Working Paper Series 

Congressional Budget Office 

Washington, D.C. 

Financing Losses from Catastrophic Risks 

Kent Smetters 

Wharton School 

University of Pennsylvania 

Smetters@wharton.upenn.edu

David Torregrosa 

Macroeconomic Analysis Division 

Congressional Budget Office 

David.Torregrosa@cbo.gov

November 2008 

CBO Working Paper 2008-09

Congressional Budget Office working papers in this series are preliminary and are 

circulated to stimulate discussion and critical comment. These papers are not subject to 

the Congressional Budget Office’s formal review and editing processes. The analysis and 

conclusions expressed in them are those of the authors and should not be interpreted as 

those of the Congressional Budget Office. References in publications should be cleared 

with the authors. Papers in this series can be obtained at www.cbo.gov. Select 

“Publications” and then “Working Papers.” 

This particular paper is adapted from and expands a version published by the Hamilton 

Project at the Brookings Institution in June 2008 and available at 

www.brookings.edu/papers/2008/06_risks_smetters.aspx.
i 

Financing Losses from Catastrophic Risks 

Kent Smetters 

David Torregrosa 

November 2008 

Abstract 

Catastrophe insurance helps spread risks and increases the ability of policyholders and 

the economy to recover from both natural disasters and terrorist attacks. Government 

policies, however, may unintentionally limit the role of the private sector in insuring 

against catastrophic losses. Several such policies at both the state and the federal level 

reduce the amount of private capital supplied to insure or hedge against catastrophic 

risks. One reason is that those policies often become outdated as markets innovate. 

Policymakers have several different options to increase private risk-bearing capacity and 

improve the effectiveness of federal involvement. The benefits and potential costs of four 

options are examined: an optional federal charter for insurers that would preempt states’ 

regulation of rates; regulatory reform of capital markets’ risk transfer mechanisms that 

substitute for reinsurance; changes in the taxation of reserves held by insurers against 

catastrophic risks; and auctions of federal reinsurance for supercatastrophic risks. 

Acknowledgments 

The authors thank Jason Bordoff, Nada Eissa, Jason Furman, Robert Litan, Eric Mindich, 

and Timothy Taylor for their constructive comments on the drafts for the Hamilton 

Project. In addition, Manasi Deshpande, Pascal Noel, and Paige Shevlin, all of the 

Hamilton Project, provided useful feedback. Christine Roh provided excellent research 

assistance. This version of the paper benefited from comments from Robert Dennis, 

Douglas Hamilton, Joseph Kile, Kim Kowalewski, Robert Shackleton, and Thomas 

Woodward of CBO. Michael Treadway edited the paper. 
ii 

Contents

Introduction 1 

How Government Intervenes in the Private Market for Catastrophic Risk Protection 5 

Four Options to Empower Private Markets to Increase Capacity 16 

Can Private Markets Really Insure Against Very Large Losses? 22 

Conclusions 25 

Appendixes 

A. Current Federal Terrorism Insurance Policy and the Options for 

Disaster Insurance 27 

B. Climate Change and Hurricanes 30 

C. State-Sponsored Insurance Funds 32 

Boxes 

1. The Recent Increase in Strong Hurricanes Hitting the Southeast: 

Implications for Insurers 6 

2. Accounting Treatment of Alternative Risk Transfer Mechanisms 11 

References 35
1 

Introduction 

The almost $37 billion in privately insured losses associated with the terrorist acts on 

September 11, 2001, and the $43.6 billion in losses stemming from Hurricane Katrina in 

August 2005 were large relative to the capital surplus of the insurance industry at the 

time.1

 The immediate effect was a contraction in the supply of disaster insurance and an 

accompanying rise in price. A couple of years following Hurricane Katrina, insurance 

markets for natural disasters had largely recovered on their own, and the market for 

terrorism insurance continues to recover from September 11 (CBO 2002, 2007a). 

However, after the events insurers reassessed their risk of losses, and the result was 

higher prices for both types of risk. 

Those disasters increased policymakers’ concern about the ability of the private sector to 

insure against catastrophic losses. That concern goes far beyond the viability of the 

insurance industry; it extends to maintaining the socially desirable amount of economic 

activity. The economic and social function of insurance is to diversify risks. Insurance 

allows individuals and firms to engage in socially efficient and profitable activities that 

they might not engage in if forced to bear all the associated risks themselves. When 

optimally provided, insurance raises the private rate of return closer to the social rate of 

return. If nondiversified firms and households were to lose their ability to recover 

catastrophic losses through insurance, economic activity might be damaged more than is 

inevitable in a natural disaster or terrorist attack. People living in those parts of the 

country most subject to such catastrophes would be forced to absorb very large property 

risks. The loss of uninsured homes following a catastrophic event could push many 

people with mortgages into bankruptcy and increase the likelihood that unrepaired homes 

could slow a neighborhood’s or a city’s recovery. 

Before this decade’s major disasters, both federal and state lawmakers had already 

intervened frequently in insurance markets to ensure that property owners had adequate 

protection against large losses. At the state level, government involvement has taken 

several forms: requirements that insurers operating in the state offer catastrophic 

protection; temporary moratoriums on insurer exit from the state; and controls on 

premiums to make coverage affordable. Some states have even created their own, 

taxpayer-financed programs to cover disaster risks: Florida did so after Hurricane 

Andrew in 1992, and California after the Northridge earthquake in 1994. Together these 

interventions have mostly achieved their aims; the contraction in the supply of insurance 

and the concomitant surge in prices that typically follow a major catastrophe are usually 

limited to the short run. 

But those policies have created problems of their own. They have shifted costs to 

taxpayers and to those policyholders who are less exposed to catastrophic risk. In the 

long run, those policies drive private insurance firms out of the market if premiums are 

 

1

 Both figures are in 2007 dollars. The Insurance Information Institute’s estimate for September 11 losses 

includes all privately insured losses, including life insurance, and thus is not limited to property and 

casualty losses. Total privately insured losses from the September 11 attacks and from Hurricane Katrina 

each totaled about 10 percent of the combined net worth of U.S. property and casualty insurers. 
2 

not high enough to cover costs. They also give property owners who no longer bear the 

full amount of risk less incentive to mitigate risk by, for example, locating in low-risk 

areas; their riskier behavior then increases losses when a catastrophe occurs. Those two 

factors—a decline of private supply of insurance, and growth in expected losses—can 

lead to higher insurance prices, more pressure on state-sponsored programs, and even 

more calls for federal action. 

Federal Initiatives and Legislative Proposals 

At the federal level, a terrorism reinsurance backstop—the Terrorism Risk Insurance Act 

(TRIA)—was passed following the September 2001 attacks, in November 2002.2

 At the 

time, policymakers were responding to an apparent shortage of terrorism coverage due to 

insurers’ uncertainty about the future risk of losses and their impaired ability to bear that 

risk. Policymakers feared that commercial property owners would be exposed to 

uninsured risk, causing commercial construction to contract and reducing economic 

activity in the short run. From a homeland defense perspective, many proponents also 

argued that the costs of terrorism should be widely shared rather than disproportionately 

borne by the owners of high-profile potential targets. 

Federal taxpayers bear most of the risk from very large terrorism losses under TRIA, 

which induces private insurers to voluntarily reduce premiums for terrorism insurance. In 

exchange for the federal government providing reinsurance without charge, TRIA 

requires insurers to “make available” insurance against acts of terror, although the act 

does not control the price charged for this added protection. TRIA has likely led to more 

coverage: the share of companies buying terrorism coverage increased from 27 percent in 

2003, shortly after TRIA was first passed into law, to 64 percent in the first half of 2007 

(CBO 2007a, 15; Government Accountability Office 2008). However, TRIA’s free 

reinsurance acts as a subsidy to terrorism insurance. Unpriced risk not only imposes a 

cost on taxpayers but may also encourage construction in areas at greatest risk, which 

could eventually increase the total loss to society from a terrorist attack (CBO 2005, 

2007a). Congress has twice extended the program, which is now due to expire at the end 

of 2014. TRIA is discussed in more detail in appendix A to this paper. 

Private markets currently provide the bulk of insurance against natural catastrophe. The 

federal government is also involved, for example through the National Flood and 

Insurance Program (NFIP). Options now before Congress would expand the federal role. 

One argument for such expansion is that the federal government can be a stable supplier 

of catastrophe insurance because, through taxation, it can draw resources from a wide 

array of sources and people. (Part of the insured losses can also be financed by issuing 

more debt, shifting the costs to future taxpayers.) By expanding coverage, the 

government might also reduce uninsured losses, which in the recent past have led to 

costly supplemental disaster appropriations at the federal level. Another argument is that 

in a democratic society, government cannot credibly commit to refrain from action after a 

catastrophe, because catastrophes have high human costs as well as monetary costs. A 

formal federal insurance role might promote better outcomes than providing 

 

2

 Reinsurance is insurance provided to insurers, to allow them to diversify their risks, rather than directly to 

individuals and noninsurance businesses. 
3 

supplemental assistance after a disaster for those individuals, firms, and institutions that 

are either uninsured or underinsured. 

 

Under one set of options, first proposed in the mid-1990s following Hurricane Andrew 

and the Northridge earthquake, the federal government would auction reinsurance 

contracts to primary insurance companies (those that write insurance policies directly for 

individuals and businesses) and state-sponsored insurers. Under another set of options, 

developed following Hurricane Katrina, the federal government would expand NFIP to 

cover losses from wind in addition to those from flooding. It has also been proposed that 

the federal government back the existing state-sponsored programs through either 

reinsurance or loans. Again, appendix A provides more details. 

The insurance industry’s trade organizations have argued for federal involvement on the 

grounds that the private insurance market cannot adequately insure against catastrophic 

risks for the following reasons:3

▪ Losses can be so large as to undermine the ability of private insurers to pool risks. 

▪ It is difficult for private insurers to predict these losses. 

▪ Government often contributes to creating these losses through its environmental and 

other policies. 

None of these considerations, however, seem to have undermined other private financial 

markets, which also must deal with large, unpredictable losses from time to time. To be 

sure, the roughly $80 billion in combined losses from the 2001 terrorist attacks and 

Hurricane Katrina caused large reductions in insurers’ capital reserves (Wharton Risk 

Management and Decision Processes Center 2008, Table 1.1). But these losses, besides 

being temporary (as noted above), were quite small relative to those commonly suffered 

in the U.S. capital markets as a whole; the value of the firms in the S&P 500 index, for 

example, even before the recent market turbulence, the value often fluctuated by $50 

billion or more in a single day. Of course, equity holders in S&P 500 companies are 

partly compensated for their risk taking in that they gain on the upside as well as lose on 

the downside, whereas insurers mostly face downside risk. But this one-sided risk is 

priced into insurance contracts; moreover, noninsurance capital markets routinely take 

similar bets on risks that are difficult to predict. Credit default swaps are one example: 

the outstanding notional value of these contracts exceeds $40 trillion (Bank for 

International Settlements 2007), or over eighty times the capital reserves of the entire 

insurance industry worldwide. Finally, insurers’ losses are indeed sometimes the result of 

government actions ranging from stricter environmental standards to war. But capital 

holders in other private markets regularly make investments in the face of these and other 

uncertain government policies that place very large sums of capital at risk. Indeed, 

private insurers themselves have lost hundreds of billions of dollars over the past two 

decades as a result of changing legal liability standards as well as “unanticipated” 

 

3

 See Smetters (2004) for an in-depth discussion of these reasons and others. 
4 

environmental liabilities. Yet the ability of most insurers to operate does not seem to have 

been greatly impaired. 

Impediments to Better Risk Sharing 

So what really makes the market for insurance against catastrophic losses any different 

from other financial markets? Specifically, 

▪ What factors currently impede private market insurers from amassing more capital as 

a reserve against large man-made and natural losses? 

▪ What barriers prevent the broader capital markets from directly participating in the 

sharing of these large risks? 

This paper argues that current government policies themselves unintentionally play a key 

role in limiting the role of the private sector in insuring against catastrophic losses. In 

other words, the argument for government intervention is implicitly predicated on the 

continuation of existing policies that offer short-term benefits but often undermine the 

role of the private market. Several such policies reduce the amount of capital supplied to 

insure or hedge against catastrophic risks: 

▪ States routinely limit the premiums that insurers may charge, especially for workers’ 

compensation insurance, where insurers have the largest catastrophic exposure. 

▪ Capital market alternatives to traditional reinsurance face prohibitive regulatory 

hurdles, even though these alternatives might be much more effective than traditional 

reinsurance in managing risk. 

Federal taxes on insurers’ capital reserves force insurers to substantially raise their 

premiums for catastrophic insurance relative to those for other insurance. 

▪ Courts have created considerable legal uncertainty over whether a given risk is 

covered under existing insurance contracts; this uncertainty has forced insurers to 

reduce coverage or raise prices. 

▪ State- and federal-based insurance programs further crowd out private insurance. 

Options 

To increase private risk-bearing capacity and improve the effectiveness of federal 

involvement, policymakers have several options, which this paper examines: 

▪ Adopt a federal insurance charter system, in which participation by insurers would be 

optional, to bypass prohibitive state rules and regulations. 

▪ Change the regulatory accounting treatment of alternative risk transfer arrangements. 

▪ Exempt insurers from tax on the earnings of their catastrophe reserves. 
5 

▪ Auction federal reinsurance contracts for extreme risks. 

How Government Intervenes in the Private Market for 

Catastrophic Risk Protection 

Why do traditional insurance markets seem overwhelmed by losses that amount to only a 

small fraction of the total capital at risk in the U.S. economy? Here we demonstrate that 

government laws and actions themselves—and generally not private sector “market 

failures”—make it costly for the private sector to increase capacity. To be sure, insurance 

regulators have legitimate objectives in many cases: primarily, to ensure that insurers are 

able to make good on their promises to pay for losses, and to protect consumers, 

especially homeowners, who are often required to purchase insurance. However, almost 

all government interventions have their costs, and insurance regulation is no exception. 

