.

8. Insured losses from the Northridge quake rose from an initial estimate of $2.5 billion to $10.4 billion one year later. The last estimate (from 2000) was $15 billion. See Richard J. Roth Jr., “A

Government Experiment: The California Earthquake Authority”

(presentation given at the Sixth International Conference on Seismic Zonation, Palm Springs, Calif., November 15, 2000). 

9. Losses above that level would hurt the credit quality of a number

of companies. See Standard & Poor’s, “World Trade Center Attack Will Not Cripple Insurance Industry,” Ratings Direct, September 14, 2001. 

10. Nonetheless, one rating agency also stated that the “overwhelming

majority of these insurers and reinsurers are expected to maintain

secure financial strength ratings.” See Standard & Poor’s, “S&P

Rating Actions on Insurers with World Trade Center Exposures”

(press release, New York, September 20, 2001). 
12 FEDERAL REINSURANCE FOR DISASTERS

Higher Uncertainty

Before accepting a risk, an insurer must be confident that

it understands the magnitude of the commitment and

that it has priced the premiums to be commensurate with

that risk. Large, unanticipated losses require insurers to

reassess risks.

Before Hurricane Andrew, the largest insured loss from a

tropical storm resulted from Hurricane Hugo, which

struck Georgia and the Carolinas in 1989, causing about

$4 billion in insured losses. After Hugo, insurers reassessed their potential risks and determined that future

hurricane losses would not exceed $8 billion. Thus, the

$17 billion in insured losses from Hurricane Andrew

invalidated their forecasting models and prompted an

urgent reassessment of the risk of loss. Those efforts were

hampered by meteorologists’ uncertainty as to whether

Hurricane Andrew was a loss that would occur once every

50 years, once every 100 years, or even less frequently.

In the weeks immediately following September’s terrorist

attacks, many insurers admitted that they had no systematic method for assessing or pricing terrorism risk. Consequently, they had no means of providing such coverage in

a way that was consistent with their fiduciary obligations

to shareholders.11

Decreased Coverage and Increased Premiums

After a disaster, insurers try to lessen their exposure to

catastrophic risk by reducing coverage and pushing up

premiums. Following Hurricane Andrew, for example, 39

insurers sought to cancel or refuse to renew 844,433

Florida homeowners’ policies.12 Reinsurers reduce their

exposure to risk by raising the deductible and coinsurance

amounts that primary insurers must pay and by limiting

coverage. One primary insurer’s catastrophe deductible

skyrocketed from $30 million to $100 million after Hurricane Andrew.13 After the Northridge earthquake, insurers representing 95 percent of the homeowners’ insurance

market in California ceased issuing policies or severely restricted their sales.14 And since September 11, securing

terrorism coverage has been difficult for some owners of

commercial property. Rates to insure large commercial

properties in the Northeast increased by more than 30

percent, on average, between October 1, 2001, and January 1, 2002, the point at which most reinsurance contracts expired. 

One study attempted to quantify the effect of catastrophic

losses on insurance supply (and prices) during the 1990s.

It found that a $10 billion loss reduced the quantity of

insurance by 5 percent to 16 percent and raised the average reinsurance price by 19 percent to 40 percent in the

following year.15

Prices for reinsurance climb after disasters because the

supply of insurance shrinks. After Hurricane Andrew,

reinsurance prices nearly doubled (see Figure 1).16 By

1995, the Andrew-induced run-up in reinsurance prices

had ended. Subsequently, reinsurance prices fell by 30

percent, mostly between 1995 and 1998.17 But prices rose

sharply again after September 11. Standard & Poor’s

11. Dwight Jaffee and Thomas Russell, “Extreme Events and the Market for Terrorist Insurance” (paper presented at the National Bureau of Economic Research Conference on Insurance, Cambridge,

Mass., February 1, 2002). 

12. Florida Department of Insurance, cited in Lecomte and Gahagan,

“Hurricane Insurance Protection in Florida,” p. 106.

13. Anne Gron and Andrew Winton, “Risk Overhang and Market

Behavior,” Journal of Business, vol. 74, no. 4 (October 2001), pp.

591-612.

14. Statement of Gregory Butler, Chief Executive Officer, California

Earthquake Authority, before the House Committee on Banking,

June 24, 1997.

15. Kenneth A. Froot and Paul G.J. O’Connell, The Pricing of U.S.

Catastrophe Reinsurance, Working Paper No. 6043 (Cambridge,

Mass.: National Bureau of Economic Research, May 1997). 

16. Kenneth A. Froot, “Introduction,” in Froot, ed., The Financing of

Catastrophe Risk (Chicago: University of Chicago Press, 1999),

p. 9; and Guy Carpenter & Company, Inc., “Global Reinsurance

Analysis 1998: A Guy Carpenter Special Report” (New York, Guy

Carpenter, September 1998).

17. The reinsurance price index adjusts for changes in relative prices.

See Paragon Reinsurance Risk Management Services, Paragon

Catastrophe Price Index (Minneapolis, Minn.: Paragon Reinsurance

Risk Management Services, January 2001).
CHAPTER TWO THE INSURANCE MARKET’S RESPONSE TO DISASTERS 13

1984 1986 1988 1990 1992 1994 1996 1998 2000

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

	

 

Catastrophe Reinsurance

Price Index, 1984 to 2001

(1984 = 1.00)

Source: Congressional Budget Office based on data from Paragon Reinsurance

Risk Management Services.

Note: The index shows changes in the price of catastrophe reinsurance relative

to a base of one. Data points are from January of each year. In July 1994,

the index reached its peak of 2.47.

expects reinsurance prices to increase by 25 percent to 35

percent in 2002; that price hike will be accompanied by

lower limits on payouts per event and exclusions for losses

related to terrorism.18

Long-Run Market Adjustments

After a disaster strikes, the insurance industry enters a

period of adjustment. During that adjustment period,

which varies in length after each disaster, higher prices for

insurance attract additional investment into the disrupted

market. As a result of that infusion of capital, capacity

recovers, risks are reassessed and better understood, and

prices typically decline—although not to predisaster levels. Instead, prices may remain permanently elevated

because disasters can increase insurers’ perceived risks of

the probability of future disasters and their potential

costs. For example, between 1993 and 1997, premiums

for private earthquake policies went up by 63 percent in

Los Angeles in real (inflation-adjusted) terms and by 57

percent in San Francisco (see Table 4). As of 2000, rates

had risen by just 1 percent in Los Angeles while remaining unchanged in San Francisco. Although the industry’s

adjustment to the financial and forecasting shocks from

Andrew and Northridge is largely complete, its adjustment to the shocks from September 11 is still under way.

Following each of those three disasters, capital flowed

into the insurance industry from investors attracted by

the prospect of high rates of return. Those capital flows

largely eliminated the drop in policyholders’ surplus, or

net worth, for most firms paying large claims. They also

supported the expansion of the industry’s capacity. In

addition, expectations of high rates of return led to several

innovations in capital markets, including catastrophe

bonds and options, which have provided about $2.5 billion of additional capacity per year (see Appendix B for

details).

Capital holdings nearly doubled between Hurricane Andrew and the World Trade Center attacks, climbing from

$163 billion as of December 31, 1992, to over $300

billion nearly a decade later.19 Since September 11, insurers have raised substantial amounts of new capital—up to

$25 billion, according to some estimates.20 Much of that

18. Standard & Poor’s, “Reinsurance Outlook 2002: Price Surge Bullish for Earnings,” Ratings Direct, December 18, 2001.

19. Data from insurance-rating company A.M. Best indicate that as of

March 31, 2001, the industry’s surplus was $302 billion, compared with $333 billion one year earlier. Unrealized losses on common stock were the primary reason for the drop in the surplus. See

A.M. Best Company, “Property/Casualty Premiums Show Strong

Growth, Earnings Remain Depressed” (Oldwick, N.J.: A.M. Best

Company), July 2, 2001.

20. See Christopher Oster, “Insurance Companies Benefit from Sept.

11, Still Seek Federal Aid,” Wall Street Journal, November 15,

2001, p. 1; and statement of Kenneth A. Froot, Professor of Finance, Harvard Business School, before the Senate Committee on

Banking, Housing, and Urban Affairs, October 24, 2001. The

latest estimate is from Standard & Poor’s, “Reinsurance Outlook

2002.”
14 FEDERAL REINSURANCE FOR DISASTERS

Table 4.

Annual Premiums for a $150,000 Frame Home in California, 1993 Through 2000

(In 2000 dollars)

Year

Homeowners’ 

Policy 

Earthquake Policy

(Private)a

Earthquake Policy

(CEA)b

Total Cost of

Private Insurance

Los Angeles—Central City 

1993 810 350 n.a. 1,160

1996 725 470 n.a. 1,195

1997 840 570 400 1,410

2000 730 575 360 1,305

San Francisco

1993 690 380 n.a. 1,070

1996 675 465 n.a. 1,140

1997 710 595 625 1,305

2000 670 595 560 1,265

Source: Congressional Budget Office based on information from California Department of Insurance, Statistical Analysis Bureau, Homeowners Premium Survey, for

1993, 1996, and 1997. Data for 2000 came from the California Department of Insurance’s Web site at www.insurance.ca.gov/docs/FS-Looking.htm.

Notes: n.a. = not applicable.

The Los Angeles example covers zip code 90011; the San Francisco example covers zip code 94109 (except for earthquake policy rates in 2000, which are

based on the city’s Nob Hill area). Minor inconsistencies occurred in the examples about which the surveys requested information. For instance, the 1993

survey used a home built in 1985, whereas the 1996 survey used one built in 1990.

Rates charged by the California Earthquake Authority (CEA) vary with a home’s age. Rates for a frame home built after 1991 in the Nob Hill area of San

Francisco are $3.30 per $1,000 of coverage, while rates for a home built prior to 1978 are $4.80 per $1,000. For homes built between 1979 and 1990, the

rate is $3.75 per $1,000 of coverage, before adjusting for inflation, which is the rate used above.

a. The private rates cited are the average rates; premiums varied considerably among companies. (In the private market, brick homes are up to four times more

expensive to insure against earthquakes.)

b. Coverage through the California Earthquake Authority is not as extensive as private coverage, so cost comparisons are problematic.

capital has been generated by new firms that have been

incorporated in Bermuda to take advantage of that island’s favorable tax and regulatory treatment. The rapid

inflow of capital suggests that the current spike in rates

for commercial property and casualty insurance may end

more quickly than it has after previous disasters.21 However, according to bond-rating agencies, most of the new

capital is not being used to back terrorism risks because of

insurers’ difficulty in pricing those risks.

States’ Responses to Reduced Supply

and Higher Prices for Coverage

States have generally reacted to catastrophic events in

three ways: by requiring insurers to continue supplying

coverage, by holding down rates, and by creating statesponsored insurers to provide coverage at below-market

rates. For example, faced with the withdrawal of insurers

from the market following Hurricane Andrew, the

Florida Department of Insurance required insurers operating in the state to renew most of their existing policies.

Specifically, in any single year, insurers were permitted to

drop no more than 10 percent of their residential policies

in a county and no more than 5 percent statewide.22

21. Letter from Warren E. Buffett, Chairman of the Board, Berkshire

Hathaway, to the Shareholders of Berkshire Hathaway, November

9, 2001, available at www.berkshirehathaway.com. 

22. Collins Center for Public Policy, Final Report of the Academic Task

Force on Hurricane Catastrophe Insurance (Tallahassee, Fla.: Collins

Center for Public Policy, 1995); and Florida Insurance Council,
CHAPTER TWO THE INSURANCE MARKET’S RESPONSE TO DISASTERS 15

Following the Northridge earthquake, providers of homeowners’ insurance sought to withdraw from California to

avoid that state’s mandate to also offer earthquake insurance. In response, California modified its requirements to

allow sellers of homeowners’ insurance to instead offer reduced, supplementary earthquake coverage through the

state-sponsored California Earthquake Authority. By

lessening insurers’ exposure to catastrophes, California

was able to induce more insurers to offer homeowners’

and earthquake policies, but only after the Northridge

crisis had passed.

States also succeeded in delaying rate increases immediately following those catastrophic events. According to

the Florida Department of Insurance, premiums for

Florida’s homeowners doubled, on average, between 1992

and 1999. But those higher premiums do not yet fully

reflect the increase in expected losses from future natural

disasters. (Because of rate suppression, state-sponsored

insurers still assume much of the risk in Florida and California.) In fact, rates in Florida remain below those

needed to attract enough insurers to reduce the size of the

state’s Windstorm Underwriting Association, an insurer

of last resort that has taken over most of the market for

hurricane insurance in high-risk areas.23

In the short run, state-sponsored funds may make coverage more available and affordable. But to the extent that

those funds keep prices below costs and crowd out private

suppliers, insurance may be harder to obtain and more

expensive in the long run. The rate structures also force

property owners in lower-risk areas to subsidize the cost

of hurricanes and earthquakes in higher-risk areas. Those

cross-subsidies reduce incentives for mitigation, leading

to higher losses over time. Large future losses can in turn

expose taxpayers to risk if the state government chooses to

bail out insolvent insurance pools.

Whereas too much regulation can potentially harm an

insurance market, a relative lack of regulation can sometimes prove beneficial. Such an outcome can be seen in

California’s large and well-functioning private market for

commercial earthquake insurance. Relative to the state’s

market for residential earthquake insurance, its muchlarger market for commercial earthquake insurance is

lightly regulated, especially with respect to price. Insurers

are also free to choose their customers geographically and

thus avoid excessive concentration of risk. Even global reinsurance companies are active in providing earthquake

coverage for commercial buildings in California.

Federal Assistance After Disasters

Through emergency supplemental appropriations, the

Congress often provides extensive financial assistance to

areas with uninsured losses after a disaster. Following

Hurricanes Andrew and Iniki in 1992, the federal government spent more than $4.4 billion on the affected areas.

Similarly, the region struck by the Northridge earthquake

received $9.5 billion in aid (see Table 5).

Under the Budget Enforcement Act of 1990 (BEA), new

spending designated by the President and the Congress as

an emergency is exempt from the BEA’s limits, or caps,

on discretionary spending and from pay-as-you-go requirements for mandatory spending and receipts. (The

caps on discretionary spending expire in 2003.) That

budgetary treatment provides a sort of safety valve for

emergencies; once the spending has been enacted, the

discretionary spending caps are adjusted upward by the

same amount.24

Federal assistance is disbursed through various departments and agencies. The Federal Emergency Management

Agency (FEMA) provides public assistance grants to state

1998 Florida Insurance FACT Book (Tallahassee, Fla.: Florida

Insurance Council, April 1998), p. 63. The moratorium expired

on July 1, 2001, but it may be renewed in 2002. 

23. After Hurricane Andrew, Florida allowed insurers to substitute the

state’s windstorm insurance for their own hurricane coverage in

certain high-risk regions. The Windstorm Underwriting Association currently has almost 410,000 policies, with an exposure exceeding $98 billion. Like all residential insurers in Florida, the

association purchases reinsurance from the state’s catastrophe fund.

Arbitrators, who hear challenges to rate decisions by the Department of Insurance, recently approved a 96 percent rate hike for the

Florida Windstorm Association. However, that rate hike was challenged and remains before the Florida courts. 

 

24. See Congressional Budget Office, Emergency Spending Under the

Budget Enforcement Act, CBO Memorandum (December 1998);

and Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2001-2010 (January 2000), Box 1-1, p. 12.
16 FEDERAL REINSURANCE FOR DISASTERS

Table 5.

Federal Financial Assistance After Selected Disasters

(In millions of dollars)

Hurricane Andrewa Northridge Earthquake

Department of Agriculture 1,057bn.a. 

Department of Commerce 101 n.a. 

Department of Defensec 839b

n.a. 

Department of Education 102 245

Department of Health and Human Services 106 n.a. 

Department of Housing and Urban Development 208b 825d

Department of Transportatione 90b 950d

Subtotal 2,503 2,020

Federal Emergency Management Agency

Public Assistance Grants 823 4,507

Temporary Housing 128 1,199

Mitigation Grants 23 738

Individual and Family Grants 177 165

Other 83 65

Subtotal 1,234 6,674

National Flood Insurance Program 168 n.a.

Small Business Administrationf

Loans to Individuals 106 429

Loans to Businesses 71 270

Salaries and Administrative Costs 100 55

Subtotal 277 754

Other Departments and Agencies 228b 67d

Total 4,410 9,515

Source: Congressional Budget Office based on information from the Federal Emergency Management Agency (FEMA), the Small Business Administration (SBA), and

the Congressional Research Service.

Note: n.a. = not applicable.

a. Totals for Hurricane Andrew also include some spending for Hurricane Iniki and Typhoon Omar. The amounts listed for FEMA and SBA cover only Hurricane

Andrew and exclude administrative costs.

b. Amounts appropriated in the 1992 Dire Emergency Supplemental Appropriations Bill Covering Hurricanes Andrew and Iniki and Typhoon Omar. Excludes

amounts totaling $991 million for which a specific budget request was necessary.

c. Includes $197 million specifically designated for repairing and maintaining U.S. air force and navy bases in Guam, which was hit by Typhoon Omar. Homestead

Air Force Base in Florida was hit by Hurricane Andrew. 

d. Amounts directly appropriated in the 1994 Dire Emergency Supplemental Appropriations Bill Covering Northridge Earthquake. Excludes $900 million in spending

for which a subsequent official budget request was necessary.

e. Includes amounts from the federal Highway Trust Fund.

f. CBO estimated the cost of SBA’s credit programs using reestimates of the long-term expected costs of those loans. The reestimates are considerably less than the

original estimates. 
CHAPTER TWO THE INSURANCE MARKET’S RESPONSE TO DISASTERS 17

and local governments to repair damaged infrastructure,

such as bridges, highways, and public buildings. The

Small Business Administration helps individuals pay for

temporary housing and offers both direct and guaranteed

loans to businesses. The federal crop insurance programs

convey additional assistance to farmers. 

The $40 billion in emergency appropriations passed by

the Congress in response to the September 11 attacks

included about $10.2 billion for New York City.25 An

estimated $4.3 billion of that amount (distributed

through FEMA) will be used to reclaim the World Trade

Center site and to rebuild transit systems and government

buildings. The remainder comprises loans and assistance

to businesses affected by the attacks, unemployment assistance for displaced workers, and health assistance and

monitoring. Other laws provide about $5.8 billion in

compensation for victims and their families. Specifically,

the Air Transportation Safety and System Stabilization

Act (Public Law 107-42) provides $5.4 billion in compensation; additional assistance comes from the USA

PATRIOT Act (P.L. 107-56), the Aviation and Transportation Security Act (P.L. 107-71), and the Victims of

Terrorism Tax Relief Act (P.L. 107-134). The President

has promised more financial assistance to New York City.

Federal disaster assistance undoubtedly reduces financial

hardships, but it may also discourage individuals and state

and local governments from purchasing adequate insurance against future losses. In effect, it subsidizes development in disaster-prone areas (ones for which private insurers might be reluctant to provide coverage), and it

weakens people’s incentives to take actions that would

reduce the cost of future natural disasters. Critics also

contend that the “emergency” designation constitutes a

large spending loophole that weakens overall budgetary

discipline. 25. Congressional Budget Office, The Budget and Economic Outlook:

Fiscal Years 2003-2012 (January 2002), pp. 111-120. 

CHAPTER

3

Proposals for Federal Reinsurance

Two groups of federal policies have been proposed

to increase the supply of property and casualty insurance.

The first group—which includes H.R. 21 (Homeowners’

Insurance Availability Act of 1999) and H.R. 230

(Natural Disaster Protection and Insurance Act of 1997)

—was developed after Hurricane Andrew and the Northridge earthquake. Those policies aim to address the perceived shortage of new insurance against losses from

natural disasters. The second group of policies, which

comprises H.R. 3210 (the Terrorism Risk Protection Act)

and S. 2600 (the Terrorism Risk Insurance Act of 2002)

responds to the market disruption following September

11. Both groups of proposals could be considered

alternative federal responses, regardless of the source of

the catastrophic loss.

The principal distinction between the groups of policies

centers on the role of the federal government. Proposals

to increase the supply of insurance for natural disasters

would have the government serve as a commercial

reinsurer, in effect. The U.S. Treasury would sell one-year

reinsurance contracts to primary insurers and reinsurers,

as well as to state-sponsored plans, through competitive

auctions. Bids would start at a set price. The policies’

intent is to offer reinsurance when it is in short supply, at

market prices that are expected to cover the government’s

costs.

By contrast, proposals developed since September 11

would have the government take on risks without full

compensation from insurers or policyholders. Under one

variation, the government would pay for losses above a

certain level, without receiving any compensation. Under

another, the government would require that some portion

of any assistance be repaid by all participating insurers

and policyholders over a number of years. In the case of

terrorism insurance, the policies’ intent is to have taxpayers subsidize insurers and policyholders by bearing most

of the cost of terrorism-related losses.

Arguments For and Against

Federal Intervention

Arguments for a federal role in the insurance market generally fall into two categories. The first category of arguments emphasizes the high cost and limited supply of

private capital.1

 According to proponents, a shortage of

risk-bearing capital leads to an inadequate supply of insurance, which keeps prices steep relative to projected

losses for low-probability, high-loss events. One analyst

estimated that catastrophe reinsurance premiums were

more than seven times the expected loss in 1994, on average, although that multiple had dropped to between three

and four by 1998.2

 Proponents also contend that the

1. For example, see David M. Cutler and Richard Zeckhauser, “Reinsurance for Catastrophes and Cataclysms,” in Kenneth A. Froot,

ed., The Financing of Catastrophe Risk (Chicago: University of

Chicago Press, 1999), pp. 233-269.

2. Premiums for the highest layers of coverage (the lowest probability

layers) were between 20 and 30 times expected losses in 1994,

according to estimates. See Kenneth A. Froot, The Market for Catastrophe Risk: A Clinical Examination, Working Paper No. 7286

(Cambridge, Mass.: National Bureau of Economic Research, February 2001), p. 7 and Figures 3 and 4. However, research emphasizes the imprecision of the estimates of actuarial losses for the least

likely events. See James F. Moore, Tail Estimation and Catastrophe

Security Pricing: Can We Tell What Target We Hit If We Are Shoot-

 
20 FEDERAL REINSURANCE FOR DISASTERS

federal government, with its vast capacity to tax and borrow, has an advantage over private insurers in bearing

catastrophe risk because it does not need to hold explicit

capital to pay off claims and avoid bankruptcy.3

 To free

insurers from the costly burden of holding huge amounts

of capital, proponents suggest that the government act as

a residual provider of reinsurance for so-called megacatastrophes (disasters costing in the $100 billion range).

The government could set premiums below those charged

by private insurers, thus lowering the cost of insurance

while protecting taxpayers from losses.

The second category of arguments emphasizes that the

biggest barrier to an adequate supply of insurance, especially immediately after a catastrophe, is insurers’ heightened uncertainty about the frequency and size of future

losses. After Hurricane Andrew, the Northridge earthquake, and the World Trade Center attacks, insurers were

not certain that they could assess the risks they were being

asked to assume.4

 Without such knowledge, they were

unwilling to commit capital by issuing coverage.5

In time, insurers are usually able to recalibrate their estimates and reenter the market. (Some insurers have already

begun to do so on a limited basis in the aftermath of the

terrorist attacks.)6 Thus, proponents contend that the

government needs to intervene to supply insurance while

insurers reassess risk after a disaster, but they argue for a

temporary federal role. 

Many counterarguments have been made against the

claim that federal intervention would improve the performance of insurance markets.7

 For example, some analysts

dispute the claim that insurers’ unwillingness to provide

coverage after a disaster is a market failure. Instead, they

argue that the absence or high price of insurance implies

that the proposed activity is too risky. (Prices often seem

higher to buyers of insurance, who just see the rate hikes,

than to capital providers, who understand the relationship

of price to risk.) Defenders of the market also assert that

capital flows to investments for which the expected rates

of return, after adjusting for risk, are highest. Thus, shortages of capital simply reflect prices (and expected rates of

return) that are too low. And many analysts are skeptical

of the claim that the federal government could establish a

temporary reinsurance program, contending that it would

become a permanent barrier, subsidized by taxpayers, to

the provision of insurance by private firms.

In addition, opponents of intervention argue that the

federal government does not have a cost advantage in

bearing risk and reinsuring catastrophes.8

 Private insuring in the Dark? Working Paper No. 99-14 (Philadelphia: Wharton Financial Institutions Center, 1999), available at http://fic.

wharton.upenn.edu/fic/.

3. Statement of Lawrence H. Summers, Deputy Secretary, Department of the Treasury, before the House Banking and Financial

Services Committee, April 23, 1998. 

4. For an analysis of the impact on risk assessment of the September 11 events, see the statement of Alan Greenspan, Chairman,

Federal Reserve Board of Governors, before the Joint Economic

Committee, U.S. Congress, October 17, 2001. Also see the statement of Kenneth A. Froot, Professor of Finance, Harvard Business

School, before the Senate Committee on Banking, Housing, and

Urban Affairs, October 24, 2001. 

5. After the September 11 attacks, actions by rating agencies reinforced that uncertainty. At least one firm said it would probably

downgrade the credit ratings of insurers who continued to cover

terrorism risks. Downgrades raise an insurer’s cost of capital. See

Standard & Poor’s, “Maintenance of Insurance Ratings Depends

on Mitigating Terrorism Risk,” Ratings Direct, October 19, 2001.

6. Insurers are thinking about how to model terrorism risk. See

John A. Major, “Advanced Techniques for Modeling Terrorism

Risk” (February 2002), available at www.guycarp.com/pdf/major_

terrorism.pdf; and Gordon Woo, “Quantifying Insurance Terrorism Risk” (paper presented at the National Bureau of Economic

Research Conference on Insurance, Cambridge, Mass., February 1,

2002).

7. For example, see Shadow Financial Regulatory Committee, “Proposed Federal Catastrophe Reinsurance,” Statement No. 158 (December 13, 1999), available at www.aei.org/shdw/shdw.158.htm;

and Shadow Insurance Regulation Committee, “The Efficient

Management of Catastrophic Risk” (Washington, D.C.: Shadow

Insurance Regulation Committee, March 1, 1999). 

8. Scott E. Harrington, “Rethinking Disaster Policy,”Regulation, vol.

23, no. 1 (2000), pp. 40-46; George Priest, “The Government,

the Market, and the Problem of Catastrophic Loss,” Journal of Risk

and Uncertainty, vol. 12, no. 2/3 (1996), pp. 219-237; and R.

Anton Braun, Richard M. Todd, and Neil Wallace, The Role of

Damage-Contingent Contracts in Allocating the Risks of Natural

Catastrophes, Working Paper No. 586D (Minneapolis, Minn.:

Federal Reserve Bank of Minneapolis, April 1998).
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 21

ance firms are agents for investors who have a relatively

high tolerance for risk. In contrast, federal reinsurance

would place risks on taxpayers indiscriminately, regardless

of their willingness or ability to bear them. Federal reinsurance may appear to be less costly, but that is only because it does not include the costs of compensating taxpayers for the burden of supplying capital.

Because terrorism risks differ from the risks of natural

disasters, some analysts believe that subsidizing terrorism

insurance is the public’s responsibility. The federal government has the leading role in protecting the nation

from terrorism, and the September 11 attacks blurred the

line between homeland security and national defense in

the budget.9

 Proponents of federal intervention assert that

losses from terrorist attacks are part of the cost of providing homeland security because targets may be specifically

chosen according to the patriotic or iconic value that the

public attaches to them.

How Would Federal Reinsurance of

Risks from Natural Disasters Work?

Advocates of the view that the market cannot provide

sufficient capital to protect property against natural disasters would establish a federal program to sell reinsurance

to state-sponsored and private insurers and reinsurers.10

(See Appendix C for an analysis of government-backed

programs in Japan and New Zealand that provide insurance against earthquakes.) Early versions of proposals that

have the government providing reinsurance covered both

residential and commercial properties; most later versions

apply only to residential ones. The proposals generally

contain provisions intended to control federal spending

and avoid crowding out the private sector.11 Those provisions would:

# Require that the reinsurance contracts be auctioned,

using minimum prices based on actuarially expected

losses plus an additional amount for risk load and

administrative costs;12

# Define a minimum level of insured losses (a “retention

level”) that must be sustained in each state or region

before the federal government would make payments;

# Limit the federal government’s maximum liability; and

# Set a date on which the program would expire.

Most proposals also demand that states increase their

efforts to reduce risk through mitigation; some proposals

go further, requiring that a small portion of the proceeds

from the sale of insurance go into a federal mitigation

trust fund, which would make money available to eligible

states for those efforts. For example, Florida could subsidize the purchase of storm shutters to protect windows

from high winds and windblown debris, and California

could subsidize the cost of bolting or bracing walls to a

home’s foundation to make the structure more resistant

to earthquake damage.

Auctioning Contracts with a Minimum Bid Price

The federal government would auction reinsurance contracts to eligible private insurers and reinsurers. The proposed contracts, which would be subject to a minimum

bid or reservation price, would pay a fixed amount per

9. See the exchange between Alan Greenspan, Chairman, Federal

Reserve Board of Governors, and Representative Carolyn Maloney

in the transcript of hearings before the House Financial Services

Committee, February 27, 2002.

10. Proposals include H.R. 21 and S. 1361 in the 106th Congress;

H.R. 219, H.R. 230, H.R. 579, and S. 1043 in the 105th Congress; and H.R. 1856 in the 104th Congress. None of those proposals is currently being considered. 

11. For an analysis of the proposals, see Christopher M. Lewis and

Kevin Murdock, “Alternative Means of Redistributing Catastrophic Risk in a National Risk-Management System,” in Kenneth A. Froot, ed., The Financing of Catastrophe Risk (Chicago:

University of Chicago Press, 1999), pp. 51-85; and Lewis and

Murdock, “The Role of Government Contracts in Discretionary

Reinsurance Markets for Natural Disasters,” Journal of Risk and

Insurance, vol. 63, no. 4 (1996), pp. 567-597. 

12. In the private sector, the risk-load factor is an amount added to the

risk-based price to compensate the insurer for the variability of

losses around the long-term average in any given year and for the

uncertainty surrounding available estimates of the average itself.
22 FEDERAL REINSURANCE FOR DISASTERS

$1 billion of losses stemming from a disaster.13 The contracts would be similar to the catastrophe options traded

on the Chicago Board of Trade. They would cover specific “layers” of loss and be divisible and tradable. Proposals typically require that separate auctions cover different

geographic regions and that Florida and California each

constitute at least one region.

Under most of the proposals, a national commission of

actuaries would determine the expected losses for each

region. Proposals typically direct that prices for the reinsurance contracts include a risk load—often 100 percent

to 200 percent of the expected loss—mainly to account

for the variability and uncertainty of claims and the government’s cost of funds. (Higher risk loads could be

added to contract prices if the program’s administrator

concluded that they were warranted.) All other things

being equal, the risk load for a catastrophic loss that happens once every 250 years, on average, should be higher

than the risk load for a loss that occurs once every 100

years.14

The contracts for state-sponsored programs would not be

auctioned under some of the proposals; rather, prices

would be set by the Treasury. In general, the proposals

require that prices be set at least as high as the combined

total of expected losses and administrative costs.

Setting Retention Levels

Because a federal reinsurance program is designed to

cover only the highest levels of losses, insurers would have

to sustain large losses before the federal contracts paid out

money. Under most proposals, neither Hurricane Andrew

nor the Northridge earthquake would have triggered

payments. The retention levels and contract payouts are

tied to overall, or aggregate, losses rather than to losses for

individual insurance companies. The use of aggregate loss

triggers has several advantages: it vastly simplifies the

program’s administration, provides incentives for insurers

to maintain high standards for underwriting and claims

adjustment, and facilitates trading of the securities in the

secondary market.