Rate Suppression and Other Restrictions at the State Level 

Insurance is generally regulated at the state rather than the federal level. Analysts agree 

that capital requirements are important to help protect policyholders against the costs of 

insurer insolvency. But rate controls have been an issue in some states prone to natural 

disasters. Many analysts believe that no strong economic rationale exists for regulating the 

rates charged by insurance companies, because the structure, conduct, and performance of 

the homeowners’ insurance industry are competitive. There is no clear evidence of firms 

earning excess profits or exercising other forms of market power (Harrington 2000; Litan 

and O’Connor 2008; Grace and Klein 2008; Wharton Risk Management and Decision 

Processes Center 2008). For terrorism insurance, a significant issue has been mandatory 

coverage, particularly in the workers’ compensation market. 

Natural Disasters 

Some state regulations have imposed price controls on property and casualty insurers in 

an attempt to make insurance more affordable. Often that has meant setting rates well 

below profitable levels. In some cases, regulators believe that the probability of another 

catastrophic loss is lower than what the market assesses. For example, although rates 

have risen substantially after the series of hurricanes in 2004 and 2005, Florida has not 

granted all requested rate increases, particularly in the coastal areas at greatest risk. 

At the center of the current disagreement is whether Florida faces a period of heightened 

losses from hurricanes, which is consistent with recent experience (see box 1). The 

scientific community is divided about the reasons behind the increase in activity since 

1995 but is largely united in the view that this high level of activity will persist for at 

least another ten to fifteen years (see appendix B). However, Florida regulators continue 

to require that loss estimates be based on a historical baseline, which may significantly 
6 

Box 1. The Recent Increase in Strong Hurricanes Hitting the Southeast: 

Implications for Insurers 

Intense hurricanes have been hitting the Atlantic and Gulf Coasts with increasing 

frequency. One researcher estimates that the average power of hurricanes in the Atlantic 

has doubled in the past thirty years, as both the peak wind speed and the duration of the 

storms have increased (Emanuel 2005). The percentage of storms rated as category 4 or 5 

on the Saffir-Simpson scale has increased by 25 to 40 percent. There has been some 

upswing in the total number of hurricanes in the North Atlantic since 1995, but that may 

be due to natural climate cycles (see Emanuel 2006 and Webster et al. 2005). 

Researchers have raised the possibility that the trend toward more-intense hurricanes is 

due at least in part to global warming resulting from human activities (Elsner, Kossin, 

and Jagger 2008). The primary link posited between warming and hurricanes has to do 

with rising sea surface temperatures in the North Atlantic during the hurricane season. 

Hurricanes arise only when those temperatures rise above a trigger level, and rising sea 

surface temperatures could provide more energy for storms to propagate. By one expert 

estimate, the warming expected from a doubling of atmospheric concentrations of carbon 

dioxide-equivalent would roughly double expected hurricane losses, which would rise by 

about 0.06 percent of GDP ($8 billion in 2005 dollars) (Nordhaus 2006). However, the 

processes that drive hurricane development are sufficiently complex that the effects of 

climate change on the frequency and intensity of hurricanes—historically and in the 

future—are currently highly uncertain (see appendix B). 

Whatever their cause, more hurricanes of greater intensity mean greater insured losses, 

particularly since development in coastal areas has boomed in recent decades. Insurers 

were surprised when four major hurricanes—Charley, Frances, Ivan, and Jeanne—hit in 

2004, resulting in about $25 billion in losses. Privately insured losses from Hurricane 

Katrina, which hit the Gulf coast in August 2005, reached $43.6 billion. Losses from 

Hurricanes Rita and Wilma, which also struck in 2005, were an additional $16.5 billion, 

making 2005 the costliest year ever for insurers. (All figures in this paragraph are in 2007 

dollars and were provided by the Insurance Information Institute.) Following those losses, 

insurers reassessed their risks of losses from hurricanes. Risk Management Solutions, one 

of the leading catastrophe risk modeling firms, raised its estimate of expected annual 

losses by close to 50 percent in the Gulf, Florida, and the Southeast (Risk Management 

Solutions 2006). The other two leading modeling firms—AIR Worldwide and 

EQECAT—also revised their loss estimates upward, but by smaller amounts (Kunreuther 

and Michel-Kerjan 2007; AIR Worldwide 2006). 

underestimate the current risk (Wharton Risk Management and Decision Processes 

Center 2008; Risk Management Solutions 2006).4

 

 

4

 Catastrophe risk modeling firms have significantly revised their expectations of losses to reflect the recent 

increase in the number and severity of storms, which is attributed to natural long-term cycles or global 

warming or both. 
7 

One of the unintended consequences is to constrain the long-run supply of private 

insurance. The lack of pricing flexibility, combined with heavy losses, has been an 

inducement for firms to cut back their exposure to the Florida market. For example, 

Allstate dramatically reduced the number of its homeowners’ policies in force statewide, 

from 576,000 in 2004 to 241,000 at the end of 2007, after its requests for rate increases 

ranging between 28 and 42 percent were denied (McQueen 2008; Grace and Klein 

2007).5

 Many former policyholders are turning instead to the state-sponsored insurance 

company for coverage. Meanwhile the implicit subsidy to insurance purchasers 

encourages development in high-risk areas, increasing expected costs even more.

Removing these price controls could substantially increase the supply of catastrophe 

insurance. 

Moreover, although rate controls may hold down average premiums in the short run, 

studies of auto insurance markets suggest that regulations do not lower premiums in the 

long run (Litan and O’Connor 2008). One reason is that claims may rise in the long run 

because regulations reduce incentives for policyholders to mitigate risks. 

Workers’ Compensation and Terrorism Insurance 

Insurance companies are especially concerned about the potentially large losses 

stemming from workers’ compensation claims caused by a terrorist act or an earthquake 

that injures hundreds or thousands of workers on the job.6

 Workers’ compensation claims 

exceeded $2.1 billion (in 2007 dollars) after the September 11 attacks; nearly all were for 

death benefits. Ongoing treatment of a worker’s permanent injuries is usually much more 

costly to an insurer than a one-time death benefit. Workers’ compensation insurance 

provides wage replacement at levels set by state law, as well as unlimited medical 

benefits to employees injured on the job, including those injured by a terrorist attack or 

an earthquake. This comprehensive protection was originally designed to avoid costly 

labor disputes. 

Virtually every aspect of the workers’ compensation market, however, is controlled by 

regulation. Benefit levels are set by statute rather than by negotiation between insurers 

and insured. All states except Texas require employers to provide this type of insurance 

to workers, and premiums are heavily regulated.7

 Such regulation naturally limits the 

supply of workers’ compensation insurance and increases the use of “involuntary 

placements,” whereby employers deemed at high risk of incurring workers’ 

compensation claims are denied coverage by private insurers at prevailing rates and 

forced instead into the involuntary or “residual” market for coverage. States generally 

 

5

 The state insurance commission has blocked Allstate from writing new automobile insurance policies in 

the state (Florida Office of Insurance Regulation 2008). Regulators generally have resisted large cutbacks 

by insurers and have in the past temporarily blocked nonrenewals or cancellations, as they did in Florida 

after Hurricane Andrew in 1992 and Hurricane Charley in 2004. 

6

 In general, hurricanes should not result in large workers’ compensation claims because most businesses 

shut down ahead of the storm. In contrast, there may be little advance warning of an earthquake or terrorist 

attack. 

7

 In some circumstances, employers may have the right to self-insure. In what are called “monopolistic” 

states, coverage is provided directly by a state-run insurer. 
8 

require insurers to participate in the residual market, which means they are unable to 

control their exposures. 

Although the structure of the workers’ compensation market varies from state to state, 

some general observations are possible: 

▪ Virtually no exclusions are allowed. Workers’ compensation must include coverage 

against acts of terrorism, including nuclear, biological, chemical, and radiological 

attacks. Analysts have identified possible scenarios involving weapons of mass 

destruction under which insured losses could exceed TRIA’s $100 billion cap on total 

federal payouts (Dixon et al. 2007). 

▪ Insurers may not adjust the terrorism insurance surcharge to take account of either an 

insured party’s location within a state or the concentration of exposure. Those 

charges, which feed into rates in most states, are generally a uniform fraction of 

payroll—typically $0.01 per $100.8

 Insurers in the District of Columbia, which has a 

high risk of terrorist attack, filed in 2002 for a terrorism loss cost of $0.07 per $100 of 

payroll, but regulators approved rates of just $0.05 per $100, according to the 

National Council on Compensation Insurance. Regulatory constraints can result in 

rate suppression and cross-subsidization of higher-risk by lower-risk activities 

(Danzon and Harrington 2001), and the insured firms face reduced financial 

incentives to mitigate losses. 

▪ Most states—New York being the notable exception—require that an employer 

purchase workers’ compensation insurance from a single insurer. This reduces 

opportunities for insurers to diversify their risk. 

▪ As noted above, unattractive risks are insured in the residual market. State regulation 

may unintentionally enlarge the residual market by denying firms the flexibility to set 

risk-based rates. Residual markets act as insurers of last resort and are established by 

law rather than as a result of market forces. In many states, firms that write policies in 

the voluntary market are required to participate in the residual market. Rates are 

higher in residual markets—typically, the allowable loss cost is 50 percent higher for 

terrorism risk than in the voluntary market. These markets grew sharply after the 

September 2001 attacks; their growth continues under TRIA but at a reduced rate 

(National Council on Compensation Insurance 2006). 

 

8

 According to the National Council on Compensation Insurance (personal communication from NCCI staff 

to the authors, August 1, 2008), the loss cost filings are higher in the following states: $0.02 per $100 in 

Florida, and $0.03 per $100 in Illinois, Virginia, and Maryland. Actual rates will include markups for 

administrative expenses and profits. New York and California are not members of NCCI; however, New 

York recently passed a law that will allow insurance companies to file their own terrorism insurance rate. 

Loss costs will be allowed to vary by carrier and by class but will average about $0.04 per $100 of payroll. 

In addition, New York, like other states, has a separate charge for natural catastrophes and catastrophic 

industrial accidents; that charge is less than $0.01 per $100. 

. 
9 

Accounting and Legal Regulation 

The current regulatory environment has not kept up with innovation in the capital 

markets. State regulations constrain the amount of capital available to hedge catastrophic 

losses. Those regulations implicitly or explicitly follow the guidance put forward by the 

National Association of Insurance Commissioners (NAIC) unless the NAIC rules are 

clearly inconsistent with the state’s laws (General Accounting Office 2002). 

Regulations covering “admitted” insurers (those allowed to do business in the state) 

mainly focus on the insurer’s ability to make good on its contractual obligations when its 

policyholders suffer losses. When a primary insurer buys reinsurance, it increases its 

underwriting capacity, which it then gets to record on its books. This accounting 

treatment recognizes that reinsurance improves the primary insurer’s ability to meet its 

contractual obligations. 

The accounting and legal treatment of products that are economically similar to 

reinsurance is less favorable. Nevertheless, recent years have witnessed an increase in the 

use of alternatives to traditional reinsurance, in the form of direct capital market 

instruments for sharing catastrophic risks. These new instruments have taken many 

forms, including catastrophe (“cat”) bonds, “sidecars,” contingent capital, industry loss 

warranties (ILWs), and some exchange-traded contracts (Michel-Kerjan and Morlaye 

2008).9

 These risk transfer mechanisms were formerly used only occasionally by primary 

insurers to make reinsurance more “contestable,” that is, to create substitutes for 

traditional reinsurance in order to increase competition. But the catastrophic losses 

suffered by the insurance industry in 2004 and 2005 created a $142 billion capital 

shortfall, followed by sharp increases in reinsurance prices (Guy Carpenter Securities 

2008, 13). Primary insurers needed a cheaper alternative to traditional reinsurance and 

increasingly turned to these instruments. 

Publicly disclosed cat bond transactions, in particular, increased dramatically in 2007. 

Total outstanding risk capital covered by cat bonds totaled $13.8 billion by the end of 

2007, with almost $7 billion coming from new issues in that year alone. Total capital at 

risk was up 49 percent from 2006 and 251 percent from 2005. Risk premiums (the “rate 

on lines” above short-term Treasury yields) relative to expected losses in the cat bond 

 

9

 Catastrophe bonds offer high-layer excess-of-loss protection over several years. For example, a 

catastrophe bond might pay 80 percent of an insurer’s losses in the layer between $1 billion and $2 billion. 

In the event of a specified catastrophe, the interest and principal owed by the issuer (generally an insurer) 

would diminish in part or in full. Sidecars are a mechanism through which outside investors choose specific 

insurance risks to assume in partnership with a reinsurance firm for a specified period of time, typically one 

to three years. Contingent capital allows an insurer to issue debt or equity at a specified rate or price 

following a disaster, when the insurer’s financial condition might otherwise preclude such a sale. (If no 

disaster occurs, no securities are issued.) ILWs are similar to catastrophe bonds. For example, they 

effectively allow hedge funds to act as reinsurers for catastrophic events by reimbursing an insurer a set 

amount if total losses to the insurance industry from a specified disaster exceed a given amount. 