But using aggregate loss triggers also means that any particular insurer’s losses may not match the contract’s payout. That mismatch—or basis risk—reduces the value of

the contracts as reinsurance because insurers could be left

underexposed or overexposed to risk. Indeed, catastrophe

options with similar features failed to attract much interest on the Chicago Board of Trade (see Appendix B).

Under some early reinsurance proposals, all holders of the

contracts would receive payments from the federal government regardless of whether they had actually incurred

losses. However, under more recent proposals, only insurers with losses would receive compensation.

Federal reinsurance proposals use three types of triggers to

describe the magnitude of catastrophe necessary to activate contract payments. Under an aggregate loss trigger,

payments would occur if total insured losses from one or

more catastrophes exceeded a set level, such as $25 billion

a year under a national contract. (One problem with that

type of “excess of loss” reinsurance is that initial estimates

of losses from earthquakes may be wildly inaccurate. For

example, initial estimates from the Northridge earthquake

were just $2.5 billion; ultimately, the insured losses were

$15 billion. Thus, payouts under a federal program of

that type might be slow to materialize.) Under an event

frequency trigger, contract payments would result following a catastrophe whose expected loss frequency exceeded

a certain threshold, such as every 100 years. Event frequency is often determined by regional insured losses. For

instance, a loss with a 100-year frequency might be identified as one that caused property damage of $6 billion in

an area less prone to disasters but $20 billion in a more

high-risk area. Finally, in the case of contracts sold to

state-sponsored insurers, the level at which payments were

triggered could be set by the purchaser’s total payment

capacity. For example, contracts sold to a state-sponsored

insurer with a total payment capacity of $5 billion would

13. Under some proposals, such as S. 1361, the contracts would be

issued by nonprofit corporations with special ties to the government, including the ability to borrow from the Treasury. That

structure increases the risk that the entity could use public benefits

for its private gain. See the statement of Stuart Eizenstat, Deputy

Secretary, Department of the Treasury, before the Senate Committee on Commerce, Science, and Transportation, April 13,

2000. 

14. For an analysis of the factors determining risk loads, see the statement of Paul G.J. O’Connell, Chair, Catastrophe Working

Group, American Academy of Actuaries, before the House Banking and Financial Services Committee, April 23, 1998. 
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 23

pay out if a catastrophe caused the insurer to incur claims

exceeding that amount.

Capping the Contingent Liability

To protect taxpayers, some proposals include provisions

to limit the government’s annual payment obligation.

Such limits are sometimes defined by a maximum level of

total payments—for instance, $25 billion a year—which

would constrain the number of contracts sold. Alternatively, a proposal might direct the program’s administrator to restrict the amount of coverage sold each year so

that total annual contract payments were “unlikely” to

exceed a specified level, such as $25 billion. The imprecision of those caps reflects the uncertainty surrounding the

number of regions and state programs that might be covered, the minimum level of insured losses that must be

sustained, and the layers of losses that would be covered,

as well as the possibility of more than one catastrophe in a

year. Many analysts believe that it would not be politically feasible to pay less than the full amount on contracts

sold and that any cap would be moot in the event of multiple disasters in the same year.15 Furthermore, using

“unlikely” as a standard would set no practical limit on

contract volume because catastrophes are, by definition,

unlikely.

Putting It All Together: An Example

Suppose the government was to offer reinsurance on a

national contract covering the layer of losses between $25

billion and $50 billion from a single disaster. The private

sector and state-sponsored plans would pay for losses

under $25 billion (the deductible) and over $50 billion

(the upper limit).16 The government could auction 1,000

contracts that would each pay insurers $1 million for

every billion dollars of industry losses in that layer.

Consider scenarios for three different disasters, causing

insured losses of $23 billion, $33 billion, and $60 billion,

respectively. For the $23 billion loss, no money would be

paid out because the loss would be below the deductible.

For the $33 billion loss, each contract would pay out $8

million, so the government’s payment on 1,000 contracts

would total $8 billion. For the $60 billion loss, each contract would pay out $25 million (the maximum amount),

capping the government’s contingent liability at $25

billion.

Setting a minimum contract price could prove tricky

because of the difficulty of determining expected losses.

Under a national excess-of-loss contract for a layer of

losses between $25 billion and $50 billion, the expected

loss component that would be included in bid prices

could range from $350,000 to $1,750,000 annually for

$25 million in coverage.17 The width of that range—the

high end is five times as large as the low end—indicates

the uncertainty surrounding estimates of actuarial losses.

The design of a federal reinsurance contract will in part

determine its viability. For example, a national contract’s

ability to attract sufficient demand depends partly on

rules governing trading. Suppose that the event triggering

a payout is an earthquake in California. A firm with limited or no exposure in the California market could

emerge as a “winner” by selling its contract to a firm with

heavy losses from the earthquake. (The federal government could restrict trades to prohibit those kinds of

windfalls, but that action would reduce demand for the

contracts.) In private markets, most reinsurance transactions are negotiated on an individual basis to avoid a

mismatch between insurers’ losses and reinsurance payouts.

15. See the statement of Stuart Eizenstat, Deputy Secretary, Department of the Treasury, before the House Banking and Financial

Services Committee, July 30, 1999.

16. Under some proposals, the government would provide only 50

percent coverage rather than 100 percent for a specified layer of

losses. That kind of coinsurance has two advantages. First, it provides a stronger incentive for firms to be more vigilant against

fraud and inflated claims. Second, it allows more opportunity for

private reinsurers to issue policies. 

17. That range is for the best-fitting estimates. See J. David Cummins,

Christopher M. Lewis, and Richard D. Phillips, “Pricing Excessof-Loss Reinsurance Contracts Against Catastrophic Risk,” in Kenneth A. Froot, ed., The Financing of Catastrophe Risk (Chicago:

University of Chicago Press, 1999), pp. 93-141, especially Table

3.8, p. 132.
24 FEDERAL REINSURANCE FOR DISASTERS

Cost to the Federal Government 

of Reinsuring Risks from 

Natural Disasters

The Congressional Budget Office (CBO) concludes that

all of the current reinsurance proposals would be costly to

taxpayers, although the proposals’ specific budgetary

impact is uncertain. In particular, a proposed 100 percent

or 200 percent risk load would be unlikely to provide an

adequate cushion against losses on an expected-value basis

(over a long time horizon).18 By comparison, risk loads in

private transactions are typically four to six times (that is,

400 percent to 600 percent) expected losses.

CBO’s conclusion rests on two factors: the uncertainty

surrounding the actuarial estimates of catastrophe risk

that would be used to set minimum contract prices, and

the federal government’s weak incentives to overcome

that uncertainty and set prices at a budget-neutral level.

For example, the actuarially expected losses for the $25

billion to $50 billion layer of losses on a national contract

could vary greatly depending on which type of probability

distribution of losses was chosen to fit the meager available data.19 Improvements in building techniques over

time would also add to the uncertainty because those

changes would make the historical record of losses less

reliable as a predictor. In addition, the risks themselves

might be shifting. Meteorologists believe that changes in

ocean cycles and atmospheric conditions may be increasing the frequency of stronger hurricanes.20

Given the irreducible uncertainty of the estimates, property owners and insurers—bringing consumer and political pressure to bear—could probably generate a strong

voice for low contract prices. (Political pressure could be

especially influential if prices were set administratively for

the state-sponsored programs.) Another option, auction

bidding, might drive contract prices toward the breakeven value, but CBO is not certain that demand for the

contracts would be sufficient to ensure vigorous bidding.

The recent halt in trading of catastrophe options on the

Chicago Board of Trade adds to that uncertainty.21

Over a 10-year period, a federal reinsurance program with

annual contracts covering losses that occurred once every

100 years, on average, for six different regions would have

60 chances to encounter a catastrophic event; the probability of at least one such event occurring would be 45

percent. (Some proposals allow the Secretary of the Treasury to lower the loss threshold for state-sponsored programs.) Furthermore, the probability of such a 100-year

loss may be more (or less) than 1 percent in any given

year, either because the historical data underlying the

estimates of the frequency of events are inadequate or

because the timing of such events is affected by meteorological cycles.

If a catastrophic earthquake or hurricane occurred, the

federal government would probably be left paying for

some of the losses. It would be difficult for the government to raise premiums by enough to recover past losses

and repay the money it borrowed from the Treasury over

the time horizons in the proposals, which vary from 10

years to 20 years. Indeed, under competitive conditions,

it would be nearly impossible for the government to recoup past underwriting losses that were based on mispriced premiums. Firms that did not participate in the

program would be able to underprice participating firms

and capture most of the market, unless the costs of past

losses were also imposed on new entrants. Moreover,

18. See Congressional Budget Office, Cost Estimate for H.R. 21, Homeowners’ Insurance Availability Act of 1999 (February 9, 2000); Cost

Estimate for H.R. 219, Homeowners’ Insurance Availability Act of

1998 (September 23, 1998); and Cost Estimate for H.R. 230, Natural Disaster Protection and Insurance Act of 1997 (October 8,

1997). 

19. Researchers tested four different loss distributions. The estimates

of expected loss ranged from $177 million (using a lognormal

distribution and adjusting past losses for population growth) to

$4,635 million (using a Pareto distribution and simulating losses).

See Cummins, Lewis, and Phillips, “Pricing Excess-of-Loss Reinsurance Contracts Against Catastrophic Risk,” pp. 93-141, especially Table 3.4 on p. 123 and Table 3.6 on p. 127. 

20. See Andrew C. Revkin, “Coasts and Islands Facing Era of Strong

Hurricanes,” New York Times, July 20, 2001, p. A1; and Stanley

B. Goldenberg and others, “The Recent Increase in Atlantic Hurricane Activity: Causes and Implications,” Science, vol. 293 (July 20,

2001), pp. 474-479. 

21. Swiss Re, “Capital Market Innovation in the Insurance Industry,”

Sigma, no. 3 (2001), pp. 21-23, available at www.swissre.com in

the Sigma archive.
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 25

firms would have an incentive to reduce their purchases

of reinsurance from the government to hold down prices.

Some of the costs to the federal government could be

offset by possible savings in payments for disaster assistance, particularly assistance provided by the Small Business Administration. However, several of the largest

disaster-assistance programs benefit individuals or organizations that would not be affected by the reinsurance

contracts (see Table 5 on page 16). For instance, most

spending from the Federal Emergency Management

Agency’s disaster-relief fund goes to state and local governments, which do not carry traditional insurance, to aid

in rebuilding public infrastructure. Federal costs for disaster assistance might also be reduced by provisions in the

reinsurance proposals that increase spending on preventive measures, but the size of any such savings would be

speculative.

How Would Federal Reinsurance of

Risks from Terrorism Work?

In countries where terrorist attacks have occurred, such as

Great Britain, Israel, and Spain, government-backed programs provide insurance coverage.22 Under the proposals

now before the Congress, the federal government would

bear most of the cost of terrorism-related losses for the

next one to three years. Neither the House bill (the Terrorism Risk Protection Act, or H.R. 3210) nor the Senate

bill (the Terrorism Risk Insurance Act of 2002, or

S. 2600) envisions a permanent program, but one could

result, especially if the threat of terrorism remains high.

The two bills differ in their deductibles, the share of risk

assumed by the government, the caps on punitive damages, and the amounts of repayment.23 Both bills cover

claims for business interruption and workers’ compensation and limit the government’s annual liability to $100

billion. If losses exceeded that amount, the Secretary of

the Treasury could ask the Congress for guidance on how

losses over the limit should be paid.

The Terrorism Risk Protection Act, which the House

passed in November 2001, requires the federal government to coinsure, or bear, 90 percent of all losses after the

insurance industry sustains $1 billion in total losses in a

year. The overall level of loss at which the government

would intervene could be as low as $100 million if the

losses for any single insurer exceeded 10 percent of its

capital surplus and 10 percent of its net premiums. Each

insurer would also have a deductible of $5 million. Insurers and policyholders as a group would partially repay the

government for its financial assistance. For losses of less

than $20 billion, property and casualty insurers would

pay assessments of up to $15 billion to the government—up to $5 billion in the first year and up to $10

billion in subsequent years (annual assessments cannot

exceed 3 percent of an insurer’s premiums).24 Commercial property and casualty policyholders would repay

losses of between $20 billion and $100 billion that were

sustained by the government through surcharges of up to

3 percent on their premiums. The government would

subsidize the repayment by not charging interest on the

funds it provided to insurers. Of course, whether the

assessments are levied on policyholders or insurers, policyholders ultimately bear the burden of repayment. However, assessments that were levied directly on insurers

would affect their balance sheets.

The Terrorism Risk Insurance Act of 2002, which the

Senate passed in June 2002, departs from the House bill

in two major ways. First, the federal government would

not be repaid for its losses. Second, in the event of a catas22. Statement of Thomas J. McCool, Managing Director, Financial trophe during the program’s first year, the industry would

Markets and Community Investment, General Accounting Office,

before the Senate Committee on Banking, Housing, and Urban

Affairs, published as General Accounting Office, Terrorism Insurance: Alternative Programs for Protecting Insurance Consumers,

GAO-02-199T (October 24, 2001).

23. For a detailed comparison of the various bills before the Congress,

see Rawle O. King, Terrorism Risk Insurance: A Summary of Legislative Proposals, CRS Report for Congress RL31209 (Congressional Research Service, December 7, 2001). 

24. Under the insurance industry’s accounting rules, an insurer would

have to recognize a liability at the time of the loss for the full future value of the payments due. If the liability was large enough, a

participating company could become insolvent, even if it suffered

no losses. Consequently, some analysts doubt whether H.R. 3210

would encourage insurers to offer substantially more terrorism

coverage than they offer now. See Standard & Poor’s, “Terrorism

Coverage Remains in Doubt,” Ratings Direct, April 15, 2002. 
26 FEDERAL REINSURANCE FOR DISASTERS

have to absorb the first $10 billion (rather than $1 billion) in losses. After the industry had paid $10 billion, the

government would pay 90 percent of the remaining

losses, up to $100 billion. If the Treasury extended the

program for a second year, insurers would have to cover

the first $15 billion in losses.

Under the provisions of the Senate bill, federal cost sharing could occur for losses of less than $10 billion if the

solvency of individual firms was at risk. A firm’s deductible in the first year of the program would be its market

share multiplied by the $10 billion industry deductible.

Thus, a firm with 5 percent of the market would face a

$500 million deductible, after which the federal government would pay 80 percent of the losses up to the $10

billion industrywide trigger.

Cost to the Federal Government of

Reinsuring Risks from Terrorism

CBO cannot predict how much insured damage terrorist

attacks could cause in any specific year. Thus, the

agency’s estimate of the cost of financial assistance provided under H.R. 3210 reflects how much the government might be expected to pay insurers on average. That

average weighs the probabilities of various outcomes,

from damages of zero up to very large amounts, resulting

from possible future terrorist attacks. On such an

expected-value basis, CBO estimates that H.R. 3210

would increase direct spending by $8.5 billion and government receipts by $5.3 billion over the 2002-2011

period.25 That estimate is based on premiums collected

for terrorism insurance in Great Britain and insurance

practices in the United States. (See Appendix C for information on Britain’s terrorism reinsurance program.) It

assumes that financial assistance to property and casualty

insurers would be paid over several years because of disputes by property and business owners about the value of

covered losses.

The federal government would need to charge insurers

about $3 billion annually for coverage over the 2002-

2004 period, CBO estimates, to receive full compensation for the risk it would assume under the Terrorism

Risk Protection Act. Although that estimate reflects

CBO’s best judgment based on available information,

costs are a function of future terrorist attacks, which are

inherently unpredictable. As such, actual costs could

cover an extremely broad range.

Advantages and Disadvantages of

the Federal Reinsurance Contracts

Reinsurance proposals seek to expand the capacity of

private insurance markets to handle catastrophes without

shifting costs to taxpayers or preempting private-sector

initiatives. Ancillary goals include mitigating losses before

disasters strike, discouraging insurance-related discrimination, and encouraging states to take steps to combat pricegouging after disasters. Federal excess-of-loss reinsurance

contracts could expand insurance coverage and reduce

some federal spending on disaster assistance. They could

also back up states’ disaster plans. In the short run, federal

reinsurance of terrorism risks may be the only way to

ensure that significant amounts of traditional insurance

are available for buildings that are landmarks or for critical infrastructure projects.26 If the reinsurance contracts

were underpriced, however, they could reduce incentives

for private mitigation, preempt the development of innovative insurance products, and shift costs to taxpayers.

Advantages

Auctioning excess-of-loss contracts would probably lower

the cost of reinsurance, which would in turn increase the

availability and decrease the price of catastrophe insurance. For that reason, primary insurance companies gen25. Congressional Budget Office, Cost Estimate for H.R. 3210, Terrorism Risk Protection Act (November 19, 2001), as ordered reported

by the House Committee on Ways and Means on November 16,

2001. The bill passed by the House differed slightly. CBO did not

prepare a cost estimate for S. 2600. 

26. Rating agencies have stated that exposure to terrorism losses could

result in ratings downgrades in the absence of a federal insurer of

last resort. See Steven J. Dreyer, Mark Puccia, and Donald Watson, “Maintenance of Insurance Ratings Depends on Mitigating

Terrorism Risks,” Standard & Poor’s, Ratings Direct, October 19,

2001; and Keith M. Buckley, “Fitch Comments on Possible Government Terrorism Solution,” Fitch Special Report (November 12, 2001).
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 27

erally support a federal program.27 The reinsurance contracts would confer benefits both before and after a disaster. They would create a safety net for private insurers and

reinsurers before disaster struck by absorbing the risk of

losses from megacatastrophes, which otherwise could

threaten firms with insolvency.28 By covering losses and

providing liquidity after a disaster, a federal program

would make insurers more willing to continue issuing

coverage in disaster-prone areas.

By relying on auctions rather than set prices to determine

the cost of the contracts, the federal government recognizes that it is probably at an informational disadvantage

relative to private insurers in pricing catastrophe risk.

Auctions offer the government a way of potentially neutralizing its disadvantage because they can compel insurers to reveal their assessment of risk in their bids. (Insurers whose bids understated their assessment of risk might

not win any of the reinsurance contracts.)29

Competition among insurers would force them to pass

the savings from a federal program on to policyholders,

many of whom would see their premiums drop. Policyholders might not realize any savings in states in which

regulators suppress rates substantially below costs, but the

quality of the insurance product could improve. Similarly, federal reinsurance for disasters could enhance the

credibility of states’ insurance programs and reduce their

reliance on postevent assessments.

By encouraging more insurers to offer greater coverage,

federal reinsurance might also reduce people’s need for

federal assistance after disasters. In particular, individuals’

need for loans through the Small Business Administration

(which cost taxpayers more than $500 million in total

after Hurricane Andrew and the Northridge earthquake)

and their need for temporary housing assistance through

FEMA (which cost more than $1.3 billion for the two

natural disasters) could decline (see Table 5 on page 16).

A federal reinsurance program for terrorism risks could

provide two additional benefits. First, it could reduce the

short-term economic effects of the current reduction in

the supply of insurance. Second, it would spread the costs

of the threat of terrorism across the country, rather than

leave those costs to be borne by the owners and users of

particular facilities. People who view losses from terrorist

attacks as part of the cost of providing homeland security

would view such cost sharing as an advantage.

Disadvantages

The federal government’s experience with other insurance

programs suggests that it has difficulty managing risk

efficiently. In part, that is because the government has less

of an incentive than private firms do to ensure that premiums cover costs and to control moral hazard (policyholders’ incentive to change their behavior in ways that

will increase losses from insured events) and adverse selection (the purchase of insurance disproportionately by

people with the highest risks).

One way in which that difficulty manifests itself is in

oversimplified pricing; federal programs seldom tailor

premiums to risks. For example, the federal flood insurance program charges premiums that are below expected

costs for some properties and covers repeated losses for

the same properties.30 Another example is evident in the

27. See the statements of Robert W. Pike, Senior Vice President,

Allstate Insurance Company, before the House Committee on

Banking and Financial Services, April 23, 1998, and July 30,

1999. Reinsurers also support a federal role provided that the retention levels are set high enough to avoid crowding them out. See

the statement of Franklin W. Nutter, President, Reinsurance Association of America, before the House Committee on Banking and

Financial Services, April 23, 1998. 

28. See Rade T. Musulin, “Would a Federal Role in Disaster Protection Be a Catastrophe?” Contingencies, American Academy of Actuaries (November/December 2000), pp. 28-33. 

29. The government is more likely to extract private information on

the value of the contracts if it sets supply below expected demand

at the reservation price. See Lewis and Murdock, “The Role of

Government Contracts in Discretionary Reinsurance Markets for

Natural Disasters.”

30. See the statement of Stanley J. Czerwinski, Associate Director,

Housing and Community Development Issues, Resources, Community, and Economic Development Division, General Accounting Office, before the Subcommittee on Housing and Community

Opportunity of the House Committee on Banking and Financial

Services, published as General Accounting Office, Flood Insurance:

Information on Financial Aspects of the National Flood Insurance

Program, GAOT-RCED-00-23 (October 27, 1999). 
28 FEDERAL REINSURANCE FOR DISASTERS

losses sustained by deposit insurance programs. Cleaning

up the thrift crisis in the 1980s and early 1990s cost

about $150 billion.31 Despite the implementation of riskbased premiums for banks and thrift institutions, few of

them pay any deposit insurance premiums today because

the government has already attained its mandated reserve

levels in the deposit insurance trust funds.32 Those examples show that the inevitable uncertainty about actuarial

risks leaves room for discretion in setting prices, which in

practice often leads to bigger subsidies. Accordingly, a

federal disaster reinsurance program could turn out to be

more costly and to encourage more risk taking than proponents claim. Moreover, as federal crop insurance has

demonstrated, the government is unable to withhold

disaster assistance from those at risk who fail to purchase

insurance.33

Federal reinsurance could have three other disadvantages.

First, it might crowd out private insurance suppliers.

Capital market products, especially catastrophe bonds

whose principal and interest would be suspended if a

disaster occurred, would be at a competitive disadvantage

against a subsidized federal program. That is because the

cost of the capital market products would be higher than

the premiums that the government would charge for its

reinsurance.

Second, a federal program that nationalized disaster risk

might reduce diversification gains from international risk

sharing by retaining all residual risk domestically. The

current system has an advantage in that reinsurance markets are international. Extensive diversification of risk

contributed to the ability of insurers and reinsurers to

survive the September 11 attacks.

Third, a federal reinsurance program for disasters could

transfer risk and wealth in unintended directions. The

rest of the nation might end up subsidizing property

owners in California, New York, and Florida, the states

that are most prone to catastrophic losses. Relatively affluent property owners in coastal areas and the owners of

commercial properties that were landmarks would also

benefit from taxpayer support.

Other Federal Policies to Promote

the Supply of Insurance

Some analysts do not think that the government needs to

provide reinsurance for natural disasters or acts of terrorism. Instead, they would rely on the market to offer an

adequate supply of insurance. Short of providing reinsurance, the federal government could adopt measures to

encourage private supply following catastrophic events.

Those measures include offering incentives for the mitigation of risks, reducing federal assistance after disasters,

changing the tax treatment of loss reserves held by insurers, and limiting damage awards. To achieve some of

those same goals, states could deregulate their insurance

markets.

Rely on the Market to Provide Disaster Insurance

The September 11 attack on the World Trade Center

alarmed people who set financial policy because it threatened the economy rather than just the insurance industry.34 The lack of terrorism insurance could retard commercial construction and be a drag on the economy, but

31. See Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1996-2000 (January 1995), pp. 46-48. Estimates

for insured losses have changed over time for both banks and

thrifts. See Timothy Curry and Lynn Shibut, “The Cost of the

Savings and Loan Crisis: Truth and Consequences,” FDIC Banking Review, vol. 13, no. 2 (2000), pp. 26-35. 

32. Moreover, deposit insurance does not attempt to price its line of

credit with the Treasury or its catastrophe coverage. See James A.

Wilcox, “Issues in Deposit Insurance Reform” (paper presented at

the Federal Reserve Bank of Chicago’s 2001 Annual Bank Structure Conference, Chicago, May 11, 2001). Also see Joe Peek and

James A. Wilcox, “Safety Net Subsidies in Banking: Decline, Resurgence, and Prospects” (working paper, University of California

at Berkeley, June 24, 2001). 

33. The 1996 farm bill allowed producers to opt out of catastrophe

coverage provided that they signed a waiver disqualifying them

from any future disaster payments for crop losses. Despite that

provision, emergency relief packages in 1999 and 2000 provided

assistance to farmers who had opted out of the subsidized federal

crop insurance program. For further analysis, see Jerry R. Skees,

“The Bad Harvest: Crop Insurance Reform Has Become a Good

Idea Gone Awry,” Regulation, vol. 24, no. 1 (Spring 2001), pp.

16-21.

34. Congressional Budget Office, Federal Reinsurance for Terrorism

Risks, CBO Paper (October 2001).
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 29

the magnitude of that risk is still not clear.35 Indeed, a

market is developing for terrorism reinsurance to bridge

that coverage gap.36

The largest reinsurance companies are willing to take on

some terrorism risks at higher premiums, but they try to

avoid issuing groups of policies that might result in large

concentrated losses. For example, reinsurance provider

National Indemnity, a subsidiary of Berkshire Hathaway,

covers some terrorism risks for a South American refinery,

several international airlines, a large North Sea oil platform, and the Sears Tower in Chicago.37 Other reinsurers

also offer terrorism coverage for airlines.38

In the aftermath of September 11, banks and other lenders are still providing credit on commercial projects that

do not have terrorism coverage, although they may demand terrorism insurance for new structures that are

landmarks in major cities.39 A March 2002 survey of bank

lending practices indicated that most banks had not tightened their loan requirements for landmark properties and

other high-profile commercial real estate, including sports

and entertainment venues and large shopping malls.40

Moreover, the survey showed little decline in demand for

those loans because of the lack of terrorism coverage.

Most banks require terrorism insurance for less than 10

percent of their high-profile properties.

Federal and state bank regulators have not yet issued any

guidelines on terrorism coverage, and bankers are tolerant

of the fact that the lack of coverage may have caused some

borrowers to breach their loan agreements.41 Calling in

loans is not a viable option for the banks, but they can

raise fees or require more collateral.

The available data on commercial construction also do

not indicate a dire situation at present. As a result of the

most recent recession, which began in March 2001, construction was already slowing prior to September 11, and

the current slowdown in activity has been less severe than

it was during the 1990-1991 recession. Moreover, national data do not show any pronounced effects from the

lack of terrorism insurance.42 Any impact could be slow

to appear, however, and spending to date may simply

reflect construction that was started before September 11

and that was bolstered by mild weather in January.

35. Alan Greenspan, chairman of the Federal Reserve Board of Governors, testified in February that to date he had not seen in the data

a significant impact on the economy from the lack of terrorism

insurance. But he also believed that it was too early to judge. Anecdotal evidence suggests that there have been some effects. See the

transcript of Greenspan’s exchange with Representative Paul

Kanjorski during hearings before the House Committee on Financial Services (February 27, 2002).

36. Christopher Oster, “Insurers Add Terrorism Coverage,” Wall

Street Journal, April 15, 2002, p. C18.

37. In November 2001, Berkshire Hathaway had announced that it

was not going to issue terrorism insurance. But high premiums

may have induced the firm to assume those risks, even if they

could not be accurately priced. See the annual letter of Warren E.

Buffett, Chairman of the Board, Berkshire Hathaway, to Shareholders, February 28, 2002, especially pp. 6-12, available at www.

berkshirehathaway.com/letters/2001pdf.pdf. 

38. Joseph B. Treaster, “A Call for the U.S. to Get Out of Terror

Insurance for Airlines,” New York Times, February 26, 2002,

p. C8.

39. Real estate lending by banks has continued to increase over the

past year in contrast to most other forms of bank lending, which

have shown greater effects from the economic slowdown. See

Board of Governors of the Federal Reserve System, “Assets and

Liabilities of Commercial Banks in the United States,” Federal

Reserve Statistical Release H.8 (May 3, 2002). 

40. The survey asked a series of questions about how the lack of terrorism insurance had affected lending. For most of the 56 domestic

banks that responded, less than 10 percent of their commercial real

estate loans involved buildings or sites that are landmarks. See

Federal Reserve Board, “The April 2002 Senior Loan Officer

Opinion Survey on Bank Lending Practices” (April 2002), available at www.federalreserve.gov/boarddocs/snLoanSurvey/200205/

default.htm. 

41. See Joseph B. Treaster, “Rethinking Dire Warnings by Insurers

After September 11,” New York Times, February 27, 2002, p. C1;

and Michelle Heller, “No Terrorism Insurance, But Lenders Still

Lending,” American Banker, January 7, 2002. 

42. Bureau of the Census, “March 2002 Construction at $874.0 Billion Annual Rate” (press release, Washington, D.C., May 1,

2002), available at www.census.gov/ftp/pub/const/C30/c300203

.pdf. The excess supply of office space in many cities has also

played a role in the slowdown of commercial construction. See

Federal Deposit Insurance Corporation, “Weak Fundamentals for

U.S. Office Markets” (press release, Washington, D.C., March 21,

2002).
30 FEDERAL REINSURANCE FOR DISASTERS

Data on commercial mortgage-backed securities (CMBSs)

do not suggest a major disruption in the supply of commercial mortgage money at this time. Issuances through

July 18, 2002, were down by about 20 percent from the

same period in 2001, but the economic slowdown would

account for most of that decline. Through July 17, 2002,

spreads of CMBSs over five-year AAA swaps had actually

fallen since the last week of 2001, when terrorism insurance was still widely in place. Spreads are also lower than

those prevailing before September 11, 2001.43 That small

change in the spreads suggests that investors are not demanding much of a premium for bearing terrorism risk,

in part because CMBSs are geographically diversified.

In spite of the market’s resilience after September 11,

some analysts doubt that it will be able to offer sufficient

quantities of terrorism insurance in the absence of a federal backstop. The General Accounting Office found

several examples of projects that have been canceled or

delayed, partly because of the lack of terrorism coverage.44

In addition, at least one bond-rating agency is considering

what impact the lack of terrorism insurance may have on

ratings for CMBS deals. Large commercial mortgage

loans may need layers of reinsurance from several providers because no single reinsurer wants all of the risk exposure.45 With the supply of terrorism insurance low and

prices for coverage high, the Administration argues that

the effect on businesses of not being able to buy insurance

will be just like a tax increase on productive capital,

which will ultimately be borne by workers and consumers.46

Provide Incentives for Risk Mitigation

Preventive measures taken before disaster strikes can reduce the risk of loss from catastrophes. For example, developers can concentrate construction in areas less prone

to catastrophic losses. To diminish losses from earthquakes, builders can bolt the wood frame of a house to its

foundation and add bracing to walls.47 In addition, securing gas water heaters to walls and installing automatic gas

shutoff valves decrease the likelihood of fire after an

earthquake. Homeowners in coastal regions subject to

hurricanes can reinforce their roofs and install storm

shutters to lessen the damage from a disaster.

But despite the potential savings that mitigation offers,

most homeowners, businesses, and state and local governments do not adopt cost-effective measures to reduce

their losses before a disaster. Surveys indicate that only

10 percent of the residents in areas hit by two recent California earthquakes had invested in loss-reduction measures.48 To help prevent future losses, California has put

43. The year-to-date volume of CMBS issues was $29.2 billion as of

July 18, 2002, compared with $36.6 billion for the same period in

2001. Spreads over the five-year AAA swaps increased from 42

basis points before September 11 to a high of 58 basis points in

November 2001. However, the spread was just 38 basis points as

of July 17, 2002, a drop of 10 basis points since the beginning of

the year. Data on commercial mortgage-backed securities are available at www.cmalert.com/Public/MarketPlace/MarketStatistics/

index.cfm.

44. See the statement of Richard J. Hillman, Director, Financial Markets and Community Investment, General Accounting Office,

before the Subcommittee on Oversight and Investigations of the

House Committee on Financial Services, published as General

Accounting Office, Terrorism Insurance: Rising Uninsured Exposure

to Attacks Heightens Potential Economic Vulnerabilities, GAO-02-

472T (February 27, 2002); and Joint Economic Committee, Economic Perspectives on Terrorism Insurance (May 2002), available at

www.house.gov/jec/. 