Catastrophe derivatives are traded on organized exchanges and over the counter. For example, the WINDX 

contract pays a specified amount based on measured wind speeds at various locations. Contract holders in 

effect are purchasing protection from capital market investors against the risk of hurricane damage. 
10 

offerings narrowed between 2006 and 2007, suggesting increased competition.10 Lane and 

Beckwith (2007) estimate that ILW activity adds another $5 billion to $10 billion of 

capacity (total capital at risk). Sidecar activity in 2007 totaled $947 million in capital at 

risk,11 and exchange-traded derivative activity across the major underlying exchanges 

stood at $25 million in capital at risk.12 

A primary insurer that purchases an alternative risk transfer contract containing basis risk 

is generally not allowed to count this holding as an asset or as a reduction in its liability 

for underwriting purposes (see box 2).13 (Basis risk is the difference between the insurer’s 

actual loss and its reimbursement from the payoff of one of these securities.) This 

prohibition holds even if the totality of the primary insurer’s risk transfer arrangement 

contains less basis risk and less credit risk than a standard unsecured reinsurance contract 

with large deductibles and other forms of loss retention. This regulatory hurdle partly 

undermines the viability of some of the best “pure plays” under which capital market 

participants would want to supply capital to those seeking to hedge catastrophic risk.14 

Almost a decade ago, a working group of the NAIC was examining whether to allow 

primary insurers to recognize pure plays as a recoverable asset for underwriting purposes, 

provided that the instruments supplied an adequate amount of “hedge effectiveness” (that 

is, a low enough basis risk). That matter was evidently dropped, but in 2003, NAIC 

considered proposals to allow reinsurance-like accounting treatment for catastrophe 

bonds that provided highly effective hedges for insurers’ losses (General Accounting 

Office 2003a). 

 

10 A recent $200 million offering from the Chubb Group that was underwritten by Goldman Sachs 

illustrates the size of the spreads over expected losses for different tranches. The A tranche has an expected 

loss of 1.65 percent and a spread over the London interbank offer rate of 625 basis points (6.25 percentage 

points); the B tranche has an expected loss of 2.04 percent and a spread of 725 basis points; and the C 

tranche an expected loss of 6.13 percent and a spread of 1,460 basis points. These spreads are roughly 

comparable to those of traditional reinsurance (personal correspondence with Goldman Sachs staff, April 9, 

2008). 

11 Guy Carpenter Securities (2008, 4, 5, 29, 44). Estimates from Goldman Sachs tell a similar story, with 

sidecar activity dropping from $4.4 billion in 2006 to $1.8 billion in 2007 (from a listing of all natural 

catastrophe bond transactions provided by Goldman Sachs). 

12 Lane and Beckwith (2007, 2). The major exchanges include the New York Mercantile Exchange and the 

Chicago Mercantile Exchange. 

13 Alternative assets with basis risk can typically count on the “investment” side of the insurer’s balance 

sheet like any other asset holding, but not in a manner that materially improves the insurer’s ability to 

underwrite additional risk. More recently, hybrid or dual-trigger contracts with indemnity-based triggers are 

being counted as reinsurance, provided that the cedant’s losses exceeds the contract’s payoff. This 

innovation reduces the regulatory hurdle somewhat but then requires suppliers of capital to make firmspecific bets. (Under dual-trigger contracts, payouts would be made following an event only if the industrywide loss threshold, or a parametric trigger, were exceeded and an insurer’s own loss exceeded a specified 

amount; Cummins 2006. In practice, the insurer often needs to show that its net loss is greater than or equal 

to its collections under the catastrophe bond.) This accounting approach falls short of comprehensive reform 

and may have unintended consequences. A dual-trigger contract may contain more basis risk than a singletrigger parametric contract; at a minimum, the market would greatly benefit from clearer accounting rules. 

Rating agencies are starting to allow dual-trigger contracts as well, but only if they make up a fairly small 

portion of the cedant’s overall reinsurance program. 

14 Not all analysts agree that the regulatory and accounting treatment of catastrophe bonds has been a 

significant impediment to their greater use (Cummins 2008). 
11 

Box 2. Accounting Treatment of Alternative Risk Transfer Mechanisms 

Basis risk is a major factor in the accounting treatment of alternative risk transfer 

mechanisms. The National Association of Insurance Commissioners’ rules allow the 

underwriting risk of a primary insurer (the “cedant”) to be transferred to the capital 

market using these alternative securities if the capital at risk is “fully hedged” by the 

security, that is, if there is no “basis risk.” Many alternative risk contract designs, 

however, pay off according to parametric (for example, Richter scale) indexes or total 

industry losses in a geographic region, not the cedant’s actual losses. These contracts 

allow capital suppliers to make a “pure play” on a broad risk rather than worry about each 

cedant’s individual portfolio. 

The conventional wisdom is that traditional reinsurance contracts have no basis risk, 

because they indemnify the cedant’s actual losses, whereas capital market-friendly “pureplay” contracts do produce basis risk, because they pay off according to metrics that are 

only correlated with, not identical to, the actual loss. But this picture is incomplete. 

Losses in traditional reinsurance contracts are subject to moral hazard: the cedant may 

increase its level of reinsured riskiness by reducing its own underwriting efforts and loss 

adjustment controls and costs. Traditional reinsurance contracts therefore require that the 

cedant absorb a substantial fraction of its own direct losses through deductibles and 

coinsurance provisions; this considerable unhedged exposure amounts to basis risk. In 

contrast, pure-play contracts do not create moral hazard since there is almost nothing that 

a cedant can do to increase its own payoff, which is based on factors outside of its direct 

control. As a result, a cedant could obtain significant protection from alternative contracts 

that would involve less basis risk than traditional reinsurance. (We are thankful to Neil 

Doherty of The Wharton School for this point.) 

Not only would an alternative risk management program involve less basis risk than 

traditional reinsurance; it could also contain less credit risk. Credit risk stems from the 

potential inability of the counterparty that is contractually obligated to bear the risk (in 

this case, the reinsurer) to make good on its obligation after a loss. Traditional 

reinsurance is subject to counterparty credit risk because reinsurers do not set aside 

capital reserves equal to their total potential losses. Instead, much like banks in a 

fractional reserve banking system, reinsurers rely on the low probability that the policies 

they write will all produce losses at the same time, which would be the equivalent of a 

bank run. Rating agencies are then employed to determine the creditworthiness of 

reinsurers. But as the recent subprime mortgage crisis has shown, rating agencies often 

guess wrong—potentially very wrong. In contrast, many of the pure-play contracts, 

including cat bonds, are fully collateralized by money set aside in special-purpose 

vehicles (essentially a “lockbox”) containing enough capital to cover the maximum 

possible underlying risk. Catastrophe bonds are generally fully collateralized with 

Treasury securities. Because the bonds cover a specific layer of risk, their maximum 

payouts are well defined. 
12 

Federal Tax Treatment 

Taxes by their nature distort some types of business decisions, but these distortions are 

especially severe when it comes to providing catastrophic insurance. The federal tax code 

currently taxes as income the earnings of an insurer that are temporarily inflated when 

disaster losses are low. Insurers may not count additions made to their reserves against 

low-probability risks as expenses for tax purposes. Instead they may expense the cost of 

reserves only for losses that have been reported by policyholders but that remain 

unsettled, as well as losses that are believed to have already occurred but for which 

claims have not yet been reported (Bradford and Logue 1997). Taxes therefore lead 

insurers to raise less capital for catastrophic protection than they would otherwise. 

In fact, federal taxes alone can significantly raise the price of catastrophic insurance, 

while having only a negligible impact on noncatastrophic insurance. This difference can 

be seen in a simplified example of two hypothetical corporate insurers: one that provides 

catastrophic hurricane coverage and one that insures against standard fire risk.15

Suppose that each insurer’s portfolio of policies issued has the same expected annual 

average loss of $10 million, but that the hurricane insurer faces a single $1 billion loss 

with certainty once every 100 years, whereas losses to the fire insurer alternate between 

$8 million and $12 million each year. Annual premiums of $10 million would cover the 

expected costs of each. But to ensure its ability to pay claims every year, the fire insurer 

needs to hold only about $2 million in capital reserves, for those years in which losses are 

$12 million. It can take advantage of the law of large numbers (since the underlying risks 

are not highly correlated) and collect just enough in premiums so that annual premium 

income plus its capital reserves cover its expected annual payments plus a small amount 

of variation. In contrast, the hurricane insurer cannot rely on the law of large numbers but 

must instead be prepared at all times for the “big one.” So it needs to hold capital of $990 

million for the $1 billion loss that will occur once every 100 years on average. 

The capital reserves of insurers are often held in the form of bonds, the interest on which 

is subject to corporate income tax, which reduces the net earnings to each insurer’s 

shareholders (Harrington and Niehaus 2001b). Since the shareholders could have 

invested instead in a mutual fund that pays no corporate tax, each insurer in our example 

must charge more in premiums to cover its tax liability so as to remain competitive in the 

capital market. If taxes absorb about one-fourth of investment income, then, for example, 

an 8 percent after-tax return on an insurer’s investments is reduced to 6 percent. Because 

shareholders could instead invest directly in a mutual fund that returned 8 percent, each 

insurer needs to collect an additional 2 percentage points in premiums. But the situations 

of the two insurers now dramatically diverge. The hurricane insurer has to charge $19.8 

million in additional premiums (2 percent of its $990 million capital reserve) to cover its 

taxes, beyond the $10 million to cover its expected loss, for a total of almost $30 million, 

or almost three times its expected loss. In contrast, the fire insurer needs only to collect 

$40,000 (2 percent of its $2 million capital reserve) in additional premiums to cover its 

taxes. In other words, the hurricane insurer must charge almost fifty times as much in 

 

15 This example is based on one presented in Musulin (1997, 2-5). 
13 

additional premiums as the fire insurer, and almost three times as much in total 

premiums, even though both portfolios have the same expected overall loss. 

This simplified example overstates the tax distortion because it fails to capture all the 

relevant attributes of the tax system. The effect is first reduced by the fact that the income 

generated by the mutual fund would be fully taxed at the individual level at current rates 

for ordinary income, whereas the dividends and capital gains from the stock in the 

insurance company would be taxed at the currently lower rates for those types of income. 

Second, the insurer would be able to deduct the catastrophic losses when they occur. 

Deductions in a given year are limited to the amount of taxable income in that year, but 

with carryforwards and carrybacks, much if not most of the loss would eventually be 

deducted. Consequently, the effective corporate tax is not really 25 percent on income 

from the portfolio, but only the cost of deferring the deduction (plus any amount that 

cannot be carried over). Nevertheless, the basic point still holds: the inability to set aside 

tax-free reserves significantly raises the cost of providing catastrophe coverage. 

In practice, insurers operating nationally have some ability to pool catastrophic risks and 

make more efficient use of capital. (They also use reinsurance, most of which is 

purchased from international reinsurers, as discussed further below.) Thus, catastrophe 

insurance prices are lower than in the example above but still high relative to expected 

claims. Losses from an event are generally concentrated regionally, so that operating in 

many states provides some diversification. Similarly, losses from earthquakes and 

hurricanes are not correlated, so there are benefits to insuring multiple catastrophic risks. 

Rating agencies, however, traditionally have given high ratings only to insurers that held 

enough capital to pay off at least a once-in-100-years loss from a hurricane or a once-in250-years loss from an earthquake (net of reinsurance). After the series of catastrophes in 

recent years, the rating agencies have increased their capital standards and now generally 

require that high-rated insurers be able to withstand two such catastrophic events within a 

year (Wharton Risk Management and Decision Processes Center 2008). 

The tax wedge is more important to primary insurers than to reinsurers.16 Most reinsurers 

avoid this tax wedge by establishing headquarters outside the United States. For example, 

most new reinsurance firms are based in Bermuda. If the interactions between primary 

insurers and reinsurers were frictionless, this tax wedge would be of little importance. 

But informational asymmetries and counterparty risks are just two reasons to believe that 

frictions matter. 

Legal Environment 

All insurers also face the risk that courts might reinterpret their contract provisions in a 

way that favors larger payouts to policyholders.17 That risk was realized after Hurricane 

Katrina. Multiple lawsuits were filed in Louisiana, Mississippi, and Texas over whether 

 

16 In equilibrium, investors in insurance funds should earn the same after-tax returns (on a risk-adjusted 

basis) as other investors. The higher prices for catastrophic coverage should compensate for the tax wedge. 17 For example, see Wilson (2007); Liam Pleven and Peter Lattman, “Rulings Bolster Insurers: Landscape 

Is Changing As Katrina Cases Move Through Higher Courts,” Wall Street Journal, December 7, 2007, C1; 

Harbin (2006). 
14 

losses suffered from the storm should be attributable to wind or to flooding. That 

determination is important because most homeowners’ policies exclude all losses from 

flood. (Policyholders may purchase federal flood insurance separately.) Some lawsuits 

argued that although much of the damage was from flooding due to storm surges, those 

storm surges were driven by the winds, and thus the losses were covered. Also, 

Mississippi’s attorney general sought to ban the flood exclusion provision retroactively. 

Insurers lost some of these cases in the lower courts, and several companies, including 

State Farm, paid sizable settlements in others. However, the federal district court upheld 

the flood exclusion clause in Mississippi, as did a Louisiana state judge. Still, insurers 

have responded by cutting back coverage: State Farm, for example, will not write new 

homeowners’ policies in Mississippi because of the added risk. 

Some insurers in California are also worried that they would face either public pressure 

or lawsuits, or both, forcing them to expand coverage to pay most claims following an 

earthquake irrespective of the terms of the insurance policy (Grossi and Muir-Woods 

2006). Depending on the circumstances, determining whether losses should be 

attributable to quake damage (which is excluded under many policies) or to the fires 

following the quake (which are not) might be difficult. This distinction is important 

because only about one in eight residences in California carries earthquake insurance. 

Crowding Out: State Insurance 

As discussed earlier, some states limit the premiums that insurers may charge. This 

makes some potential policyholders uninsurable because they are too high a risk at the 

maximum allowable premiums. As a consequence, these states often end up providing 

insurance themselves to these otherwise uninsurable customers. But these state-based 

policies also typically compete at the margins with traditional private insurance, and 

political pressure sometimes leads to expansion of these programs beyond just the 

privately uninsurable. These cheap programs therefore crowd out the private sector, 

leaving taxpayers and the less risky policyholders to foot the bill. 

State-sponsored programs provide natural disaster insurance at lower prices, and with 

minimal underwriting, to policyholders at the greatest risk. Many coastal states operate 

“beach plans,” which are risk-sharing pools specifically designed to insure high-risk (and 

often highly valued) properties against hurricane damage.18 Florida operates the largest 

such plan and separately offers mandatory catastrophe reinsurance to all property insurers 

operating in the state. (See appendix C for details.) California has a state-sponsored plan 

for earthquakes. Eligibility rules vary, but only in some cases are the programs restricted 

to insuring only those at the highest risk. Rates in such state programs are typically 

subsidized by taxpayers and by participating insurance companies. 