45. Daniel B. Rubock and Tad Philipp, CMBS: Moody’s Approach to

Terrorism Insurance for U.S. Commercial Real Estate, Structured

Finance, Special Report (New York: Moody’s Investors Service,

March 1, 2002).

46. Statement of Mark J. Warshawsky, Deputy Assistant Secretary for

Economic Policy, Department of the Treasury, before the Subcommittee on Oversight and Investigations of the House Committee on Financial Services, February 27, 2002.

47. See Patricia A. Grossi, Paul Kleindorfer, and Howard Kunreuther,

The Impact of Uncertainty in Managing Seismic Risk: The Case of

Earthquake Frequency and Structural Vulnerability, Working Paper

No. 99-23 (Philadelphia: Wharton Financial Institutions Center,

December 1998); and Patricia A. Grossi, Assessing the Benefits and

Costs of Earthquake Mitigation, Working Paper No. 99-24 (Philadelphia: Wharton Financial Institutions Center, June 1999). Both

are available at http://fic.wharton.upenn.edu/fic/.

48. Howard Kunreuther, “Managing Catastrophic Risks Through

Insurance and Mitigation” (paper presented at the Fifth Alexander

Howden Conference on Disaster Insurance, Gold Coast, Australia,

August 1997).
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 31

in place a program that provides subsidized loans to

homeowners to retrofit their homes.

Stronger state and local building codes and better enforcement of those codes may also provide net benefits.

But stronger codes are often resisted by builders, who

argue that loss-prevention measures will not be appreciated by buyers and thus not fully reflected in a home’s

value.49 One study estimated that 25 percent of insured

losses from Hurricane Andrew could have been prevented

through better building code compliance and enforcement.50 Both Florida and California have recently

adopted tougher building codes. For example, Orange

County in California now requires that a new roof have

plywood over the rafters to make it stronger. Also, the

city of Los Angeles no longer allows masonry chimneys;

manufactured chimneys, which have a wooden or stucco

frame with a metal cylinder inside to vent the smoke, are

acceptable.

The federal government could reform its own insurance

programs to encourage risk mitigation and discourage

construction in high-risk areas. By subsidizing flood insurance, for instance, the federal government has encouraged building in hazardous areas, putting more real estate

at risk and raising the cost of postdisaster assistance.51

Federal insurance will cover repeated losses (up to

$350,000 for property and contents) on the same oceanfront property without an increase in premiums. The

federal government could also provide financial incentives

to state and local governments and private property owners to undertake measures to reduce losses.

Reduce Postdisaster Assistance

The federal government provides extensive financial assistance to individuals and state and local governments in

areas hit by a disaster. For example, homeowners are eligible for low-interest loans from the Small Business Administration following disasters, and they can deduct uninsured property losses from taxable income.

The large share of federal disaster assistance targeted toward state and local governments is usually provided

through a supplemental appropriation, which generally

covers 75 percent to 100 percent of public rebuilding

costs.52 In an effort to lessen state and local governments’

reliance on federal aid, which reduces their incentive to

adopt mitigation measures and to purchase insurance, the

Administration has proposed reducing the federal share of

costs to 50 percent and requiring public buildings to

carry disaster insurance.53

Change the Tax Treatment of Capital Reserves

Altering the way in which expected catastrophic losses

and income from investments are taxed could expand the

availability and lower the cost of disaster insurance.54 The

tax code currently limits the amount of capital reserves

that insurers can accumulate by taxing as income those

profits that are temporarily inflated when disaster losses

are low. Insurers cannot count as expenses for tax purposes additions made to their reserves against low49. Michael Quint, “A Storm Over Housing Codes: Builders Resist

Insurers’ Call for Tougher Standards,” New York Times, December

1, 1995, p. D1. 

50. The estimate from the Insurance Information Institute is cited in

Howard Kunreuther, Mitigating Disaster Losses Through Insurance,

Working Paper No. 95-09-02 (Philadelphia: Wharton Risk Management and Decision Processes Center, 1995).

51. For an analysis of the federal government’s flood insurance program and changes made to reduce its losses, see the statement of

Stanley J. Czerwinski, Director, Physical Infrastructure Issues,

General Accounting Office, before the Subcommittee on Housing

and Community Opportunity of the House Committee on Financial Services, published as General Accounting Office, Flood Insurance: Information on the Financial Condition of the National Flood

Insurance Program, GAO-01-992T (July 19, 2001). 

52. See Rutherford H. Platt, “Shouldering the Burden: Federal Assumption of Disaster Costs,” in Platt, ed., Disasters and Democracy:

The Politics of Extreme Natural Events (Washington, D.C.: Island

Press, 1999); and David A. Moss, “Courting Disaster? The Transformation of Federal Disaster Policy Since 1803,” in Kenneth A.

Froot, ed., The Financing of Catastrophe Risk (Chicago: University

of Chicago Press, 1999), pp. 307-355. 

53. William Claiborne, “Disaster Management Cuts Raise Concerns,”

Washington Post, May 8, 2001, p. A21. 

54. Scott E. Harrington and Greg Niehaus, “Government Insurance,

Tax Policy, and the Affordability and Availability of Catastrophe

Insurance,” Journal of Insurance Regulation, vol. 19, no. 4 (Summer 2001), pp. 591-612. 
32 FEDERAL REINSURANCE FOR DISASTERS

probability risks.55 Instead, insurers can expense the cost

of reserves only for losses that have been reported by policyholders but that remain unsettled and losses that are

anticipated to have already occurred but for which claims

have not yet been reported.56

For example, an insurer who will experience a $100 million loss from a disaster once over the next 100 years is

incurring an expected loss of $1 million annually. The

firm pays taxes each year on the premiums it collects until

the disaster occurs, after which the firm is able to deduct

the losses for tax purposes. Some of that 100-year loss

may be offset by current income from other sources, and

the remainder may be carried forward or back. But the

potential for the firm to lose money still exists. Even if the

total loss is offset or carried forward, the firm will lose the

time value of its money because the taxes were paid before

the deduction could be taken. Consequently, one might

argue that insurers should be able to treat expected losses

as a cost of doing business each year, regardless of

whether insurers set aside reserves.

As an alternative, the government might allow insurance

companies to put money aside tax-free to cover expected

losses. State-sponsored plans generally can already do so

and avoid paying taxes on investment income. Similarly,

private mortgage guaranty insurers are permitted to hold

50 percent of their premiums in a tax-deductible reserve

for 10 years. (The reserve must be invested in special noninterest-bearing Treasury bonds.) Another possibility is to

allow insurers to carry back catastrophe losses 10 years or

20 years, instead of the current two years, and recover

federal taxes paid in past years. A precedent for that alternative exists because product liability insurers can carry

back losses 10 years.

Such changes to the tax code could have several disadvantages, however. First, they could lead to substantial distortions in the allocation of capital, especially between insurers and other financial institutions not subject to the same

tax treatment. Second, changes would result in losses of

federal revenue.57 Third, without adequate oversight, insurers could abuse the option to set aside tax-free reserves

by overestimating expected losses. Insurers and other

corporations can already carry back losses two years and

carry forward losses 20 years, which helps smooth out

their cash flow following a disaster. Finally, altering the

tax code would not address the problem that underlies

insurers’ reluctance to provide coverage for terrorism risk:

the inability to assess risk well enough to price policies.

The taxation of income on capital reserves increases the

premiums insurers must charge for catastrophe insurance.58 Taxation of portfolio income is not unique to

catastrophe insurance; it is characteristic of the corporate

income tax. But catastrophe insurance is distinguished

from other insurance by its necessarily high ratio of capital to expected losses and therefore by the high ratio of

taxable investment income to expected losses. Consequently, insurers must increase premiums to cover those

taxes and provide equity investors with at least the same

expected after-tax return as they could achieve by purchasing a similar investment directly. For instance, say the

insurer in the previous example earns 6 percent on its

$100 million bond portfolio, which backs the risk of

catastrophic loss. If taxes absorbed one-quarter of the

investment income, then the insurer’s 6 percent market

return on its investments would be reduced to 4.5 percent

after taxes. Thus, the insurer would need to collect an

additional 1.5 percentage points ($1.5 million) in premiums beyond the $1 million in expected losses to compensate capital providers for catastrophe exposure.

55. Proponents of this tax treatment argue that insurers would opportunistically set aside too large a portion of their reserves for catastrophes if reserves were allowed to accumulate tax-free. See Robert

E. Litan, “Earthquake! Planning and Paying for the ‘Big One’,”

Brookings Review (Fall 1990), pp. 42-48. 

56. David F. Bradford and Kyle D. Logue, The Influence of Income

Tax Rules on Insurance Reserves, Working Paper No. 5902 (Cambridge, Mass.: National Bureau of Economic Research, January

1997). 

57. The Joint Committee on Taxation estimated that establishing taxfree reserves for terrorism coverage would reduce revenues by

$12.4 billion over 10 years. See Congressional Budget Office, Cost

Estimate for H.R. 3210, Terrorism Risk Protection Act (November

19, 2001). 

58. Scott E. Harrington and Greg Niehaus, “On the Tax Costs of

Equity Finance: The Case of Catastrophe Insurance” (working

paper, University of South Carolina, May 2001).
CHAPTER THREE PROPOSALS FOR FEDERAL REINSURANCE 33

That tax treatment may help explain the limited scope of

catastrophe insurance and the growth of untaxed reinsurers incorporated in Bermuda. But only highly complicated alterations of the corporate tax code could change

them. The same problem arises with respect to other

competing financial institutions but to a different degree.

An analysis of tax-code changes is beyond the scope of

this paper, however.

Limit Damage Awards

Another way to increase the viability of privately provided

insurance is to limit the liability of companies, and therefore insurers, for losses from terrorist attacks, as H.R.

3210 does. Such restrictions could stand alone or be combined with other policies. For instance, the federal government could limit the maximum awards for third-party

damages or the awards for economic loss and pain and

suffering associated with death benefits.

When considering limits on damage awards, policymakers

need to balance the goals of making terrorism insurance

available and affordable and of providing firms with incentives to mitigate risks.59 Restricting damage awards

would make risk more manageable for insurers and

firms.60 Although considerable uncertainty would remain

about the probability of attacks and the number of people

likely to be affected, the restrictions would lessen some of

the uncertainty associated with the potential size of claims

and could reduce the likelihood of litigation. Any such

limitations would increase the risk borne by potential

claimants and could reduce firms’ incentives to mitigate

losses.61

Deregulate Insurance Markets

As another way to promote the supply of insurance, the

federal government could encourage states to deregulate

their insurance markets, giving consumers more choices.

Many analysts argue that no strong economic rationale

exists for regulating insurance companies. In particular,

the structure, conduct, and performance of the homeowners’ insurance industry is already fairly competitive.

Moreover, there is no clear evidence of firms earning

excess profits or exercising other forms of market power.62

Deregulation offers benefits as well as drawbacks. Deregulating rates and allowing insurance firms to leave Florida

as well as ending the mandatory offer of earthquake insurance in California could heighten companies’ earnings

prospects, increase their ability to purchase reinsurance,

and encourage entry into the market. Deregulation would

also reduce the likelihood of a federal reinsurance program having to pay for mistakes made by state regulators.

On the downside, consumers would pay more for disaster

insurance in Florida, and, to some extent, in California,

at least in the short run. In addition, insurance markets

would still be subject to disruption, and companies would

be prone to insolvency, after a catastrophe.63

59. For an analysis of the trade-offs in the context of environmental

liabilities, including a discussion of the Price-Anderson Act, which

limits the nuclear industry’s liability, see James Boyd, Financial

Responsibility for Environmental Obligations: Are Bonding and Assurance Rules Fulfilling Their Promise? Discussion Paper 01-42

(Washington, D.C.: Resources for the Future, August 2001).

60. See Allan M. Feldman and John Frost, “A Simple Model of Efficient Tort Liability Rules,” International Review of Law and Economics, vol. 18, no. 2 (June 1998), pp. 201-215; and James Boyd

and Daniel Ingberman, “Do Punitive Damages Promote Deterrence?” International Review of Law and Economics, vol. 19, no. 1

(March 1999), pp. 47-68.

61. For a review of the importance of liability rules on loss prevention

and the maximization of social welfare, see I.P.L. Png, “Litigation,

Liability, and Incentives for Care,” Journal of Public Economics,

vol. 34, no. 1 (October 1987), pp. 61-85.

62. Scott E. Harrington, Insurance Deregulation and the Public Interest

(Washington, D.C.: AEI-Brookings Joint Center for Regulatory

Studies, 2000). 

63. J. David Cummins, Neil Doherty, and Anita Lo, Can Insurers Pay

for the ‘Big One’? Measuring the Capacity of the Insurance Industry to

Respond to Catastrophic Losses, Working Paper No. 98-11-B (Philadelphia: Wharton Financial Institutions Center, June 24, 1999),

available at http://fic.wharton.upenn.edu/fic/papers/98/9811.pdf.

APPENDIX

A

State-Sponsored Insurance Programs

in Florida and California

State-sponsored programs provide natural disaster

insurance at low prices directly to policyholders at the

greatest risk. They also offer reinsurance to companies

that issue coverage for natural disasters. (No coverage is

provided for terrorism risks.) In some cases, the programs

only cover risks rejected by private insurers. Rates are generally subsidized, although not explicitly, and subsidies

vary across different types of policyholders.

The ability of state-sponsored programs to offer low-cost

insurance is more illusory than real, for several reasons.

First, most of the programs appear to be undercapitalized.

Major catastrophic events would probably result in deficits for the programs, which would then need to be

funded through assessments on all policyholders. A

catastrophe would also significantly increase a state’s debt.

Although states are not legally required to back the insurance pools, political considerations make such support

very likely following a disaster. Second, today’s low

premiums are in effect being paid for by premiums and

taxpayer liabilities that will in all likelihood be higher in

the future. Low premiums have the added disadvantage of

discouraging preventive measures that would reduce

losses over the long term. Third, because state-sponsored

plans generally base postdisaster assessments on an insurer’s market share, they discourage private-sector insurers from issuing new policies.

Florida Residential Property and

Casualty Joint Underwriting

Association

All property insurance companies underwriting policies in

Florida are required to belong to the Florida Residential

Property and Casualty Joint Underwriting Association

(FRPCJUA), which primarily provides residential coverage to property owners who were unable to obtain coverage from private insurers after Hurricane Andrew struck

in 1992. (In certain high-risk areas, separate windstorm

coverage is provided by the Florida Windstorm Underwriting Association.) Rates charged by the FRPCJUA in

each county must be at least as high as the highest rates

charged by the 20 largest private insurance companies in

Florida. Despite that requirement, however, the association’s rates are still likely to be below market rates because

the association faces adverse selection: any property owner

who could find cheaper coverage in the private market

would do so.

If the association runs a deficit, as it did in 1994 and

1995, it can levy assessments—up to 10 percent of the

deficit or 10 percent of statewide premiums, whichever is

greater—on each member on the basis of its market share

in the state. The insurance companies can then pass

through the cost of the assessments to their policyholders
36 FEDERAL REINSURANCE FOR DISASTERS

by filing for a recoupment. If the special assessments are

insufficient to eliminate the deficit, the association can

issue bonds, which will be paid off through emergency

assessments directly levied on all policyholders of property and casualty insurance. The association has operated

at a profit since 1996, but no major loss has occurred

since Hurricane Andrew.

The association’s capacity to pay claims was $1,864 million as of January 31, 2002. That amount greatly exceeds

the probable maximum loss that the association would

face from a disaster that occurred once every 100 years,

on average, but it is less than the loss from a disaster that

occurred once every 250 years.1

 The association would

pay claims first by drawing down its surplus of $190

million. Once that surplus was exhausted, the association

would pay claims through private reinsurance ($34 million), assessments on members ($400 million), reimbursement from the state-sponsored Florida Hurricane Catastrophe Fund ($320 million), pre-event disaster notes

($350 million), and a line of credit ($570 million). Thus,

most of the association’s payment capacity is based on

special assessments, borrowed funds, and reinsurance

purchased from another state program.

For several years, the FRPCJUA was the second-largest

insurer in Florida. The association’s exposure peaked in

the fall of 1996 at $98 billion, when it had 937,000 policies. To encourage private-market coverage, the Florida

legislature granted various incentives—cash payments and

exemptions from special assessments—to firms taking

policies out of the fund. Those efforts have been successful; as of June 2002, the association had $19.3 billion in

exposure from roughly 119,000 policies.2

 Private companies are allowed to remove policies from the pool by selectively matching its rates and terms, thus leaving the

association with only the most underpriced policies.

But the success of the effort to transfer risk from the association to private insurers may prove temporary. Rating

agency A.M. Best has expressed concern that the incentives offered by the state legislature encouraged financially

weak insurers to take policies out of the fund. Those

firms may become financially impaired or insolvent from

a low-intensity hurricane. Moreover, their thin capitalization has led them to purchase 90 percent catastrophe

reinsurance from the Florida Hurricane Catastrophe

Fund. In effect, those insurers may be making a one-sided

bet. If no hurricanes hit Florida, they gain; if one hits,

both the Florida Guaranty Fund, a state-sponsored fund

that pays off claims for the state’s insolvent insurers, and

the hurricane fund lose.3

Florida Windstorm Underwriting

Association

The Florida Windstorm Underwriting Association

(FWUA) provides hurricane and windstorm coverage to

property owners who cannot obtain that coverage from

private insurance companies. Standard homeowners’

policies from private insurers must cover hurricane losses

in most areas, but insurers may exclude those losses in

areas covered by the association. By taking on hurricane

risk, the FWUA makes the prospect of offering standard

homeowners’ policies in high-risk areas more attractive to

private insurers, thus reducing pressure on the FRPCJUA

to provide coverage.

Created by the state legislature in 1970 to offer coverage

in the Florida Keys, the FWUA provides coverage to the

most exposed areas in 29 of Florida’s 35 coastal counties.

(Coverage is more extensive in south Florida than in the

rest of the state.) In some cases, only properties within a

quarter-mile of the beach are eligible for coverage.

The median value of a home in areas of the state that are

eligible for coverage is almost 70 percent higher than in

areas that are not eligible, suggesting that poorer property

1. The modeling firm EQECATestimated that a 100-year loss would

probably cost the association a maximum of $1.2 billion, and a

250-year loss would cost the association $2.1 billion. See Florida

Residential Property and Casualty Joint Underwriting Association,

“JUA Resources to Pay Hurricane Claims as of January 31, 2002,”

available at www.frpcjua.com/WWWjua.nsf/VURL/Claims.

2. Ron Bartlett, “Bringing Stability to a Market in Crisis: An Overview of the FRPCJUA, 1992-2000” (paper, Florida Residential

Property and Casualty Joint Underwriting Association, May 2000),

available at www.frpcjua.com (JUA Information). Figures have

been updated using the latest “Policies & Exposure Report.” The

number of policies reached a low of just under 60,000 in April

2000 with a total exposure of $9.5 billion.

3. A.M. Best Company, “Florida Insurers May Be Unprepared for

Major Storms,” Best’s Viewpoint, Release 6 (March 13, 2000).
APPENDIX A STATE-SPONSORED INSURANCE PROGRAMS IN FLORIDA AND CALIFORNIA 37

owners could end up cross-subsidizing richer ones

through assessments imposed after a disaster.4

 Special

assessments on members were imposed after two hurricanes in 1995—an assessment of $84 million after Hurricane Opal and one of $33 million after Hurricane Erin.

(Each of those hurricanes caused insured losses of less

than $1 billion in Florida.) A $100 million assessment

followed Hurricanes Georges and Mitch in 1998. Those

assessments were borne by all property and casualty policyholders in the state.

The FWUA currently has almost 410,000 policies with

an exposure exceeding $98 billion; annual premiums and

surcharges approach $414 million.5

 Before Hurricane

Andrew, the FWUA had fewer than 62,000 policies and

less than $8 billion of exposure. Much of the association’s

growth stemmed from decisions in 1997 and 1998 by

State Farm and Allstate, the two largest private insurers in

Florida, to stop offering windstorm coverage to a large

number of policyholders.

Although the basic operating principles of the Florida

Windstorm Underwriting Association are similar to those

of the FRPCJUA, the two associations differ in the way

they set their rates. Under state law, the FRPCJUA’s rates

must equal or exceed the highest rates charged by the

state’s 20 largest insurance carriers. The Windstorm Underwriting Association, in contrast, must set its rates

through the regulated process that applies to rate filings in

general. Because the FWUA covers wind perils for which

computer modeling may be the best available tool to

determine rates and because the association’s board is

composed of representatives from private insurers, rate

setting for the FWUA has been contentious. For example,

on the basis of its computer modeling, the association

asked for a 61 percent rate hike in 1997 (see Table A-1).

That request was turned down by the Florida Department of Insurance; on appeal, arbitrators awarded a 12

percent increase. In May 1999, the association requested

a 96 percent increase to be phased in over several years.

That request was also denied by regulators, but arbitrators

overturned the decision during the appeals process. The

arbitration decision is now being challenged in the courts.

Rate comparisons based on data filed with the Florida

Department of Insurance consistently show that the

Windstorm Underwriting Association’s rates are significantly below rates for private policies in the same areas. In

Dade County, for example, State Farm charges an average

of $1,260 a year for hurricane coverage for a $150,000

home. The same coverage in the FWUA plan costs just

over $880.6

 Rates are also below expected annual losses,

even though Florida law mandates that rates be actuarially

sound.7

As of February 2002, the FWUA had a claims-paying

capacity of $5.8 billion.8

 A storm that occurred an average of once every 100 years could cost the association

$4.8 billion and necessitate more than $1 billion of regular and emergency assessments.9

 (If the FWUA incurs a

deficit, it can impose regular assessments, the amount of

4. Rade T. Musulin, “Would a Federal Role in Disaster Protection Be

a Catastrophe?” Contingencies, American Academy of Actuaries

(November/December 2000).

5. See FWUA’s “Inforce Liabilities and Policies Summary Spreadsheet

as of January 31, 2002,” available at www.fwua.com (status reports).

6. The differences in coverage for screened-in enclosures and other

detached dwellings complicate rate comparisons between the

FWUA and private insurers. Nonetheless, data show that the association’s rates are significantly below market rates. See Florida Senate

Committee on Banking and Insurance, “Availability and Cost of

Residential Hurricane Coverage,” Report No. 2000-03 (August

1999), pp. 28-31 and Appendix A; and Florida Senate Committee

on Banking and Insurance, “Availability and Cost of Residential

Hurricane Coverage,” revised report (September 1999), p. 7. 

7. Florida Senate Committee on Banking and Insurance, “Availability

and Cost of Residential Hurricane Coverage,” p. 4. The Florida

Senate considered in 2001 a joint resolution (S300 Windstorm

Insurance Rate Increases) proposing a constitutional amendment

that would limit rate increases to 3 percent annually. Another bill

would have prohibited the wind pool from using arbitration to

raise rates and would have shifted about 200,000 homes back to

the private market through an assigned-risk program.

8. FWUA, “Florida Windstorm Underwriting Association 2002

Claims Paying Resources,” available at www.fwua.com/ftp/claims

payingresource0202.pdf.

9. Florida Senate Committee on Banking and Insurance, “Availability

and Cost of Residential Hurricane Coverage,” Table 5, p. 18. A

250-year loss would cost $7.4 billion, and a 500-year loss would

cost $9.5 billion as of November 30, 2000. Data were supplied to

the Congressional Budget Office by the Florida Windstorm Underwriting Association in February 2002.
38 FEDERAL REINSURANCE FOR DISASTERS

Table A-1.

Arbitration Decisions in Florida

Company Filing Date

Requested

Rate Change

(Percent)

Arbitration

Decision

(Percent)

 Date of

Panel’s Decision

 Effective

 Date of

Rate Change

State Farm Fire & Casualty May 1997 25.6 25.6 June 1997 October 1997

Continental Insurance Group August 1997 28.1 0 May 1998 August 1998

Florida Windstorm 

Underwriting Association August 1997 61.0a 12.0 March 1998 August 1998

USAA September 1997 19.4 14.8 June 1998 October 1998

Nationwide Insurance Co.

of Florida December 1998 29.0 18.0 September 1999 July 2000

Florida Windstorm

Underwriting Association May 1999 96.0b 96.0b February 2000 Unknownc

First Floridian June 1999 17.2 11.8 February 2000 Unknownc

State Farm Florida October 1999 7.0 7.0 June 2000 Unknown

USAA November 1999 16.6 7.7 May 2000 October 2000

Cypress (Homeowners’ Program) February 2000 12.0 0 September 2000 October 2000

Cypress (Dwellings) February 2000 14.0 0 September 2000 October 2000

Source: Congressional Budget Office based on Florida Senate Committee on Banking and Insurance, Availability and Cost of Residential Hurricane Coverage,

Report No. 2000-03 (August 1999), Table 1, p. 8. Updates were provided by Rade T. Musulin, vice president of the Florida Farm Bureau Insurance

Companies.

a. This rate change was to be implemented over three years.

b. Rate filing was to be implemented with caps of 20 percent and 30 percent for years one and two, respectively. A cap of 40 percent would apply in subsequent

years.

c. Arbitration decision is being challenged in court.

which is the greater of 10 percent of the association’s

deficit or 10 percent of property insurance premiums in

the state.) As of December 31, 2001, the association had

a surplus of $290 million. Like all residential insurers, the

association must purchase reinsurance from the Florida

Hurricane Catastrophe Fund, which would cover just

over 50 percent of the cost of a 100-year storm.10 Preevent notes issued by the association as part of its payment capacity exceed $1.75 billion.

Florida Hurricane Catastrophe Fund

As the world’s largest hurricane reinsurer, the Florida

Hurricane Catastrophe Fund is used extensively by the

state’s other two residual pools as well as by private insurers. When created in November 1993, the fund provided

reinsurance on commercial properties in addition to residential properties, but it has since stopped offering commercial coverage, partly because commercial reinsurance

is widely available in the private market. (Administrative

difficulties also played a role in the fund’s decision to

drop its commercial reinsurance program.)

Florida requires all insurers to participate in the Hurricane Catastrophe Fund. Each private insurer may choose

coverage that pays 45 percent, 75 percent, or 90 percent

of losses in excess of its “retention level,” a deductible

10. Presentation by the Florida Hurricane Catastrophe Fund before

the Florida State Board of Administration’s cabinet meeting, June

26, 2000.
APPENDIX A STATE-SPONSORED INSURANCE PROGRAMS IN FLORIDA AND CALIFORNIA 39

determined by dividing the programwide retention

among individual insurers in proportion to their share of

the fund’s total premiums. (Both the FRPCJUA and the

FWUA must purchase 90 percent coverage.) In 2001, the

total retention level was about $3.4 billion. The level

increases annually with the growth of premiums. To retain its tax-exempt status, the fund must invest about $10

million a year in public projects that reduce hurricanerelated losses.11

Annual rates for residential coverage exceed a total of

$475 million—or more than 13 percent of the estimated

$3.5 billion in residential premiums collected in Florida

in 2001. Those rates are based on hurricane models approved by the Florida Commission on Hurricane Loss

Projection Methodology. The fund’s rate-on-line—its

ratio of premiums paid to coverage purchased—is now

significantly below rates in the private market, and that

gap has widened over time with growth in the fund’s

claims-paying capacity. During the 1995-1996 contract

season, for example, the fund’s rate-on-line was about 9

percent (a $1 premium bought $11 of coverage), more

than twice as high as the rate-on-line of roughly 4 percent

(a $1 premium bought $25 of coverage) seen in the first

half of 2001. In comparison, the rate-on-line for private

reinsurance coverage in Florida was closer to 10 percent

(a $1 premium bought $10 of coverage) in the first half

of 2001.12 The fund’s rate-on-line rises significantly after

a disaster because the losses reduce its claims-paying

capacity.

The fund’s total exposure was $919 billion as of December 31, 2001, but the state legislature capped the claimspaying capacity of the fund at $11 billion—a cash surplus

of $4.3 billion and bonding authority of $6.7 billion.

Combined with the retained risks of the private insurers

and state pools, the fund could have hypothetically covered a $16 billion disaster in 2000.13 Any insured loss that

exceeded $16 billion (a 100-year loss was estimated to

cost $21.6 billion in 2001, and a 250-year loss was estimated at $31.9 billion) would require that claims be paid

on a prorated basis. However, by paying less than the full

amount on reinsurance contracts, the fund could damage

the ability of all insurers, including the FRPCJUA and

the FWUA, to meet their policyholders’ claims. In that

event, the state of Florida might have little choice but to

provide additional money to the fund, even though it is

not legally obligated to do so.

Whether the fund could actually borrow as much as the

state has authorized is uncertain. A $16 billion disaster

would require a municipal bond issue of $6.7 billion, an

unprecedented amount for a state to borrow. The bond

would be backed by an emergency assessment of 3.47

percent, which would be directly added to all premiums

for property and casualty policies—except for workers’

compensation policies—in the state. Moreover, the

FRPCJUA and the FWUA might be forced to impose

special levies at the same time, which could provoke a

consumer backlash. The legislature also intends that the

catastrophe fund rebuild its capacity through a second

bond issue of nearly $7.9 billion.14 That bond issue

would be backed by an emergency assessment of 2.53

percent directly levied on all policyholders.

California Earthquake Authority

California law requires insurers to offer earthquake coverage as a rider to homeowners’ policies. Insurers can satisfy

that requirement by offering coverage from the California

11. Neither the FRPCJUA nor the Windstorm Underwriting Association has tax-exempt status; however, the Florida legislature is considering some structural changes that could make the two funds

tax-exempt. Personal communication to the Congressional Budget

Office from Jack Nicholson, director of the Florida Hurricane

Catastrophe Fund, February 25, 2002.

12. See Rade T. Musulin, “Federal Natural Disaster Legislation: Current Issues with H.R. 219" (discussion draft, Florida Farm Bureau

Insurance Companies, June 13, 1998); and Musulin, “Taming the

Big Cats,” Best’s Review, A.M. Best Company (March 1999). Both

papers are available at www.ffbic.com/actuary/papers/.

13. The financial data and actuarial estimates come from the presentation by the Florida Hurricane Catastrophe Fund before the State

Board of Administration’s cabinet meeting and the fund’s Annual

Report for fiscal year 1998-1999. But actuary Rade Musulin argues

that a $16 billion loss is an event that would occur once every 65

years, on average.

14. Guy Carpenter & Company, Inc., “Florida Hurricane Catastrophe

Fund 1999/2000—Creating a Stable Fund,” Special Report (October 1999), available at www.guycarp.com/pdf/flcatfund.pdf. Figures were updated to 2001 using data from the Florida Hurricane

Catastrophe Fund.
40 FEDERAL REINSURANCE FOR DISASTERS

Earthquake Authority (CEA), which was established by

the state legislature following the Northridge earthquake

in 1994. The CEA’s coverage is less extensive than the

coverage that was available privately before the Northridge quake. For example, it carries a deductible of 15

percent of the amount of insurance on a property, excludes coverage for swimming pools and detached garages, and limits coverage to $5,000 for contents and to

$1,500 for additional living expenses. The CEA’s premiums are risk-based; they vary depending on a home’s

location relative to fault zones, its type of construction, its

age, its degree of retrofitting, and the type of soil underneath it. In November 2001, the average policy for a

house cost about $560 a year (or $2.37 per $1,000 of

coverage), but costs were several times higher in areas

with greater risk of seismic activity.