Although these public programs provide affordable insurance coverage and fill the 

temporary gap caused by the sharp contraction of supply after megacatastrophes, they 

also have major disadvantages. First, their ability to offer low-cost insurance is largely 

illusory; most of the risk is simply shifted to other policyholders and to taxpayers. Major 

catastrophes have resulted in deficits for the Florida plans that have been funded through 

 

18 For an analysis of selected state plans, see Government Accountability Office (2007, 55-78). 
15 

“assessments,” which are in effect taxes on all policyholders in the state, and through 

legislative appropriations. The programs also take advantage of their tax-preferred status 

by accumulating reserves on a tax-free basis and by issuing municipal debt, which is 

cheap to the issuer since the interest on it is tax-free, to cover losses after a disaster. 

Second, the low premiums charged by the state programs discourage those at risk from 

undertaking preventive measures that would reduce losses in the future. A negative 

feedback loop is thus created: the subsidized rates produce an even larger wedge between 

expected losses and the premiums collected. Third, because each insurer’s postdisaster 

assessment is based on its market share, private insurers are discouraged from issuing 

more policies. Fourth, losses incurred by the state programs lead to efforts to shift risks to 

federal taxpayers through federal emergency declarations. 

In these circumstances a reduction in regulation can lead to an increase in coverage. 

California, for example, has a large and well-functioning private market for commercial

earthquake insurance that is lightly regulated, especially with regard to price. Coverage in 

the commercial marketplace is several times that in the residential market. This 

difference is surprising since the diversified shareholders of commercial policyholders 

should be less concerned about earthquake risk (which is typically uncorrelated with risks 

in the rest of the economy) than nondiversified homeowners. Some analysts attribute this 

difference to the lack of mandated coverage in the commercial marketplace.19

Commercial insurers are free to choose their customers and thus avoid excessive 

concentrations of risk. They also use global reinsurance markets to limit exposure to 

catastrophic losses. 

Crowding Out: Federal Insurance 

In addition to the subsidy for terrorism insurance provided under TRIA, discussed 

previously, the federal government provides various forms of implicit insurance against 

natural catastrophe. Following such a disaster, Congress generally provides extensive 

federal assistance to individuals, small businesses, and state and local governments to 

help cover uninsured losses and assist in economic recovery, with the Federal Emergency 

Management Agency (FEMA) serving as the lead agency. The federal government 

typically pays at least 75 percent of the cost of infrastructure repairs. The Small Business 

Administration also helps individuals pay for temporary housing and offers direct lending 

and loan guarantees to businesses. The Department of Housing and Urban Development 

frequently assists individuals in their transition from emergency shelters to permanent 

housing. Although all these types of assistance reduce financial hardship and help 

stimulate the economy after a disaster, they also discourage individuals and businesses 

from taking steps to mitigate future losses and from seeking private market solutions for 

financing those losses.20 

 

19 Personal communication from Richard Roth, Jr., consulting actuary and former assistant insurance 

commissioner in California, February 21, 2008. See also Grossi and Muir-Woods (2006) and CBO (2002, 

39-41). 

20 Some studies have not found a strong link between the decision to forgo insurance coverage and 

policyholders’ expectations of postdisaster assistance. For a review of those studies, see Wharton Risk 

Management and Decision Processes Center (2008, 134). However, the widespread attention devoted to the 

federal assistance following Hurricane Katrina may have a stronger influence on insurance decisions 

(Kunreuther 2006). 
16 

 

According to estimates by the CBO, additional federal spending for hurricane-related 

disaster assistance—including the $43.6 billion (in 2007 dollars) in insured losses for 

Hurricane Katrina—together with various forms of disaster-related tax relief, will add 

about $125 billion to the federal budget deficit over 2006-10.21 About $26 billion of this 

relief will go to homeowners and renters who were uninsured or underinsured, according 

to the Government Accountability Office (2007, 6). 

Even when most businesses and individuals have insurance, federal assistance can still be 

substantial. Federal disaster assistance to individuals, businesses, and state and local 

governments following the 2001 terrorist attacks totaled somewhere between $25 billion 

and $33 billion, and possibly more, depending on which outlays are assumed to be 

directly related to the attacks (CBO 2005, 25–26; General Accounting Office 2003b; 

Dixon and Stern 2004). Just over $20 billion of the aid was targeted to the New York 

City area, another $7 billion was paid to victims or their families from the September 

11th Victim Compensation Fund, and $5 billion went to U.S. airlines. Between two-thirds 

and three-quarters of retail businesses in lower Manhattan had insurance that covered 

losses from the attacks, but small businesses in the area generally did not carry enough 

business interruption coverage (which replaces business income lost because of physical 

disruption). Although the federal government assisted small businesses that had not 

purchased insurance, such aid covered only a modest portion of their uninsured losses. 

Many of these interventions would not be needed if the private market were encouraged 

to insure these losses in the first place. 

Four Options to Empower Private Markets to Increase Capacity 

We now examine four potential reforms that would increase private market participation 

in insuring catastrophic risk and could make federal interventions more effective. 

An Optional Federal Charter for Insurers 

Insurance companies operate nationally but are regulated at the state level (Grace and 

Klein 2008). This treatment distinguishes them from banks and securities firms and was 

most recently reaffirmed by the Gramm-Leach-Bliley Act in 1999. A federal insurance 

charter system in which participation by insurers is optional would give insurers the same 

choice over regulatory regime that banks currently have (Rust and Killinger 2007; 

Shadow Financial Regulatory Committee 2006). Although the specifics of the various 

proposals differ, an optional federal charter could preempt state regulation, encourage 

innovation, and reduce the administrative burden on insurers, who today must deal with 

different state regulations. It also might increase competition among insurers, banks, and 

security firms. Competition between the federal charter and the existing state charters for 

 

21 CBO (2007a, 11). Five supplemental spending bills provided direct assistance to individuals and public 

assistance to state and local governments to cover the costs of repairing and replacing damaged 

infrastructure. For an analysis of federal disaster relief, see Holtz-Eakin (2005). In addition to authorizing 

direct assistance, Congress increased the borrowing authority of the flood insurance program to $20.8 

billion, of which a total of $17.5 billion has been used, primarily to pay off hurricane-related claims. 
17 

insurers could also result in regulatory reform at the state level. Under most proposals, 

insurers holding an optional federal charter would still participate in state mandatory 

residual risk pools and guarantee funds and pay state taxes on premiums. This 

participation would eliminate the need for a federally run guarantee system (U.S. 

Department of the Treasury 2008). 

Current optional federal charter proposals would generally prohibit rate regulation at the 

federal level. State regulation of premiums is a major impediment to insuring catastrophic 

risks. Under one charter proposal, the proposed National Insurance Act of 2007, the new 

federal charter would have freed property and casualty insurers from both premium 

regulation and “form” regulation (the latter covers what a policy may include or exclude; 

see Webel 2007, 2008). In the few states where rates are not highly regulated, such as 

Illinois, the evidence has shown that competition has held down auto insurance 

premiums. Similarly, where states have reduced premium regulation, more firms have 

entered the market, and the residual pool (see above) has shrunk (Wallison 2006). 

Moreover, risk-based rates would provide policyholders with stronger incentives to 

mitigate risks and to consider risks more carefully when choosing locations for new 

development. In the long run, studies of auto insurance markets suggest that rate 

deregulation should not harm the average consumer; average rates might even fall as a 

result of lower claims (Litan and O’Connor 2008). 

Premium deregulation may raise concerns about affordability, particularly for lowincome policyholders in the short run. States or the federal government could choose to 

provide policyholders with insurance vouchers to make insurance more affordable 

(Wharton Risk Management and Decision Process Center 2008). Vouchers would allow 

government subsidies to better target lower-income policyholders; today the implicit 

subsidies delivered through premium regulation are greatest for those with the biggest 

homes and properties. Because these subsidies would now result in explicit budget 

outlays, their costs would be transparent to taxpayers. 

Preemption of state regulation is not without risk, and not without disadvantages. State 

insurance regulators might have better information about local market conditions and 

stronger incentives to be responsive to residents. If a federal regulator proved lax in 

enforcing its safety and soundness regulations or provided weaker consumer protections, 

some policyholders could be made worse off. Some consumer advocates also fear that a 

dual system could result in a “race to the bottom,” in which state and federal regulators 

compete to give insurers more-favorable treatment and thus secure greater power and 

bigger budgets. Conversely, another possibility is that a federal regulator might impose 

stronger rate regulation in the future. In addition, the banking regulatory model is not 

without problems. For example, recent events have revealed significant gaps in the 

oversight of mortgage originations, which have led to various reform proposals (U.S. 

Department of the Treasury 2008). 

Moreover, the creation of an optional federal charter would require that a new regulatory 

structure be created, possibly within the Treasury and likely modeled along the lines of 

the Office of the Comptroller of the Currency, which oversees national banks (U.S. 
18 

Department of the Treasury 2008). The new office would have to handle chartering, 

licensing, and supervision of insurers. It would also be in charge of safety and soundness 

regulation and new product approval. New regulations would be required for each of 

those activities. Because regulation of insurance companies is now largely a state 

function, the federal government lacks experience in this area. How the federal 

government would perform in this role is uncertain. Some important questions include 

the following (Grace and Scott 2008): 

▪ Should the McCarran-Ferguson Act (1945), which generally exempts the business of 

insurance from most federal antitrust law, be kept in force? 

▪ What capital requirements should be set to ensure insurance companies’ solvency, 

and how far should capital be allowed to fall before triggering prompt corrective 

action?22 

▪ Would requiring insurers to participate in state residual risk pools and guaranty funds 

(which pay claims if an insurer fails) lead to consistent regulation of federally 

chartered insurers? Might a federal guaranty system be necessary? 

▪ What consumer protections should exist for deceptive advertising, unfair policy 

terms, and discriminatory treatment, and how would the large volume of likely 

consumer complaints and policy inquiries be addressed? 

Regulatory Improvement of Risk Transfer Mechanisms with Basis Risk 

Another avenue for increasing insurance capacity would be to allow primary insurers to 

tap the capital markets more directly, through pure-play contracts that contain some basis 

risk. Capital market participants could then base their decisions about whether to supply 

capital on their best forecasts of average industry losses in a geographic region or some 

other broad metric. In particular, they would no longer need detailed knowledge of a 

particular primary insurer’s idiosyncratic characteristics, including its own loss portfolio 

and individual underwriting and loss adjustment practices. With pure-play contracts, 

these idiosyncratic risks largely cancel out in the aggregate. 

As explained above, the usefulness of current NAIC rules is suspect, because they 

prohibit transactions that potentially have greater “hedge effectiveness” (less basis risk) 

and less credit risk than traditional reinsurance programs. These rules effectively protect 

the “franchise value” of reinsurers that have accumulated detailed customer knowledge 

over the years. But the rules are likely counterproductive and may actually reduce total 

hedge effectiveness and increase exposure to credit risk. Catastrophic insurance 

premiums are typically several times higher than the underlying expected losses. 

Expanding the scope for capital market participation would likely greatly reduce the cost 

of catastrophic risk insurance by allowing insurers to more broadly diversify their 

exposure using pure-play contracts available in the capital markets. 

 

22 “Prompt corrective action” is a term borrowed from banking regulation. It sets the requirements for 

regulatory intervention when institutions fail to meet prescribed capital tests. 
19 

To be sure, it would be inefficient for regulators to allow any sort of alternative security 

to count as a substitute for reinsurance if the hedge effectiveness thereby provided is too 

low (that is, if basis risk is too high). For example, a primary insurer with considerable 

hurricane exposure in Florida would obtain very little hedging from an instrument whose 

payoff is correlated with earthquake risk in Tokyo. But regulators could establish a 

minimum hedge effectiveness ratio that any security could satisfy for regulatory 

purposes. If the NAIC does not revisit this issue in a timely manner, an optional federal 

charter could be established that preempts traditional state-level regulations. 

Tax Reform 

Changes in the taxation of income on capital reserves of insurers against expected 

catastrophic losses could expand the availability of catastrophic risk coverage while 

lowering its cost (CBO 2002; Harrington and Niehaus 2001b). As discussed above, the 

taxation of income on capital reserves increases the premiums that insurers must charge 

for catastrophe insurance (Harrington and Niehaus 2001a). Taxation of portfolio income 

is not unique to catastrophe insurance, of course; it is a basic feature of the corporate 

income tax. But, as explained above, catastrophe insurance is distinguished from other 

types of insurance, such as auto, life, and health insurance, by its necessarily high ratio of 

capital reserves to expected losses, and therefore by its high ratio of taxable investment 

income to expected losses. 

Under one potential reform, the government would allow insurers to put money aside taxfree to cover expected losses (Rust and Killinger 2007). State-sponsored plans generally 

may already do so, and so avoid paying taxes on investment income. Similarly, private 

mortgage guaranty insurers are permitted to hold 50 percent of their premiums in a taxdeductible reserve for ten years. (The reserve must be invested in special non-interestbearing Treasury bonds.) Many European countries also allow reserves to be set aside 

tax-free for catastrophic losses. 

Another possibility is to allow insurers to carry back catastrophe losses for, say, ten or 

twenty years, instead of the current two years, and to recover federal taxes paid in past 

years.23 A precedent for this alternative already exists: product liability insurers may carry 

back losses for ten years. 

Tax reform could also have a large impact on the alternative risk transfer mechanisms 

that serve as a substitute for traditional reinsurance. In particular, almost all catastrophe 

bonds are now, for tax reasons, issued through offshore special-purpose vehicles 

(SPVs).24 If cat bonds were issued through an onshore SPV, they would be treated like 

equity for tax purposes because of the contingent nature of the interest payments. From a 

practical standpoint, this means that an onshore SPV cannot deduct such payments as can 

 

23 Insurers and other corporations may already carry back losses two years and carry forward losses twenty 

years, which helps smooth out their cash flow following a disaster. 