Neither the government nor mortgage lenders requires

consumers to purchase earthquake insurance. Only about

16 percent of homeowners in California have earthquake

coverage today, down from 30 percent just after the

Northridge quake.15 Consumer interest in the CEA’s

policies has been limited because of coverage restrictions

and other factors. To encourage more homeowners to

purchase coverage, the CEA now offers policies with

lower deductibles and broader coverage at higher premiums.16

In contrast to insurers in most other states that sponsor

programs, insurers in California are not obligated to join

the CEA’s program. However, the CEA has approximately 66 percent of the residential market.17 The remaining firms—now about 90—offer their own earthquake policies. But most of those firms have been able to

hold down the number of residential earthquake policies

they issue by charging relatively high rates and by carefully selecting the location of the homes they insure. The

main deterrent to participation in the state-sponsored

program is the threat of assessments on insurers and policyholders after a disaster.18

As of January 2002, the CEA had approximately 814,000

basic earthquake policies outstanding and an exposure

from all policies of $174.7 billion; the authority’s total

payment capacity was $7.36 billion.19 In addition, its

annual premiums will exceed $429 million in 2002. Although the CEA has accessed the private reinsurance

markets and arranged contingent lines of credit, it still

relies on postdisaster assessments to meet nearly half of its

maximum payout. As of November 2001, the CEA’s

capacity to pay claims consisted of the following layers:

capital or cash reserves ($1,034 million); a first assessment

on participating insurers ($2,183 million); a first layer of

reinsurance provided by a consortium of private reinsurance firms ($1,433 million); a line of credit provided by a

consortium of banks ($716 million); a second layer of

reinsurance obtained primarily from Berkshire Hathaway

($538 million); and a second assessment on participating

insurers ($1,456 million).20 The CEA would impose surcharges on policyholders—of up to 20 percent of premiums—and on insurers to repay its debt issues. Insurers

would in turn try to recoup those assessments by passing

them through to their customers.

The CEA asserts that its current capacity would be adequate to pay all claims that it would face from an earthquake roughly two and a half times as costly as the Northridge quake. (Had the authority been in operation when

the 1994 Northridge earthquake struck, it would have

15. Personal communication to the Congressional Budget Office from

consulting actuary Richard J. Roth Jr., July 16, 2001.

16. As of January 24, 2002, almost 113,000 supplemental policies, at

an average annual premium of $184, were in force with a total

exposure of $7 billion, according to the California Earthquake

Authority’s supplemental weekly status report.

17. Personal communication to the Congressional Budget Office from

Stan Devereux, Legislative and Public Affairs Director, California

Earthquake Authority, January 25, 2002. 

18. The number of policies issued by the California Earthquake Authority declined from 1995 to 2001, a period during which there

was little seismic activity. In contrast, the amount of commercial

earthquake insurance increased during that period. Analysts attribute much of that difference in trends to the lack of a mandatory

offer requirement for commercial insurers. Personal communication to CBO from Richard J. Roth Jr., July 27, 2002.

19. According to CEA’s basic weekly status report of January 24,

2002. 

20. Personal communication to CBO from Stan Devereux, January

25, 2002. 
APPENDIX A STATE-SPONSORED INSURANCE PROGRAMS IN FLORIDA AND CALIFORNIA 41

faced claims of about $4 billion, according to estimates.)21

Indeed, the authority contends that it could pay all its

claims from a loss of that magnitude occurring once every

1,000 years, which puts the CEA’s probability of default

at less than 0.1 percent.22 If claims exceeded the fund’s

capacity, the CEA would prorate payments. The state has

no legal obligation to stand behind the CEA, but many

policyholders might assume an implicit guarantee.23

Because the residential earthquake coverage offered by the

CEA is minimal, critics have suggested two reforms to

open up California’s market to private insurers.24 First,

repealing the law that requires insurers to offer earthquake coverage would allow them to spread policies geographically, thus reducing their risk. Second, allowing

members of the CEA to also issue their own earthquake

policies to some of their policyholders would put the

industry’s capital and surplus to better use. The top three

insurers participating in the CEA have a total of $60

billion in capital and surplus, which could be used to

support the market for residential earthquake insurance.

An advantage of those reforms is that private insurers

would have an incentive to offer earthquake policies that

were more attractive than the policies currently offered by

the CEA.

21. That figure is lower than the $16.6 billion (in 1999 dollars) in

actual claims resulting from the Northridge quake because the

limited coverage of policies issued by the CEA would have resulted

in fewer and smaller claims and policies would not have included

commercial losses.

22. Those assertions are based on estimates of expected losses made by

EQECAT, a modeling firm. A 500-year loss would result in the

CEA paying about $6 billion in claims, while a 100-year loss

would trigger about $3 billion in claims. Such estimates are, however, uncertain. For details on capacity and the probability of

losses, see Tillinghast-Towers Perrin, “CEA Project Consulting

Team Report” (New York, July 5, 2001), especially Appendix A.

23. By making the CEA independent, the state has avoided having

those contingent liabilities counted against its bond ratings. 

24. Personal communication to CBO from Richard J. Roth Jr.,

July 16, 2001.

APPENDIX

B

Innovations in Capital Markets

Financial markets have recently developed several

new types of securities to spread catastrophic risks among

capital market investors.1

 Traders use variations on

standard financial instruments, such as options and

bonds, to transfer income received in the form of

premiums to the capital markets for their assumption of

risk. The amount of risk transferred to the markets has

been relatively small—roughly $2.5 billion a year between

1996 and 2000. But the development of those

catastrophe-linked securities should make the reinsurance

market slightly more competitive.2

 That could slow the

climb in prices following a future hurricane or earthquake.3

 None of the transfers have involved terrorism

risks, but those risks could, in theory, also be shared with

the capital markets.

Capital markets may prove to be an efficient alternative to

traditional reinsurance markets.4

 Because of their larger

size, international capital markets could absorb the losses

from a natural disaster without significant disruption.

Indeed, daily fluctuations in the overall value of the capital markets commonly exceed the losses associated with

the largest natural disasters to date.5

Catastrophe-linked securities also offer investors a major

advantage—portfolio diversification. Losses from natural

disasters are largely uncorrelated with changes in the stock

and bond markets.6

 For that reason, the price of catastrophic protection should theoretically be close to insurers’ expected losses, which means that such investments

would deliver a return comparable to that of Treasury

1. For example, see John Pollner, Catastrophe Risk Management: Using

Alternative Risk Financing and Insurance Pooling Mechanisms,

Working Paper No. 2560 (Washington, D.C.: World Bank, February 26, 2001); Sara Borden and Asani Sarkar, “Securitizing Property Catastrophe Risk,” Current Issues in Economics and Finance,

Federal Reserve Bank of New York, vol. 2, no. 9 (August 1996);

and Insurance Services Office, Inc., Financing Catastrophe Risk:

Capital Market Solutions (Jersey City, N.J.: ISO Insurance Issues

Series, January 1999).

2. For an analysis of the factors retarding growth of insurance-linked

securities, see Swiss Re, “Capital Market Innovation in the Insurance Industry,” Sigma, no. 3 (2001), available at www.swissre.com

in the Sigma archive.

3. Kenneth A. Froot, The Evolving Market for Catastrophic Event Risk,

Working Paper No. 7287 (Cambridge, Mass.: National Bureau of

Economic Research, August 1999). 

4. See Dwight M. Jaffee and Thomas Russell, “Catastrophe Insurance, Capital Markets, and Uninsurable Risks,” Journal of Risk and

Insurance, vol. 64, no. 2 (June 1997), pp. 205-230. 

5. Neil A. Doherty, “Financial Innovation in the Management of

Catastrophe Risk,” Journal of Applied Corporate Finance, vol. 10,

no. 3 (Fall 1997), pp. 84-95.

6. In contrast, the September 11 terrorist attacks triggered a substantial short-term drop in the stock market. 
44 FEDERAL REINSURANCE FOR DISASTERS

securities.7 In practice, however, catastrophe-linked securities and derivatives appear to deliver excess returns to

investors. That anomaly may result from the residual

uncertainty that surrounds estimates of expected losses,

the lack of liquidity in the market, and investors’ high

cost of information.

Disaster Bonds

Disaster or catastrophe bonds (also known as “Act of

God” bonds) forgive interest and principal, in part or in

full, in the event of specified catastrophes. After a covered

event, those forgiveness provisions enable the issuer—an

insurer—to use the money that would have otherwise

been paid to bondholders to instead pay catastropherelated claims. Bond purchasers are compensated for

those provisions by receiving a higher interest rate before

a disaster strikes. (See Box B-1 for an example.) Between

1994 and early 2002, a total of $5.5 billion in catastrophe

bonds was issued in 42 transactions.8

 Most of the issues

were for risks with less than a 1 percent likelihood of loss.

To date, no losses have occurred on the bonds.9

Disaster bonds have benefits as well as costs. For the issuer, they provide better protection than reinsurance,

which carries the risk of counterparty (reinsurer) default.

For investors, disaster bonds provide an element of security because they are collateralized by Treasury securities.

Investors are exposed only to the risk of a disaster, not to

the underlying credit risk of the issuer. Currently, insurers

must establish an offshore special-purpose reinsurer to

issue catastrophe bonds and then issue the reinsurance.

That structure allows primary insurers to treat the catastrophe bonds as reinsurance rather than debt for tax and

accounting purposes, but it also significantly raises the

cost of issuing the bonds.

If the estimates of losses generated by catastrophe models

are correct, then people who invest in disaster bonds are

earning excess returns.10 A survey of transactions over the

past several years showed that the yield on catastrophe

bonds, on average, was nearly seven times the expected

loss. Investors apparently require high yields to compensate for several factors: the bonds’ lack of liquidity, the

possibility that expected losses may be higher than estimated, and the cost of educating themselves about the

bonds.

The high yield on disaster bonds may also result in part

from market perceptions of moral hazard. Even though

insurers cannot control the likelihood of a disaster, catastrophe bonds may elevate insurers’ tolerance for risk. As a

result, insurers may increase the number of policies issued

in areas prone to disasters and be less aggressive in pushing mitigation and in managing claims for losses beyond

the deductible.11 Those actions could cause insurers’

losses to be higher than expected, lowering returns to

investors.

7. In theory, investors would expect to earn the risk-free rate of return

when they were not exposed to the credit risk of the underlying

firm and the catastrophic losses had zero correlation with market

returns. 

8. See J. David Cummins and Christopher M. Lewis, “Advantages

and Disadvantages of Securitized Risk Instruments as Pension Fund

Investments” (paper presented at the Pension Research Council and

Wharton School of the University of Pennsylvania Conference on

Risk Transfers and Retirement Income Security, Philadelphia,

April 23, 2002). Only part of the bond issue represents a transfer

of risk because only part of the bond’s principal and interest are at

risk. See J. David Cummins, David Lalonde, and Richard D.

Phillips, The Basis Risk of Catastrophic-Loss Index Securities (Philadelphia: Wharton Financial Institutions Center, May 24, 2000);

General Accounting Office, “Insurers’ Ability to Pay Catastrophe

Claims,” GAO/GGD-00-57R (February 8, 2000); and Joe

Niedzielski, “Catastrophe-Bond Market Is Poised for Growth in

Wake of Significant Storm Damage Last Year,” Wall Street Journal,

June 12, 2000, p. C29.

9. Lehman Brothers, “Review and Application of Capital Market

Products,” Appendix A of Tillinghast-Towers Perrin, “CEA Project

Consulting Team Report” (New York, July 5, 2001), p. A-24.

10. Vivek Bantwal and Howard Kunreuther, A Cat Bond Premium

Puzzle? Working Paper No. 99-05-10 (Philadelphia: Wharton

Financial Institutions Center, May 28, 1999). 

11. Neil A. Doherty, “Financial Innovation for Financing and Hedging Catastrophe Risk” (paper presented at the Fifth Alexander

Howden Conference on Disaster Insurance, Gold Coast, Australia,

August 1997). 
APPENDIX B INNOVATIONS IN CAPITAL MARKETS 45

Box B-1.

USAA’s Catastrophe Bonds

In 1997, a special-purpose reinsurer (an insurer who assumes all or part of another insurer’s risk for unusual hazards) issued a $400 million catastrophe bond for USAA, a

large mutual insurance company owned by its policyholders.

In effect, USAA was purchasing reinsurance coverage for 80

percent of its losses between $1 billion and $1.5 billion from a

single event.1

 Although traditional reinsurance probably was

available at a lower cost, the firm’s goal with the bond issue

was to gain access to another source of risk-bearing capacity,

one that might lead to lower prices for coverage and a greater

supply. The deal took months to develop. Rating agencies

needed to establish criteria for rating the bonds, and regulators had to agree that the bondholders were not writing contracts for, or issuing, insurance.

The price of such a bond, whose rate of return is largely independent of other financial assets, would be expected to equal

the risk-free rate plus 63 basis points (a basis point is onehundredth of a percentage point), the expected loss from a

catastrophe.2

 However, people who invested in the 1998

1. For more details on USAA’s various bond issues, see Kenneth A. Froot,

The Market for Catastrophe Risk: A Clinical Examination, Working

Paper No. 7286 (Cambridge, Mass.: National Bureau of Economic Research, February 2001).

2. Ibid., pp. 9-14.

issue received 576 basis points over the London interbank

offered rate (LIBOR), or nine times the expected loss.3

 The

bond issues were significantly oversubscribed, and secondarymarket yields, as measured in basis points over LIBOR, fell to

the mid-400s. The substantial premiums paid to place the

catastrophe bonds may be viewed in two ways: as excessive or

as a development cost necessary to establish that market and

educate investors.

Premiums fell on subsequent USAA bond issues, as did estimates of expected losses, but those declines resulted from

incremental changes to the forecast model. People who invested in the 1999 bond issue, which was for $200 million,

received 366 basis points over LIBOR to cover an expected

loss of 44 basis points. As a result, the ratio of premiums to

expected losses was still more than 8 to 1 in 1999.4

 USAA also

purchased nearly $250 million of traditional reinsurance that

year at nearly identical terms; thus, pricing in the two markets

was similar.

3. Uncertainty over the actuarial estimates of loss also affects the pricing of

catastrophe bonds. See James F. Moore, Tail Estimation and Catastrophe Security Pricing: Can We Tell What Target We Hit If We Are

Shooting in the Dark? Working Paper No. 99-14 (Philadelphia: Wharton Financial Institutions Center, 1999).

4. Froot, The Market for Catastrophe Risk, p. 14.

Catastrophe Options

Exchange-traded catastrophe options give the holder a

right to payment if an index of catastrophe-related losses

exceeds a specified threshold. Because the options are

standardized, they can be traded at short notice and with

little cost—an advantage over other forms of insurance.

Catastrophe options are similar to the excess-of-loss reinsurance contracts that have been proposed for sale by the

federal government.12 The options that were traded on

the Chicago Board of Trade until December 2000, when

trading in those options ceased, protected insurers from

total insured losses of up to $50 billion.13 However, trad12. An option is the right, but not the requirement, to buy an asset at

a fixed price. Most trades of catastrophe options create call

spreads—a trading strategy in which a market participant simultaneously buys a call at one strike price and sells another call at a

higher strike price, with both calls expiring on the same date. That

strategy is basically equivalent to buying a layer of reinsurance. See

Borden and Sarkar, “Securitizing Property Catastrophe Risk.”

13. Between September 1995 and April 1998, about $80 million in

reinsurance capacity was created through the Chicago Board of

Trade. The market grew by 65 percent between 1996 and 1997.

See the statement of Sylvia Bouriaux, Group Manager, Financial

Products, Chicago Board of Trade, before the House Committee

on Banking and Financial Services, April 23, 1998; and Insurance

Services Office, Inc., Financing Catastrophe Risk, pp. 26-33.
46 FEDERAL REINSURANCE FOR DISASTERS

ing activity above $10 billion in losses was minimal. (Another trading venue, the Bermuda Commodities Exchange, started in 1997 but shut down two years later

because of a lack of activity.)

Catastrophe options differ from traditional reinsurance in

their use of an index of losses for one of nine regions and

states, rather than for a particular insurer, as a payout

threshold. Using an index of industrywide losses significantly reduces moral hazard and adverse selection, but it

creates basis risk for an insurer. Because the options contracts are not designed to match the losses of any individual portfolio, which may be more concentrated in one

region than another, insurers will be exposed to the possibility of a mismatch between their losses and the contract’s payout. Thus, insurers who purchase the options

have an incentive to issue policies uniformly over a region, potentially lowering their cost of bearing risk.

Recent research indicates that such hedging of basis risk

in catastrophe options for Florida insurers is effective only

for the largest insurers and for smaller insurers that are

highly diversified throughout the state. Creating intrastate

index contracts (as opposed to statewide contracts) by

separating Florida into regional zones would reduce basis

risk and make the contracts more attractive to primary

insurers.14 However, regional subdivisions would raise

transaction costs and reduce liquidity.

Catastrophe options are at a disadvantage compared with

other financial instruments used by insurers in terms of

their supply and demand. For insurers, the cost of the

options cannot be deducted from income until the options are exercised or expire, whereas premiums paid for

reinsurance may be deducted immediately. Furthermore,

the National Association of Insurance Commissioners

does not treat the options as reinsurance; consequently,

insurers cannot increase the level of coverage they have

issued after purchasing options. In addition, although the

Chicago Board of Trade’s clearinghouse guaranteed the

options, some people doubted its ability to cover them

following a major event.15 For investors, the high cost of

becoming informed about catastrophe risks may reduce

their willingness to supply funds. (That drawback is present in most capital market products for disaster risks.)

Contingent Notes

Debt financing helps insurers avoid financial distress

following a catastrophe. Before an event, insurers agree to

sell, and purchasers agree to buy, a debt issue (a note) at a

fixed price. That arrangement for contingent financing

allows insurers to issue debt at a specified rate following a

disaster, when the insurer’s financial condition might

otherwise preclude such a sale. (If no disaster occurs, no

debt is issued.) To guarantee the availability of funds, an

insurer may require a potential bond purchaser or investor to hold funds equaling the amount of the note in

government securities in a trust account; in the event of a

catastrophe that met agreed-upon criteria, those funds

would revert to the insurer. Investors receive a higher rate

of return, or an up-front fee, to induce them to commit

funds and to compensate them for the risk of interest

rates rising or of only partial repayment. Since 1995,

three of this type of transaction have been recorded, involving a total of $585 million in postdisaster bond placements.16

Contingent Equity

A catastrophe equity put is a type of option that grants an

insurer the right to sell a specified number of its equity,

or stock, shares at a set price in the event of a catastrophe

that exceeds a certain magnitude. Insurers would use the

money they received from the sale of those shares to pay

claims. Investors in the put option would receive a payment from the insurer to compensate for the risk that the

price at which they agreed to buy the shares would be

greater than the stock’s market price. To the extent that

the value of the stock after a disaster was less than the

14. See Cummins, Lalonde, and Phillips, The Basis Risk of

Catastrophic-Loss Index Securities.

15. For an explanation of this default risk, see Jaffee and Russell, “Catastrophe Insurance, Capital Markets, and Uninsurable Risks,” pp.

220-222. 

16. Insurance Services Office, Inc., Financing Catastrophe Risk,

pp. 23-26.
APPENDIX B INNOVATIONS IN CAPITAL MARKETS 47

price at which the put option was exercised, the insurer

would be partly hedged against catastrophic losses.17

For example, one insurance company paid investors about

$2.4 million a year for the right to sell them $100 million

in shares of preferred stock. The company could exercise

that right if its losses from a single disaster exceeded $200

million or if its overall losses for any year exceeded $250

million. The dividends that would be paid on the preferred stock were tied to the London interbank offered

rate, or LIBOR, plus a spread based on the company’s

credit rating at the time of the stock issue.18 Because losses

never reached the trigger level during the coverage period,

the put options were never exercised.

One drawback specific to contingent equity is that investors are exposed to the general business risk of the primary insurer.19 That is, a catastrophe might occur after a

period in which the insurer’s stock has performed poorly

for reasons other than huge losses from a catastrophe. For

example, a firm’s management could change or its strategies could fail, making its stock price fall. Between 1996

and 1998, three catastrophe equity put deals were negotiated, with obligations to purchase stock totaling $250

million.20

Swaps

Swaps allow insurers to trade exposures and diversify their

holdings, thus reducing the risk that they could become

insolvent after a disaster. Swaps do not change insurers’

cash flows. For example, a Florida-based insurer might

swap a portion of its hurricane exposure for some earthquake risk from a California-based insurer. Swaps may be

negotiated over the counter or through the Catastrophe

Risk Exchange, an electronic listing service started in

October 1996 for insurers and reinsurers. The exchange

will randomly select the policies to be swapped, preventing insurers from trading only their riskiest holdings. 

Most large swaps are negotiated directly between companies that understand the risk of counterparty default. For

example, Swiss Re and Tokio Marine & Fire Insurance,

two of the largest global reinsurance companies, recently

agreed to a $450 million swap. They engaged in three risk

exchanges of $150 million to cover losses from natural

perils: a Japanese earthquake for a California earthquake;

a Japanese typhoon for a Florida hurricane; and a Japanese typhoon for a French storm. 17. “Knock out” provisions, which eliminate the option if the postloss 21

equity value is sufficiently low, can be embedded in the put option. See Doherty, “Financial Innovation for Financing and Hedging Catastrophe Risk.”

18. Froot, The Evolving Market for Catastrophic Event Risk, pp. 8-9. 

19. See Christopher M. Lewis and Peter O. Davis, “Capital Market

Instruments for Financing Catastrophe Risk: New Directions?”

Journal of Insurance Regulation, vol. 17, no. 2 (Winter 1998),

pp. 110-133. 

20. Insurance Services Office, Inc., Financing Catastrophe Risk,

pp. 34-36.

21. Swiss Re, “Swiss Re and Tokio Marine Arrange Unique USD 450

Million Cat Risk Swap” (press release, Zurich, July 12, 2001),

available at www.swissre.com (media center).

APPENDIX

C

Disaster Insurance Programs

in Japan, Great Britain, and New Zealand

Most developed countries have governmentbacked programs that provide insurance against natural

disasters. Similarly, most European countries have established, or plan to create, government reinsurance

programs for terrorism risks.1

 Most of the programs

provide limited coverage for property owners in the event

of a disaster, generally at subsidized prices that make few

adjustments for risks. The programs have two significant

drawbacks: their subsidies discourage risk mitigation, and

their setup does not allow the programs to receive the full

benefits of sharing disaster risks internationally, through

global reinsurers. That lack of risk diversification is

especially evident in Japan’s earthquake insurance program, Great Britain’s terrorism reinsurance program, and,

to a lesser extent, in New Zealand’s earthquake insurance

program.

Japan’s Earthquake Insurance

Although Japan has a government-backed insurance

program (the Japan Earthquake Reinsurance Company),

property owners in that country bear most of the risk of

earthquakes. Despite the high risk of quakes, however,

most homeowners choose to remain uninsured. In part,

that choice may reflect the government’s regulation of

insurance rates, differences between risks and premiums,

the taxation of capital reserves, and restrictions on market

entry by foreign insurers, all of which limit the coverage

that is available. Optimal risk spreading would dictate

that most of Japan’s earthquake risk be diversified globally. Such sharing of risks could ease the burden on the

government’s finances from a catastrophe in the $100

billion range, which could weaken the Japanese economy

while leaving the government liable for most of the costs

and claims.

In January 1995, an earthquake struck Kobe, Japan, destroying about 100,000 houses and buildings and resulting in 6,500 deaths and more than $110 billion in damages. Of that amount, insured losses were just over $6

billion.2

 (That magnitude-7.2 quake was considerably

stronger than the quake that struck Northridge, California, in January 1994.) Less than 5 percent of residents

had earthquake coverage, at least in part because the re1. See the statement of Thomas J. McCool, Managing Director, Financial Markets and Community Investment, General Accounting

Office, before the Senate Committee on Banking, Housing, and

Urban Affairs, published as General Accounting Office, Terrorism

Insurance: Alternative Programs for Protecting Insurance Consumers,

GAO-02-199T (October 24, 2001). 

2. That loss was about 2.3 percent of Japan’s output in 1995 but less

than 1 percent of its stock of capital. For an analysis of the economic effects of the quake, see George Horwich, “Economic Lessons of the Kobe Earthquake,” Economic Development and Cultural

Change, vol. 48, no. 3 (2000), pp. 521-542. 
50 FEDERAL REINSURANCE FOR DISASTERS

gion was thought to be at low risk.3 Losses were also large

because of the number of old and substandard structures

in Kobe. The government picked up many of the postdisaster costs, subsidizing about 90 percent of the cost of

rebuilding public facilities.4

 To help the victims, the government also provided relief grants, low-cost loans, housing assistance to low- and middle-income residents, and

tax breaks.

Since 1996, the Japanese government has reinsured the

Japan Earthquake Reinsurance Company. The government bears about 85 percent of the liability for the company, which is capped at about $18 billion (1,800 billion

yen). When the massive Kobe quake hit, the earthquake

endorsement covered roughly 30 percent to 50 percent of

a property’s replacement value; claims were limited to less

than $100,000 (10 million yen) for property and an additional $50,000 (5 million yen) for contents. The policy

covered only minor additional living expenses. Premiums,

which are generally more than twice as high as those in

California, are based on the 500-year record of earthquakes in Japan and include a risk load. Only about 7

percent of Japanese homeowners choose to purchase

earthquake insurance (16 percent in Tokyo.)5

 The government does not cover commercial insurance lines, but

global reinsurers absorb some of that risk. 

After the Kobe earthquake, the government increased the

maximum amount of insurance that residents could buy.

But the government still classifies risks incompletely.

Rates for coverage distinguish between only two types of

dwellings in four rate zones. Furthermore, they do not

adjust for the age of a building, soil conditions, or the

structural quality of surrounding buildings.6

Great Britain’s Terrorism Reinsurance

The British government created Pool Re as a reinsurer of

last resort in 1993 after private reinsurers reduced their

coverage for risks from terrorism following bombings by

the Irish Republican Army (IRA).7

 With Pool Re, which

is mutually owned by participating insurers, primary insurers may reinsure their risks from terrorism for commercial property losses and losses from business interruption. The program does not cover personal losses or workers’ compensation claims. Pool Re sets premiums on the

basis of the amount of insurance coverage, geographic

location, and other risk factors; primary insurers set coverage limits. Pool Re must reinsure all offered polices.

(That coverage begins after primary insurers pay roughly

the first $150,000 in claims.) In turn, the British government reinsures Pool Re and agrees to guarantee any loans

or lines of credit that Pool Re might seek. Once the pool’s

reserves exceed $1.5 billion, then it will pay to the government the greater of 10 percent of the net premiums

remitted each year or a payment geared to the government’s past losses. As of January 2001, Pool Re’s reserves

were nearly $1 billion.8

The government accepts liability for all of the claims

above Pool Re’s ability to pay. While the pool has had

numerous claims—including one for about $150 million

—there has yet to be a draw on the Treasury or premiums

paid to the British government. (Pool Re would levy a

special assessment on all participating firms before relying

on the government’s backstop.) Annual dividends are

paid to participants each year that there is an underwrit- 3. More homeowners purchased coverage after the earthquake, a situation that is also typical in the United States. Coverage rose from

7.2 percent to 10.8 percent in Japan. Larger increases occurred in

the areas hit hardest by the Kobe quake. See Tsuneo Katayama,

“The Kobe Earthquake and Its Implication in Earthquake Insurance in Japan,” in Report on the January 17, 1995, Kobe Earthquake, Japan (September 1997), available at http://incede.iis.utokyo.ac.jp/reports/Report_15/Katayama.pdf.

4. EQE International, The January 17, 1995 Kobe Earthquake, EQE

Summary Report (April 1995), available at www.eqe.com/

publications/kobe/economic.htm.

5. Ibid.

6. Katayama, “The Kobe Earthquake and Its Implication in Earthquake Insurance in Japan,” p. 259. 

7. For a more detailed description of Pool Re, see United Nations

Conference on Trade and Development, Comparative Examples of

Existing Catastrophe Insurance Schemes, September 29, 1995. 

8. Tillinghast-Towers Perrin, “Pool Re and Terrorism Insurance in

Great Britain,” October 2001, available at www.towers.com/

towers/services_products/Tillinghast/update_pool_re.pdf. 
APPENDIX C DISASTER INSURANCE PROGRAMS IN JAPAN, GREAT BRITAIN, AND NEW ZEALAND 51

ing surplus—that is, premiums exceed claims. The dividend is 10 percent of the annual underwriting surplus.

Through Pool Re, terrorism insurance is widely available

throughout Great Britain (although some commercial

properties have decided to self-insure). Rates have

dropped sharply as the IRA’s terrorist activity has declined; no claims have occurred since mid-1996. Annual

premiums have ranged from about $530 million in the

early years of the program to less than $75 million in

2000.9

Critics have raised several concerns about Pool Re.10 First,

premiums are crudely set. There are only two geographic

zones—the commercial districts of all major cities including London, and all other regions—and just a single adjustment for “target risk.”11 Rate schedules for the cities

are three to five times those for the other zone. Target risk

is related to a property’s prominence and visibility. Buildings in London that are determined to be high risk are

assessed an extra premium of 50 percent. Second, the

premiums do not include any risk loads to compensate

the British taxpayers for the risks that they accept. In fact,

the British government explicitly subsidizes Pool Re

through a 3 percent tax on all household and vehicle

policies. (The larger subsidy is implicit.) Third, the government prevents risks from being diversified internationally by creating strong incentives for British insurers to

reinsure only through Pool Re. This retains all terrorism

risk within Great Britain, which may be an inefficiently

diversified pool. Fourth, the program initially offered no

incentives for risk mitigation. Companies that installed

security cameras or hired extra guards, for example, were

not able to share in the lowered risk through reduced

premiums. That policy has been changed, and discounts

are now available.

New Zealand’s Earthquake Insurance

The government of New Zealand insures residential

properties against natural disasters through its Earthquake

Commission. In addition to damage from earthquakes,

policies cover damage from volcanoes, tsunamis, floods,

and landslides. Although rates are not actuarially set and

do not reflect risks, the program’s fund balances have

grown significantly in the absence of a major disaster.

The Earthquake Commission charges a flat rate of $0.05

for $100 of coverage, up to a maximum charge of $50,

plus $10 for contents and a $7.50 tax.12 (All amounts in

this section are given in New Zealand dollars.)13 The rate,

which has not changed since 1944, was originally based

on premiums charged by New Zealand’s War Damage

Commission. The government caps individual claims at

$100,000 (and $20,000 for contents), roughly the replacement cost of a typical three-bedroom house in New

Zealand. Private insurers provide coverage for exposures

over $100,000 through their homeowners’ policies. 

No major earthquake or volcanic eruption has occurred

in New Zealand since the government started insuring

against disasters. The largest claim stemmed from a 1987

earthquake, which cost about $170 million (in current

dollars). However, most of that cost was a result of commercial claims, and the government no longer offers commercial coverage. In most years, claims have been under

$10 million. Only about half of the claims have been

attributable to earthquakes; most of the remainder have

resulted from landslides.

The earthquake fund has more than $4 billion in assets,

primarily in the form of nontradable government securities (the fund can invest up to 35 percent of its balances

in global equities). The Earthquake Commission has also

purchased reinsurance of $1.5 billion in the private marketplace, improving its risk diversification. Estimates sug- 9. Ibid.

10. William B. Bice, “British Government Reinsurance and Acts of

Terrorism: The Problems of Pool Re,” Comment in University of

Pennsylvania Journal of International Business Law, vol. 15 (Fall

1994), p. 441. 

11. Northern Ireland is covered by a different program. The government directly reimburses terrorism losses and does not assess any

premiums. 

12. Personal communication to the Congressional Budget Office from

David Rafferty of the New Zealand Treasury, March 18, 2002.

13. At exchange rates on August 21, 2002, a New Zealand dollar was

worth about $0.47 in the United States. 
52 FEDERAL REINSURANCE FOR DISASTERS

gest that claims from a major earthquake hitting the country’s capital of Wellington could range from $3.5 billion

to $6.8 billion. If claims exceeded the commission’s capacity to pay, New Zealand’s treasury would provide

additional financial support.