24 One concern with special-purpose vehicles is how their sponsor should account for those entities. Most 

are not reported on a firm’s balance sheet and are instead disclosed in the notes to the financial statements, 

raising issues of transparency. However, this issue is not limited to the issuance of catastrophe bonds and 

other insurance-linked securities but is common to a range of financial transactions and is beyond the scope 

of this paper. 
20 

the holder of a regular bond, which makes the onshore arrangement tax inefficient. 

Giving onshore SPVs tax treatment similar to other bond issuers could bring this 

securitization on shore, which means that negotiations over these contracts would not 

have to be held off shore. 

Changes to the tax code, however, do not come for free; all have various costs and 

drawbacks. First, the above changes would result in a loss of federal revenue. Second, 

such changes could lead to substantial distortions in the allocation of capital, especially 

between insurers and other financial institutions not subject to the same tax treatment. For 

example, in the case of onshore SPVs, similar tax treatment for other financial 

instruments with contingent payments might be necessary, reducing government revenue 

even more. (Because of concerns about transparent disclosure by all types of firms, some 

analysts are also generally skeptical about proposals that would encourage greater use of 

off-balance-sheet SPVs.) Third, without adequate oversight, insurers could abuse the 

option to set aside tax-free reserves: by deliberately overestimating expected losses, they 

could shelter additional capital income from taxation (Litan 1990). Fourth, such changes 

would require highly complicated revisions to the corporate tax code. (An analysis of tax 

code changes is beyond the scope of this paper.) 

Federal Reinsurance for Catastrophic Risks 

The federal government is today the implicit insurer of last resort for natural catastrophes, 

and it provides, through TRIA, explicit free reinsurance for terrorism risks. Until the 

impediments to private insurance of catastrophic risks can be reduced, some analysts 

favor a limited yet formal role for the government in selling reinsurance for such risks 

(Litan 2006; see also Kunreuther and Pauly 2006). This reinsurance would be sold only 

for the very highest “layers” of risk, to reduce crowding out of private coverage 

(Cummins 2006). Government provision could increase the availability and decrease the 

price of insurance for the largest catastrophes (CBO 2002). Unlike private insurers, the 

federal government would not need to hold explicit capital reserves to pay off claims and 

avoid insolvency, and it could potentially diversify risks better than private insurers, 

according to proponents. Some analysts, however, challenge the notion that the 

government has a cost advantage in bearing risk and reinsuring catastrophes. They note 

that the premiums charged by the federal government would not compensate taxpayers 

for the burden of supplying the capital (or “market risk”) and that losses might simply be 

shifted across generations (Priest 1996; Braun, Todd, and Wallace 1998). 

More important, using risk-based premiums to cover expected losses could actually 

reduce the expected costs to taxpayers relative to the current approach, where the federal 

government implicitly assumes the role of guarantor of last resort. In theory, the use of 

risk-based premiums would also strengthen the financial incentives for firms and 

households to mitigate risks, including through the location and design of new 

construction and retrofitting of existing structures. 

Government policies, however, can fail or have unintended consequences in practice 

(CBO 2002; Stiglitz 2006). First, federal programs seldom tailor premiums to risks, and 

as a result, federal insurance programs can be undermined by moral hazard and by 
21 

adverse selection (whereby those at higher risk are more likely to buy insurance in the 

first place). The government faces less pressure than private firms to control for adverse 

selection and moral hazard. Second, federal reinsurance could crowd out private suppliers 

and deter innovative private market solutions. Capital market products, including 

catastrophe bonds, would be at a competitive disadvantage. Third, a federal program that 

nationalized disaster risk might reduce the diversification gains from international risk 

sharing. Extensive diversification of risk contributed to the ability of insurers and 

reinsurers to remain in business following the attacks on the World Trade Center. Global 

reinsurers bore much of those losses. 

Rather than set prices administratively, the federal government could therefore auction 

reinsurance to insurers and state-sponsored programs (Lewis and Murdock 1996, 1999), 

and for only those losses in excess of a large deductible. An auction approach could elicit 

new information and allow the private market to determine the appropriate risk-adjusted 

premiums, provided that bidding was significantly competitive. These auctions could 

▪ require minimum prices based on actuarially expected losses plus an additional 

amount for risk load (to cover uncertainty surrounding the estimates) and 

administrative costs; 

▪ set a large minimum level, or “retention level,” of insured losses that policyholders 

must sustain before the federal government will pay; 

▪ limit the federal government’s maximum liability by controlling the number of 

contracts sold; and 

▪ demand that states participating in the auctions increase their efforts to mitigate risk. 

The reinsurance contracts would be similar to the catastrophe options that once traded on 

the Chicago Board of Trade. They would cover specific “layers” of loss and be divisible 

and tradable, paying a fixed amount per billion dollars in losses stemming from a 

disaster. 

Because a federal reinsurance program could be designed to cover only the highest levels 

of losses, insurers would have to sustain large losses before the federal contracts paid out 

any money. Specifying the contracts in terms of aggregate losses would simplify the 

program’s administration, maintain incentives to underwrite policies and adjust claims, 

and facilitate trading of the securities in the secondary market. To be sure, setting the 

minimum bid would require some careful analysis, as well as determining the appropriate 

risk load to compensate for the uncertainty surrounding the available loss estimates, so 

there is no guarantee that taxpayers would be fully protected against losses (CBO 1997, 

1998, 2000). If the contracts were well designed and there was no collusion, the bidding 

could exceed this minimum. 

Still, the effectiveness of federal reinsurance contracts would depend on their design and 

on the competitiveness of the auction process. Most legislative proposals to auction 
22 

federal reinsurance contracts would leave a great deal of discretion with the secretary of 

the Treasury in designing the auction and setting the terms of the contracts. The design of 

a federal reinsurance contract and the format for the auctions would in part determine the 

viability of the policy and the potential cost to taxpayers (CBO 2002). Proposals typically 

require that separate auctions cover different geographic regions. Some bills have even 

proposed separate auctions for Florida and California; others carve out special provisions 

for state-sponsored programs. Proposals also typically include a risk load, which is often 

100 to 200 percent of the expected loss. The goal is to get bidders to reveal their marketbased values, but that will only happen if the contracts are limited in number and attract 

sufficient demand. Some of the key trade-offs and concerns are the following: 

▪ Using an aggregate loss trigger (that is, tying retention levels and contract payouts to 

aggregate losses rather than to losses suffered by individual insurance companies) 

simplifies administration, facilitates trading in the secondary market, and limits moral 

hazard. But such a trigger also means that any particular insurer’s losses may or may 

not match the contract’s payout. This approach, rather than a conventional indemnity 

approach, may be much better suited to natural disaster risks than to terrorism risks, 

which are more site specific. 

▪ Estimates of expected losses from the catastrophic risks covered by the contracts 

would be subject to great uncertainty. For example, modelers vary responses to 

climate change for their estimates of hurricane risk. Thus, significant discretion is 

likely to be needed in setting the retention levels and identifying the appropriate risk 

loads. The federal government has weaker incentives than the private sector to 

overcome that uncertainty and set prices at a budget-neutral level. (This is particularly 

true when the greatest risks are from infrequent events that pose remote likelihoods of 

loss in any particular year. Such events make it harder to detect underpricing.) If 

bidding is robust, how the retention levels and risk loads are set may not matter, but if 

the contracts are awarded at or near their reservation prices (minimum bids), 

taxpayers may be at greater risk. 

If separate auctions are established for state-sponsored programs, the risk of losses being 

transferred to taxpayers is greater. (Some bills would allow the secretary of the Treasury 

to lower the loss threshold for state-sponsored programs.) The danger is of greater 

political pressure to set low reservation prices and avoid competitive bidding. In addition, 

special provisions might unintentionally create incentives for states to introduce statesponsored plans, which would crowd out private reinsurance. 

Can Private Markets Really Insure Against Very Large Losses? 

Can private markets really be expected to shoulder more catastrophic risk? Two 

commonly stated motivations for government intervention are that more insurance 

against catastrophes is always good and that private insurance markets are unable to deal 

with ambiguity and uncertainty, particularly for very large risks. Some analysts question 

the validity of those motivations. 
23 

First, asset diversification is an alternative to insurance. However, individuals generally 

are less able than firms to diversify risks. Personal lines of insurance (for example, home, 

auto, and life insurance) help individuals mitigate a risk that is otherwise 

nondiversifiable. Most personal lines, however, cover losses from acts of terror; as 

argued earlier, coverage for natural catastrophes would also likely be available if the 

private market were not hampered in numerous ways. So the real question is whether 

large property owners should really be purchasing catastrophic protection. 

Some firms and commercial properties may not need insurance against catastrophic risks, 

because their owners can effectively diversify risk. Large properties that are affected by 

government policies such as TRIA are typically owned by shareholders who are well 

diversified and have access to capital markets even after a loss (Cummins 2006; Doherty 

and Tinic 1981). Firms’ demand for insurance, therefore, is typically much lower than 

that by nondiversified individuals. Firms owned by diversified shareholders optimally 

buy insurance only if the benefits from lowering informational asymmetries and other 

capital market costs exceed the underwriting costs. That condition is unlikely to hold in 

the case of catastrophic losses, where the capital market can easily identify the nature of 

the loss (Smetters 2004). Forgoing insurance and instead raising capital after a loss 

occurs is likely preferable for many companies to buying insurance. This suggests that 

the current take-up rate under the TRIA program may be inefficiently high because of the 

low price.25

Second, are private insurers really incapable of dealing with ambiguity and uncertainty? 

U.S. capital markets other than those for insurance—those in equities, fixed income, and 

derivatives—routinely gain or lose $100 billion on a daily basis, and often several trillion 

dollars in a single month. Much of this risk can be traced to new companies that have 

very little history or few close substitutes that investors can look to in order to accurately 

assess future earnings. Nonetheless, investors provide enormous amounts of liquidity to 

U.S. firms, producing one of the most efficient mechanisms for financing risky activity 

that has ever existed in the history of the world. It is unclear why private insurers should 

act any differently. 

To be sure, supply in private insurance markets often contracts following a major 

disaster. For example, after September 11, 2001, terrorism exclusions in propertycasualty policies began to be routinely enforced in 2002 for larger and more obvious 

targets, although major insurers of small and medium-size risks with annual premiums 

below $1 million, including Travelers, still typically did not write such exclusions into 

policies for nonlandmark properties (A.M. Best Co. 2002). An anonymous survey by the 

Real Estate Roundtable, a proponent of TRIA, claimed that $15.5 billion in real estate 

transactions had been delayed or canceled as of September 2002 because of concerns 

about terrorism insurance (Real Estate Roundtable 2002a, 2002b). It is likely that many 

of the postponed projects were on the verge of being delayed anyway, given the sharp 

cyclical reduction in commercial fixed investment before September 11 (Bureau of 

 

25 Of course, firms are sometimes required to purchase insurance in order to simplify the ratings process 

(CBO 2005, 10). 
24 

Economic Analysis 2001, Table 1). Moreover, even if this suspension of activity was 

mostly due to terrorism concerns, it constituted only a small fraction of the over $600 

billion in combined annual commercial and residential construction in 2001. Still, 

commercial construction activity had already started to shrink before September 11, and 

so the terrorist attacks clearly made things worse. 

Private insurance markets, however, soon begin to add capital after a disaster. Moreover, 

the speed with which insurers resume adding capital after a major disaster has in general 

increased rapidly over time. It took several years for insurers to replace the capacity lost 

after Hurricane Andrew. Yet just a decade later, in the wake of September 11, insurers 

increased capital reserves by $21 billion in just three months (Morgan Stanley 2001). The 

appearance of general agreement on a government backstop in late 2001 likely slowed 

the entry of even more capital into the insurance industry. However, many industry 

analysts argued that because of the uncertainty surrounding terrorism risk, most of the 

new capital was not backing the underwriting of such risk. Nonetheless, by September 

2002 premiums had dropped by as much as 75 percent per unit of coverage from the 

beginning of the year. Limits, or the maximum amounts that can be paid out on a policy, 

as high as $1 billion became available and were increasing over time (Shadow Financial 

Regulatory Committee 2002). At least ten start-up insurers were formed, and other 

insurers continued to add capital (Guy Carpenter Securities 2003). Two months before 

TRIA went into force, insurers already had added $30 billion of capital, with another $10 

billion in new issues pending. Even the Building Owners and Managers Association, also 

a proponent of TRIA, acknowledged that three-quarters of owners of larger commercial 

and residential buildings had secured terrorism coverage.26 The Shadow Financial 

Regulatory Committee (2002, 2), an independent group of leading academic scholars and 

experts, concluded, “Private insurance, reinsurance, and lending markets have made and 

are continuing to make substantial progress in adjusting to the post-September 11 world.” 

By September 20, 2007, insurer capital stood at $522 billion, compared with $290 billion 

at the end of 2001 (Hartwig 2007). A.M. Best Co. (2008) projected that insurers would 

realize record net earnings of more than $59 billion in 2007. As the financial strength of 

the insurance industry improves, so, too, does its ability to bear catastrophic risks. 

Cyclical fluctuations, however, will remain a problem. 

Alternative risk transfer products have also grown over time. Cat bonds, for example, 

hardly existed a decade ago but now account for about 8 percent of global property 

insurance limits, and ILWs for about another 4 percent. (The remaining 88 percent of 

global property limits are largely covered by traditional reinsurance.) These alternatives 

together accounted for less than 1 percent of risk limits a decade ago (Guy Carpenter 

Securities 2008, 5). 

A 12 percent market penetration for alternative risk transfer mechanisms might appear at 

first glance to represent considerable growth, but in fact these mechanisms are still well 

short of their potential. As argued earlier, it is likely that prohibitive government 

regulation and existing tax rules severely limit the growth of alternative risk transfer 

 

26 See “Terrorism Insurance Survey Reveals Disturbing Trends,” PR Newswire, September 20, 2002. 
25 

classes, despite their superior ability to deal with basis risk and preferred 

creditworthiness. 

Indeed, even the current figures might overstate the growth of these alternative securities, 

since many are actually fairly traditional in nature. Five of the twenty-seven cat bonds 

issued in 2007—accounting for $2.3 billion of the $7 billion in new issuance—used 

indemnity-based triggers, just as standard reinsurance does (Guy Carpenter Securities 

2008, 23). These contracts have the look and feel of a traditional reinsurance policy, but 

the payoff after a loss takes the form of forgiving bond repayments from the primary 

insurer rather than a direct payment from the reinsurance company. Their main advantage 

over traditional reinsurance stems from having no credit risk. Moreover, another eight of 

the cat bonds issued in 2007—accounting for another $1.7 billion of the $7 billion in new 

issuance—used a combination of indemnity-based and another sort of trigger; these 

instruments, called “hybrid” or “modeled” contracts, therefore also require investors to 

have fairly detailed knowledge of the specific risks being insured. Almost all ILWs also 

embed some form of indemnity-based trigger (usually along with some other trigger).27

Indemnity contracts are generally much less transparent and fail to provide capital market 

investors with a clean “pure play” in the general sources of catastrophic risk. Indemnity 

contracts also create moral hazard, which must be estimated, mitigated, and priced.28

From a portfolio perspective, insuring catastrophic risk is mostly a pure “alpha play,” 

where returns are largely uncorrelated with the rest of the economy. So the supply side of 

capital for pure-play contracts should be fairly strong. However, the demand side appears 

to be fairly weak, probably because these contracts cannot count as a recoverable asset in 

most states. 

Conclusions 

Enabling capital markets to more easily finance catastrophic losses in a diversified 

manner is substantially more efficient than forcing nondiversified property owners to 

bear the losses without recoupment, which could lead to large ripple effects throughout 

the economy. This paper has examined how existing government policies play key roles 

in unintentionally limiting the amount of capital available to finance the nation’s 

catastrophic losses. Although government policies are typically motivated by clear and 

reasonable objectives when initially implemented, they often become outdated as markets 

innovate. Not surprisingly, policymakers routinely revise government policies and 

regulations in the face of changing conditions. This paper has examined several different 

 

27 The relevance of the indemnity trigger in ILWs depends on the threshold of the trigger. For example, if 

the indemnity trigger were set to $1, then only the parametric trigger would be meaningful. ILWs have not 

received much regulatory scrutiny, presumably because they are not a large part of many issuers’ 

reinsurance programs. 

28 Some investors prefer indemnity contracts for reasons other than pure regulatory and accounting reasons. 

For example, some may be more comfortable with a specific insurer’s underwriting than having payouts 

determined by an index of industry-wide losses. 
26 

options to deal with today’s changed conditions, including their benefits and potential 

costs. 
27 

Appendix A 

Current Federal Terrorism Insurance Policy and the Options for 

Disaster Insurance 

A federal financial backstop to private terrorism insurance coverage is in place through 

2014. Lawmakers are also considering options for a more formal federal role in natural 

disaster insurance. 

The Terrorism Risk Insurance Act 

Before the attacks of September 11, 2001, insurers and reinsurers typically covered 

conventional acts of terrorism. Insured losses of all types from the September 2001 

attacks reached nearly $37 billion and were largely unanticipated.29 The majority of those 

losses were borne by global reinsurers, many of which subsequently exited the market. In 

several states, including New York and California, primary insurers were required to 

continue to provide terrorism coverage, so they could not exit the market. 

In response to fears that a shortage of terrorism insurance would slow economic growth, 

Congress passed the Terrorism Risk Insurance Act in November 2002. TRIA was 

intended as a temporary measure, designed to help insurers recover from the economic 

shock of covering the catastrophic losses of September 11 and to give the industry time to 

develop more accurate ways of modeling terrorism risk. The program was extended in 

subsequent legislation and was scheduled to expire on December 31, 2007, but was 

reauthorized. 

Under TRIA, property and casualty insurance companies are required to offer 

commercial terrorism coverage. That coverage is subsidized by the federal government, 

which in 2008 agrees to pay 85 percent of an insurer’s losses, above a deductible, in the 

event of attack by foreign terrorists. The insurer pays the deductible (20 percent of 

premiums in the previous year) and the 15 percent of losses not paid by the government, 

up to a total limit for the program of $100 billion. The government does not charge for 

this coverage but would be required to recoup some of its costs after an attack by taxing 

all policyholders. 

Although the capital lost to the insurance market after September 11 has since been 

restored, the private reinsurance market remains limited, with less than $10 billion of 

coverage issued for the risks retained by the private insurers. Most industry analysts 

argue that the supply of reinsurance will remain constrained as long as estimates of 

expected losses from terrorism remain highly uncertain. Other analysts argue that federal 

reinsurance crowds out private reinsurance. 

Congress considered two proposals to extend TRIA beyond 2007. The first, which was 

debated in the House of Representatives but ultimately rejected, would have extended the 

 

29 That estimate includes all insured losses, including group life and aviation, and is expressed in 2007 

dollars. See Hartwig (2006). 
28 

program for fifteen years, lowered deductibles, added group life insurance, and required 

insurers to offer coverage for risks posed by weapons of mass destruction involving 

nuclear, biological, chemical, and radioactive (NBCR) materials.30 Proponents of adding 

coverage for weapons of mass destruction argued that the government is likely to end up 

covering much of the losses from their use in any case, even without an explicit 

commitment to do so. Making the commitment explicit, but doing so through existing 

insurance, would have the advantage of using private insurers to underwrite risks, bear 

some of the losses, and adjust claims. Private insurers have largely excluded NBCR risks 

from their insurance policies because of their greater magnitude and uncertainty relative 

to conventional terrorism risks.31

In the end, Congress approved the Senate version of the TRIA reauthorization, which 

extends the program for seven years, maintains current deductibles, and covers attacks by 

domestic as well as by foreign terrorists.32 Covering domestic terrorism reduces the 

ambiguity of current law, particularly for cases in which domestic groups are acting in 

sympathy with, but not necessarily under the direction of, international terrorists. The bill 

did not require the offer of coverage for weapons of mass destruction. To satisfy budget 

scoring rules, the final version of the reauthorization required insurers as a group to 

reimburse the federal government for any outlays after an attack that are covered under 

TRIA. Those repayments would occur over time through assessments on commercial 

policyholders, including those that decline terrorism coverage. As before, insurers do not 

pay any premiums for the federal coverage. 

Legislative Proposals Concerning Natural Disasters 

Hurricane Katrina demonstrated that many homeowners were inadequately insured, 

because traditional homeowners’ policies do not provide integrated multiperil coverage. 

Although most homeowners are insured against wind damage, including that from 

hurricanes, private insurance does not cover flood losses, which is provided separately 

through the federal government. Consequently, disputes arise over whether losses are 

covered under the contracts and who should pay. Disputes over whether losses should be 

attributed to wind or flooding ended up in the courts. Many insurers found themselves 

paying claims that they thought fell outside the policies, and many homeowners were left 

with uninsured flood losses. 

A proposal before the House would allow FEMA to offer multiperil insurance for floods 

and windstorms (CBO 2007c). Currently the federal government insures only flood losses 

(up to a $250,000 ceiling for residential properties and another $100,000 for contents) 

and had to borrow $17.5 billion to cover the claims from Hurricanes Katrina and Rita that 

the NFIP could not pay out of its reserves. Under the proposal, the federal government 

would insure against damages from flood or hurricane up to a maximum of $650,000 per 

residence for structure, contents, and additional living expenses. Multiperil coverage 

would avoid the ambiguity of whether the losses were due to wind or flooding and so 

 

30 For more details see CBO (2007b). 

31 Insurers do provide NBCR coverage in the workers’ compensation line, because states mandate that there 

be no exclusions in that line. 

32 For more details see CBO (2007d). 
29 

would likely reduce litigation. The government is supposed to charge actuarial rates for 

such coverage. However, some analysts contend that while the private sector may have 

strong incentives to overcharge, governments have strong incentives to undercharge 

(Stiglitz 2006). In particular, relative to private insurers, the government may find it 

harder to charge high rates for properties that pose the greatest risks. Consequently, the 

government might base rates on the average risks and suffer as a result from adverse 

selection. 

The proposal as currently drafted thus does not provide sustainable long-term multiperil 

insurance, because it does not guarantee indefinite borrowing authority. If the multiperil 

program were to incur losses, additional borrowing authority would be needed to pay the 

claims. The costs to taxpayers would be recorded only when such borrowing occurred. 

The legislation would prohibit FEMA from renewing multiperil policies until such 

borrowing is repaid. 

Congress is considering other approaches to increase the supply of catastrophe insurance 

and lower the premiums paid by policyholders. The House of Representatives passed the 

Homeowners’ Defense Act of 2007 (H.R. 3355), which would create two federal direct 

loan programs for state reinsurance and insurance funds—one for liquidity purposes and 

one to cover catastrophic losses (CBO 2007e).The Florida Hurricane Catastrophe Fund 

and the California Earthquake Authority, as well as other existing state programs, would 

likely be participants. The loans, which would only be available following a disaster, 

would be backed by the full faith and credit of the state, and the terms would vary. If the 

state insurance funds are unable to access other sources of funds at reasonable rates, the 

federal government may extend liquidity loans at rates 3 percentage points above 

comparable rates for five- to ten-year terms. Loans may also be extended if the 

reinsurance program suffers insured losses greater than 150 percent of the property and 

casualty premiums written in the state over the preceding year. Demand for catastrophe 

loans is uncertain, because state reinsurance programs are not responsible for losses 

above their ceiling coverage level. 

As amended, the proposal would also allow the establishment of a federal reinsurance 

plan for state reinsurance programs for losses of a magnitude expected to occur only once 

every 200 years, whether triggered by a single event or by multiple events. The federal 

government would cover 90 percent of losses above that amount and charge rates that, on 

an expected value basis, would be sufficient to cover the costs of claims. 

Reinsurance coverage for natural catastrophes is available in the private market. The root 

problem is that because state programs charge below-market premiums (see appendix C), 

purchasing private reinsurance is an unattractive option. Because the federal reinsurance 

would be available with no markups above expected losses, which are highly uncertain 

for once-in-200-years events, private reinsurers would be unable to compete successfully 

for this business. Federal taxpayers would be at risk if the federal reinsurance contracts 

were underpriced. 
30 

Appendix B. Climate Change and Hurricanes 

The recent increase in the frequency and intensity of Atlantic and Gulf Coast hurricanes 

may be due in part to human-induced warming. Evidence suggests that human activities 

are changing the global climate, and that the resulting warming is influencing patterns of 

sea-level rise, rainfall, and hurricane intensity around the world (Intergovernmental Panel 

on Climate Change 2007). Changes in those patterns could increase the risk of 

catastrophic damage in the United States from Atlantic and Gulf hurricanes. 

However, it remains uncertain how large any contribution of warming to hurricane 

frequency and intensity might be, compared with the natural variability in hurricane 

intensities and the resulting increase in damages associated with continued development 

of the nation’s coastal regions (CBO forthcoming). Several factors affect the 

development, frequency, and intensity of hurricanes, making them difficult to predict. 

The processes that drive hurricane development are sufficiently complex that the effects 

of climate change on the frequency and intensity of hurricanes are currently highly 

uncertain. To complicate matters, the factors that influence the frequency of hurricanes 

appear to be quite different from the factors that influence their intensity (Emanuel 

2006a). Moreover, the net effect of warming on the frequency and intensity of hurricanes 

that strike the United States may differ from its effect in other parts of the world. As a 

result, no single catastrophe or even a single season of multiple catastrophes can be 

attributed solely or even primarily to human-induced changes in climate (Pilke et al. 

2005). 

Other things being equal, increases in ocean temperatures from global warming will raise 

the potential intensity of a hurricane: theory predicts that hurricane wind speeds should 

increase about 5 percent for every 1 degree Celsius (1.8 degrees Fahrenheit) increase in 

average sea surface temperature, and the destructive power of hurricanes rises with the 

cube of the wind speed. Consequently, even modestly more intense hurricanes could 

cause considerably greater damage. Researchers estimate that temperatures in the North 

Atlantic, where hurricanes striking the Atlantic and Gulf Coasts form, have risen about 

0.67 degree Celsius since 1906, with just over 40 percent of the increase attributable to 

global warming (Holland and Webster forthcoming). Most global climate models project 

further increases in sea surface temperatures. Patterns of strong decrease of air 

temperature with altitude also contribute to hurricane formation, while patterns of high 

wind tend to reduce peak winds and thus retard hurricane formation. 

However, research suggests that warming may also contribute to factors that tend to 

neutralize the formation and duration of hurricanes. The most important such factor is 

wind shear—horizontal winds that blow in different directions and speeds at different 

altitudes at a given location—which can disrupt the circular flow of hurricanes and break 

them apart. 

The influence of wind shear on the development and intensity of storms remains rather 

poorly understood, but even modest amounts of vertical wind shear can prevent weak 
31 

disturbances from intensifying into hurricanes and may limit the intensity of storms that 

have already formed. It appears possible that climate change could lead to larger changes 

in wind shear than in potential intensity, tending to inhibit the development of hurricanes 

in spite of their increasing potential intensity. One recent study concludes that increasing 

wind shear caused by climate change could moderate any increase in both the intensity 

and frequency of hurricanes reaching the Atlantic and Gulf Coasts (Vecchi and Soden 

2007). Moreover, recent studies that use proxy data to analyze the historical intensity and 

frequency of hurricanes conclude that variability in wind shear (rather than sea surface 

temperature) has been the dominant factor affecting major hurricane activity over the past 

few centuries to millennia (Donnelly and Woodruff 2007; Elsner 2007; Nyber et al. 

2007). 

Hurricanes are also influenced by quasi-periodic, multidecadal shifts in climate that affect 

hurricanes by heating or cooling the seas, and by changing regional patterns of wind 

shear (Goldenberg et al. 2001; Bengtsson 2001; CBO forthcoming). In the Atlantic those 

shifts include El Niño, the West African monsoon, and probably the Atlantic Multidecadal Oscillation (Dailery and Zuba 2007; Donnelly and Woodruff 2007). Climate 

change therefore may ultimately affect hurricanes through its as-yet-uncertain effects on 

such multidecadal cycles. 

At present, there is little evidence of a long-term trend in the number of tropical storms 

and hurricanes worldwide. There has been some upswing in the number of hurricanes in 

the North Atlantic after 1995, but the relative contributions of human-induced warming 

and other causes is unclear (Emanuel 2006b; Webster et al. 2005). Under the influence of 

the Atlantic Multi-decadal Oscillation, the Atlantic was unusually cool from the late 

1800s to about 1930, warmer than its long-term average from the 1930s to the 1960s, 

cooler from about 1970 until 1995, and warmer than average again after 1995 (Dailery 

and Zuba 2007). Observed increases in hurricane intensity in the North Atlantic may also 

be due to multidecadal variability rather than climate change (Mann and Emanuel 2006). 

A recently developed analytic technique, applied to results from climate models, 

indicates that global warming could reduce the global frequency of hurricanes but 

increase their frequency off the southeastern coast of the United States (Emanuel, 

Sundararajan, and Williams 2008). The study also found that the intensity of hurricanes 

may increase in some locations, including the North Atlantic. 
32 

Appendix C. State-Sponsored Insurance Funds 

Proposals that the federal government extend loans to state-sponsored insurance funds or 

offer those funds reinsurance are partly motivated by the recent losses sustained by the 

Florida funds. Rather than being borne by the policyholders in the residual funds (those 

who cannot find willing insurers at the maximum allowable rates), the losses are largely 

shifted to all insured policyholders in the state through “assessments” or taxes on 

insurance policies. Analysts also recognize that none of the funds could pay for a 

supercatastrophe. 

The Florida Hurricane Catastrophe Fund 

The Florida Hurricane Catastrophe Fund was established in 1993, after Hurricane 

Andrew, to provide a cheap source of reinsurance. Florida requires that all residential 

property insurers operating in the state, including the Citizens Property Insurance 

Corporation, the state’s residual pool, purchase reinsurance from the fund. Premiums are 

a quarter to a third the rates charged by private reinsurers, according to some estimates, 

and even lower by others’ accounts.33 The fund charges no risk loads to cover uncertainty 

surrounding either the timing or the amounts of the payments. After the losses 

experienced in 2005-06, a 25 percent rapid cash buildup factor was added to premiums in 

2006, but the Florida legislature repealed that provision the next year. The fund’s 

maximum statutory payout is less than $30 billion, so claims might not be paid in full 

after a major event (see State Board of Administration of Florida 2006, 2008; see also 

Florida Hurricane Catastrophe Fund 2007). 

To pay claims of $3.95 billion arising from the 2004 hurricanes (Charley, Frances, Ivan, 

and Jeanne) and claims of $4.5 billion from the 2005 hurricanes (Katrina, Rita, and 

Wilma), the fund issued $1.35 billion in municipal revenue bonds. The bonds are backed 

by a 1 percent emergency assessment beginning January 1, 2007, on all property and 

casualty lines (excluding workers’ compensation and, for a limited time, medical 

malpractice). The state’s assessment base for the taxes is about $35 billion; the tax will 

apply to all homeowners’ policies and to auto insurance policies for the next six years. 

The state does not explicitly back any of the bonds issued by the catastrophe fund. 

Florida’s Citizens Property Insurance Corporation 

The Citizens Property Insurance Corporation is the largest property insurer in Florida, 

collecting over $3.3 billion in premiums annually, with almost 1.4 million policies in 

effect as of October 21, 2007, including over 400,000 in high-risk areas that almost 

exclusively cover losses from wind.34 The number of policies increased by nearly 500,000 

between 2005 and 2006 following rate hikes in the private market. One of Citizens’ goals 

is to be able to cover a once-in-130-years event for the high-risk accounts. To pay claims 

in these accounts, however, assessments and policyholder surcharges would be triggered 

 

33 Government Accountability Office (2007, 20). The fund estimates that its rates are just one-fourth to onefifth the price of private reinsurance. See also Florida Hurricane Catastrophe Fund (2007, 3). 

34 In August 2007 Citizens began offering a multiperil policy in the high-risk account that had previously 

covered only windstorm damage (Citizens Property Insurance Corporation 2007). 
33 

at a much lower level—after just a one-in-six-years event (Citizens Property Insurance 

Corporation 2007, slide 9). 

Recent legislative changes have made Citizens a more attractive option for policyholders, 

making it more of an alternative market than a market of last resort. In 2007 the 

legislature rejected planned rate increases of 55 percent for wind coverage on top of an 

additional surcharge of nearly 25 percent (Citizens Property Insurance Corporation 

2006). Rates for all Citizens policies were frozen for two years following double-digit 

rate increases in 2005 and 2006. 

Deficits are covered by assessments on all property and casualty insurers and 

policyholders in the state. Assessments have been necessary even after relatively small 

losses, such as those experienced in 1995 after Hurricanes Opal and Erin. (Those 

assessments were levied by the predecessors to Citizens.) Large operating losses in both 

2004 and 2005 also triggered assessments. The legislature decided to cushion the impact 

by appropriating $715 million to reduce Citizens’ 2005 deficit (liabilities in excess of 

assets) of $1.8 billion. A regular assessment of $163 million was levied, and an additional 

1.4 percent emergency assessment was levied on most property and casualty insurance 

policies issued after July 1, 2007, which will raise $888 million over ten years.35

(Emergency assessments are levied if regular assessments and Citizens policyholder 

assessments are insufficient to fully fund the deficit.) The assessments will pay off $4.7 

billion worth of bonds issued by Citizens. These bonds are not explicitly backed by the 

state. 

The California Earthquake Authority 

Following the Northridge earthquake in 1994, California created a state-sponsored plan to 

offer earthquake insurance to homeowners. Like flood insurance, earthquake insurance is 

not part of a standard homeowners’ policy but must be purchased separately. However, 

state law requires insurers to offer earthquake coverage as a rider to their homeowners’ 

policies. To discourage insurers from withdrawing from the market, California modified 

its requirement by allowing insurers to offer the state-sponsored plan; private firms today 

provide only about 30 percent of policies purchased (Government Accountability Office 

2007, 59). 

Premiums are risk-based and vary depending on the home’s location relative to a fault 

zone, its type of construction, its age, and the type of soil underneath it. Discounts are 

given for mitigation measures and retrofitting. Rates for basic coverage were reduced by 

an average of over 20 percent effective July 1, 2006. Claims have been minimal, totaling 

less than $50,000 for 2005 and 2006, for example. 

The California Earthquake Authority (CEA) insures about 750,000 policyholders and has 

a total claims paying capacity of $8.2 billion (PriceWaterhouseCoopers 2007). As of June 

 

35 Citizens Property Insurance Corporation, financial statements for years ended December 31, 2005, and 

December 2004, available at www.citizensfla.com. 
34 

30, 2007, the CEA had a net worth of about $2.7 billion;36 most of that capacity is based 

on private reinsurance ($1.8 billion), debt, and postevent assessments on participating 

insurers. Should capacity be insufficient to cover claims, payments would be either prorated or disbursed over time. The state has no legal obligation to stand behind the CEA, 

but many policyholders might assume an implicit guarantee. 

Lack of coverage may be an issue after the next major earthquake. Only about 12 percent 

of households in California have earthquake insurance today, compared with about 30 

percent when the Northridge earthquake hit. Many analysts believe that individuals have 

a difficult time making choices involving low-probability, high-consequence events. As 

more years pass without a big earthquake to remind them of the risk, drops in coverage 

might be expected (see Wharton Risk Management and Decision Processes Center 2008). 

However, the design of the policy is also a contributing factor; insured policyholders still 

bear substantial risk.37 For example, the basic policy carries a deductible of 15 percent of 

the value of insurance on the property, rather than a dollar amount, which on a standard 

homeowners’ policy might typically be $1,000. In addition, the standard policy limits 

coverage for contents ($5,000) and additional living expenses ($1,500) and excludes 

coverage for swimming pools, patios, decks, and detached garages. 

 

36 California Earthquake Authority, unaudited balance sheet, June 30, 2007, available at 

www.earthquakeauthority.com. 

37 To reduce their exposure, policyholders could purchase private earthquake coverage by switching to one 

of the homeowners’ insurance companies that does not participate in the CEA. 
35 

References 

AIR Worldwide. 2006. Understanding Climatological Influences on Hurricane Activity: The AIR Nearterm Sensitivity Catalog. Boston, MA. 

A.M. Best Co. 2002. “A Year After Terror, Commercial Insurers Look Closer at Concentrations of Risk.” 

BestWire, Oldwick, NJ (September 12). 

___________. 2008. “A.M. Best Special Report: U.S. P/C Industry Records Strong Results—But for How 

Long?” Press release. Oldwick, NJ (January 29). 

Bank for International Settlements. 2007. “Triennial and Semiannual Surveys on Positions in Global Overthe-Counter Derivatives Markets at End-June 2007.” Basel (November). 

Bengtsson, Lennart. 2001. “Enhanced Hurricane Threats.” Science (293) 5529 (July 20): 440-41. 

Bradford, David F., and Kyle D. Logue. 1997. “The Influence of Income Tax Rules on Insurance 

Reserves.” Working Paper 5902. National Bureau of Economic Research, Cambridge, MA (January). 

Braun, Anton, Richard M. Todd, and Neil Wallace. 1998. “The Role of Damage-Contingent Contracts in 

Allocating the Risks of Natural Catastrophes.” Working Paper 586D. Federal Reserve Bank of 

Minneapolis, Minneapolis, MN (April). 

Bureau of Economic Analysis. 2001. Survey of Current Business. Washington, DC: U.S. Department of 

Commerce (August). 

Citizens Property Insurance Corporation. 2006. “Citizens Board Votes to Table Rate Increase Pending 

Legislative Action.” Press release. Jacksonville, FL (December 7). 

___________. 2007. “Citizens At-a-Glance.” PowerPoint presentation to the House Insurance Committee. 

Jacksonville, FL (December 13). www.citizensfla.com/about/generalinfo.cfm?show=pdf&link 

=/shared/documents/citizensPresentation12-07.pdf. 

Congressional Budget Office. 1997. “CBO Cost Estimate for H.R. 230, Natural Disaster Protection and 

Insurance Act of 1997.” Washington, DC (October 8). 

___________. 1998. “CBO Cost Estimate for H.R. 219, Homeowners’ Insurance Availability Act of 1998.” 

Washington, DC (September 23). 

___________. 2000. “Cost Estimate: H.R. 21, Homeowners’ Insurance Availability Act of 1999.” 

Washington, DC (February 9). www.cbo.gov/ftpdocs/18xx/doc1837/hr21.pdf. 

___________. 2002. “Federal Reinsurance for Disasters.” Washington, DC (September). 

cbo.gov/ftpdocs/37xx/doc3787/09-20-FederalReinsurance.pdf. 

___________. 2005. “Federal Terrorism Reinsurance: 

An Update.” Washington, DC (January). cbo.gov/ftpdocs/60xx/doc6049/01-05-Terrorism.pdf. 

___________. 2007a. “Federal Reinsurance for Terrorism Risks: Issues in Reauthorization.” Washington, 

DC (August). www.cbo.gov/ftpdocs/85xx/doc8520/08-02-TRIA.pdf. 

___________. 2007b. “Cost Estimate: H.R. 2761, Terrorism Risk Insurance Revision and Extension Act of 

2007.” Washington, DC (September 6). www.cbo.gov/ftpdocs/86xx/doc8600/hr2761.pdf. 

___________. 2007c. “Cost Estimate: H.R. 3121, Flood Insurance Reform and Modernization Act of 

2007.” Washington, DC (September 20). www.cbo.gov/ftpdocs/86xx/doc8648/hr3121.pdf. 

___________. 2007d. “Cost Estimate: Terrorism Risk Insurance Program Reauthorization Act of 2007.” 

Washington, DC (October 29). www.cbo.gov/ftpdocs/87xx/doc8761/TRIAsenate.pdf. 

___________. 2007e. “Cost Estimate: H.R. 3355, Homeowners’ Defense Act of 2007.” Washington, DC 

(October 30). 

www.cbo.gov/ftpdocs/87xx/doc8774/hr3355.pdf. 

___________. Forthcoming. “The Expected Impacts of Climate Change in the United States.” Washington, 

DC. 

Cummins, David. 2006. “Should the Government Provide Insurance for Catastrophes?” Federal Reserve 

Bank of St. Louis Review 88(4): 337-79. 

___________. 2008. “CAT Bonds and Other Risk-Linked Securities: State of the Market and Recent 

Developments.” Risk Management and Insurance Review 11(1) (Spring): 23-47. 

Dailery, Peter S., and Gerhard Zuba. 2007. “Examining U.S. Hurricane Landfall Probability.” AIR Currents

(October 10). www.air-worldwide.com/-public/html/air_currentsitem.asp?ID=1333. 

Danzon, Patricia M., and Scott E. Harrington. 2001. “Workers’ Compensation Rate Regulation: How Price 

Controls Increase Costs.” Journal of Law and Economics 44 (April): 

1-36. www.journals.uchicago.edu/doi/pdf/10.1086/320270. 
36 

Dixon, Lloyd, and Rachel Kagnoff Stern. 2004. Compensation for Losses from the 9/11 Attacks. Santa 

Monica, CA: RAND Institute for Civil Justice (November). 

Dixon, Lloyd, et al. 2007. The Federal Role in Terrorism Insurance: Evaluating Alternatives in an 

Uncertain World (Santa Monica, CA.: RAND). 

Doherty, Neil A., and S. Tinic. 1981. “Reinsurance under Conditions of Capital Market Equilibrium: A 

Note.” Journal of Finance 36: 949-53. 

Donnelly, Jeffrey P., and Jonathan D. Woodruff. 2007. “Intense Hurricane Activity over the Past 5,000 

Years Controlled by El Nino and the West African Monsoon.” Nature 447 (May 24): 465-68. 

Elsner, James B. 2007. “Tempests in Time.” Nature 447 (June 7): 647-79. 

Elsner, James B., James P. Kossin, and Thomas H. Jagger. 2008. “The Increasing Intensity of the Strongest 

Tropical Cyclones.” Nature 455 (September): 92-95. 

Emanuel, Kerry. 2005. “Increasing Destructiveness of Tropical Cyclones over the Past 30 Years.” Nature

436 (August): 686-88. 

___________. 2006a. “Anthropogenic Effects on Tropical Cyclone Activity.” Massachusetts Institute of 

Technology, Cambridge, MA. wind.mit.edu/%7Eemanuel/anthro2.htm. 

___________. 2006b. “Climate and Tropical Cyclone Activity: A New Model Downscaling Approach.” 

Journal of Climate 19 (October 1): 4797-4802. 

Emanuel, Kerry, Ragoth Sundararajan, and John Williams. 2008. “Hurricanes and Global Warming: 

Results form Downscaling IPCCC AR4 Simulations.” Bulletin of American Meteorological Society 89 

(March): 347-67. ftp://texmex.mit.edu/pub/emanuel/PAPERS/Emanuel_etal_2008.pdf. 

Florida Hurricane Catastrophe Fund. 2007. “Changes in the FHCF Coverage Due to Legislative Changes.” 

Tallahassee, FL (January 24). 

www.sbafla.com/fhcf/pdf/legislation/Special%20Session%20FHCF%20Changes%201-24-07.pdf. 

Florida Office of Insurance Regulation. 2008. “Florida Office of Insurance Regulation Files Formal 

Complaint to Suspend Allstate Companies’ Licenses.” Tallahassee, FL (February 19). 

www.floir.com/Press Releases/viewmediarelease.aspx?ID=2875. 

General Accounting Office. 2002. “Catastrophe Insurance Risks: The Role of Risk-Linked Securities and 

Factors Affecting Their Use.” GAO-02-941. Washington, DC (September). 

___________. 2003a. “Catastrophe Insurance Risks: Status of Efforts to Securitize Natural Catastrophe and 

Terrorism Risk.” GAO-03-1033. Washington, DC (September). 

___________. 2003b. “September 11: Overview of Federal Disaster Assistance to the New York City 

Area.” GAO-07-72. Washington, DC (October). 

Goldenberg, Stanley B. et al. 2001. “The Recent Increase in Atlantic Hurricane Activity: Causes and 

Implications.” Science (293) 5529 (July 20): 474-79. 

Government Accountability Office. 2007. “Natural Disasters: Public Policy Options for Changing the 

Federal Role in Natural Catastrophe Insurance.” GAO-08-7. Washington, DC (November). 

___________. 2008. “Initial Results on Availability of Terrorism Insurance in Specific Geographic 

Markets.” GAO-08-919R. Washington, DC (July 11). 

Grace, Martin F., and Robert W. Klein. 2007. “Facing Mother Nature.” Regulation (Fall): 28-34. 

___________. 2008. “Insurance Regulation: The Need for Policy Reform.” Paper presented at the 

American Enterprise Institute Conference on the Future of Insurance Regulation, Washington, DC 

(July 9). www.aei.org-20080707_GraceKleinInsuranc.pdf. 

Grace, Martin F., and Hal S. Scott. 2008. “Optional Federal Chartering of Insurance: Rationale and Design 

of a Regulatory System.” Paper presented at the American Enterprise Institute Conference on the 

Future of Insurance Regulation, Washington, DC (July 9). 

www.aei.org/docLib/20080707_GraceScottOptionalFed.pdf. 

Grossi, Patricia, and Robert Muir-Woods. 2006. “The 1906 San Francisco Earthquake and Fire: 

Perspectives on a Modern Super Cat.” Risk Management Solutions, Newark, CA. 

www.rms.com/Publications/2006_SF_EQ.pdf. 

Guy Carpenter Securities. 2003. “The World Catastrophe Reinsurance Market: 2003.” Guy Carpenter & 

Company, New York, NY (September). 

___________. 2008. “The Catastrophe Bond Market at Year-End 2007.” Guy Carpenter & Company, New 

York, NY (February). 

Harbin, Dana. 2006. “Hurricanes Katrina and Rita: Coverage Disputes and Pending Litigation.” Institute 

for Risk Management, Dallas, TX (July). www.irmi.com/Expert/Articles/2006/cooper05.aspx. 
37 

Harrington, Scott E. 2000. Insurance Deregulation and the Public Interest. Washington, DC: AEIBrookings Joint Center for Regulatory Studies. 

Harrington, Scott E., and Greg Niehaus. 2001a. “Government Insurance, Tax Policy, and the Affordability 

and Availability of Catastrophe Insurance.” Journal of Insurance Regulation 19(4): 591-612. 

___________. 2001b. “On the Tax Costs of Equity Finance: The Case of Catastrophe Insurance.” Working 

paper, University of South Carolina, Columbia, SC (May). 

Hartwig, Robert P. 2006. “9/11 and Insurance: The Five Year Anniversary.” Insurance Information 

Institute, New York, NY (September). 

___________. 2007. “2007—First Nine Months Results.” Press release. Insurance Information Institute, 

New York, NY (December 19). www.iii.org/media/industry/financials/2007firstninemonths/. 

Holland, Gregg J., and Peter Webster. Forthcoming. “Heightened Tropical Cyclone Activity in the North 

Atlantic: Natural Variability or Climate Trend?” Philosophical Transactions of the Royal Society.

Holtz-Eakin, Douglas. 2005. Statement before the House Committee on the Budget. Congressional Budget 

Office, Washington, DC (October 6; later published as “Macroeconomic and Budgetary Effects of 

Hurricanes Katrina and Rita”). 

Intergovernmental Panel on Climate Change. 2007. Climate Change 2007: The Physical Science Basis: 

Summary for Policymakers. Geneva (February 5). www.ipcc.ch/SPM2feb07.pdf. 

Kunreuther, Howard. 2006. “Has the Time Come for Comprehensive Natural Disaster Insurance?” In On 

Risk and Disaster: Lessons from Hurricane Katrina, eds. Ronald J. Daniels, Donald F. Kettl, and 

Howard Kunreuther. Philadelphia, PA: University of Pennsylvania Press. 

Kunreuther, Howard C., and Erwann O. Michel-Kerjan. 2007. “Climate Change, Insurability of LargeScale Disasters and the Emerging Liability Challenge.” Working Paper 12821. National Bureau of 

Economic Research, Cambridge, MA (January). 

Kunreuther, Howard, and Mark Pauly. 2006. “Rules Rather Than Discretion: Lessons from Hurricane 

Katrina.” Journal of Risk and Uncertainty 33 (September): 101-16. 

Lane, Morton N., and Roger G. Beckwith. 2007. “A Half Term Report for 2007 Securitizations.” Lane 

Financial, Wilmette, IL. 

Lewis, Christopher M., and Kevin C. Murdock. 1996. “The Role of Government Contracts in Discretionary 

Reinsurance Markets for Natural Disasters.” Journal of Risk and Insurance 63(4): 567-97. 

___________. 1999. “Alternative Means of Redistributing Catastrophic Risk in a National RiskManagement System.” In The Financing of Catastrophic Risk, ed. Kenneth A. Froot. Chicago, IL: 

University of Chicago Press. 

Litan, Robert E. 1990. “Earthquake! Planning and Paying for the ‘Big One.’” Brookings Review (Fall): 42-

48. 

___________. 2006. “Sharing and Reducing the Financial Risks of Future ‘Mega-Catastrophes.’” Issues in 

Economic Policy 4. Washington, DC: Brookings Institution (March). 

www.brookings.edu/~/media/Files/rc/papers/2006/03business_litan02/200603_iiep_litan.pdf 

Litan, Robert E., and Phil O’Connor. 2008. “The Consumer Benefits of an Optional Federal Charter: The 

Case of Auto Insurance.” Paper presented at American Enterprise Institute Conference on the Future of 

Insurance Regulation, Washington, DC (July 9). www.aei.org/docLib/20080707_LitanO'Connor.pdf. 

Mann, Michael E., and Kerry A. Emanuel. 2006. “Atlantic Hurricane Trends Linked to Climate Change.” 

EOS (American Geophysical Union) 87(24) (June 13): 233-44. 

McQueen, M. P. 2008. “Florida’s Allstate Fight Intensifies.” The Wall Street Journal (January 17): D4. 

Michel-Kerjan, Erwann, and Frederic Morlaye. 2008. “Extreme Events, Global Warming, and InsuranceLinked Securities: How to Trigger the ‘Tipping.’” Geneva Papers 33: 153-76. 

Morgan Stanley. 2001. “An Update on WTC—Related Issues.” New York, NY (December 12). 

Musulin, Rade. 1997. “Can Our Children Afford ‘Affordable’ Insurance?” Emphasis 2: 2-5. 

National Council on Compensation Insurance. 2006. “Comments to the President’s Working Group on 

Financial Markets on the Long-Term Availability and Affordability of Terrorism Risk Insurance.” 

Boca Raton, FL (April). www.ncci.com/ncci/media/pdf/Terrorism_NCCI_Presidents_Group.pdf. 

Nordhaus, William D. 2006. “The Economics of Hurricanes in the United States.” Working Paper 12813. 

National Bureau of Economic Research, Cambridge, MA (December). 

Nyber, Jahan, et al. 2007. “Low Atlantic Hurricane Activity in the 1970s and 1980s Compared to the Past 

270 Years.” Nature 444 (June 7): 698-701. 

Pilke, R. A., Jr., et al. 2005. “Hurricanes and Global Warming.” Bulletin of the American Meteorological 

Society 86(11): 1571-75. 
38 

PriceWaterhouseCoopers. 2007. “California Earthquake Authority, Report on Audits of Financial 

Statements for the Years Ended December 31, 2006, and 2005.” New York, NY. 

Priest, George. 1996. “The Government, the Market, and the Problem of Catastrophic Loss.” Journal of 

Risk and Uncertainty 12(2/3): 219-37. 

Real Estate Roundtable. 2002a. “Survey Confirms Economic Toll of Terrorism Insurance Gap: Over $10 

Billion of Real Estate Projects Affected Across the U.S.” Washington, DC (September 4). 

___________. 2002b. “Terror Insurance Drag on Real Estate Still Climbing: Over $15.5 Billion of Projects 

in 17 States Now Affected.” Washington, DC (September 19). 

Risk Management Solutions. 2006. “U.S. and Caribbean Hurricane Activity Rates: The New RMS 

Medium-Term Perspective and Implications for Industry Loss.” Newark, CA (March). 

www.rms.com/publications/60huactivityrates_whitepaper.pdf. 

Rust, Edward B., Jr., and Kerry Killinger. 2007. “The Financial Services Roundtable Blue Ribbon 

Commission on Mega-Catastrophes: A Call to Action.” Financial Services Roundtable, Washington, 

DC. www.fsround.org/media/pdfs/FINAlmegacat4.pdf. 

Shadow Financial Regulatory Committee. 2002. “A Proposed Federal Backstop for Terrorism Insurance 

and Reinsurance.” Washington, DC (September 23). 

www.aei.org/publications/pubID.14325/pub_detail.asp 

___________. 2006. “Federal Preemption for Financial Services Firms.” Washington, DC (May 8). 

www.aei.org/research/shadow/publications/pubID.24338,projectID.15/pub_detail.asp 

Smetters, Kent. 2004. “Insuring Against Terrorism: The Policy Challenge.” Brookings-Wharton Papers on 

Financial Services 2004: 139-82. 

State Board of Administration of Florida. 2006. Florida Hurricane Catastrophe Fund, Fiscal Years 2005-

2006 Annual Report. Tallahassee, FL. www.sbafla.com/fhcf/pdf/reports/2005_2006.pdf. 

___________. 2008. “Florida Hurricane Catastrophe Fund.” PowerPoint presentation to the Reinsurance 

Association of America. Tallahassee, FL (February 12). 

www.sbafla.com/fhcf/pdf/announcements/RAA%202-12-08.pdf. 

Stiglitz, Joseph E. 2006. “Panel Discussion: What Is the Appropriate Role of the Federal Government in the 

Private Market for Credit and Insurance? What Is the Outlook?” Federal Reserve Bank of St. Louis 

Review 88(4): 392-95. 

U.S. Department of the Treasury. 2008. Blueprint for a Modernized Financial Regulatory Structure. 

Washington, DC (March). www.treas.gov/press/releases/reports/Blueprint.pdf. 

Vecchi, Gabriel A., and Brian J. Soden. 2007. “Increased Tropical Atlantic Wind Shear in Model 

Projections of Global Warming.” Geophysical Research Letters 34 (April 18) L08702, 

doi:10.1029/2006GL028905. 

Wallison, Peter J. 2006. “Groundhog Day: Reliving Deregulation Debates.” Financial Services Outlook. 

Washington, DC: American Enterprise Institute (October). 

www.aei.org/docLib/20061019_200610FSOg.pdf 

Webel, Baird. 2007. “Insurance Regulation: Optional Federal Charter Legislation.” CRS Report for 

Congress RL34286. Washington, DC: Congressional Research Service (December 14). 

___________. 2008. “Insurance Regulation: Issues, Background, and Current Legislation.” CRS Report for 

Congress RL32789. Washington, DC: Congressional Research Service (April 23). 

Webster, P. J., et al. 2005. “Changes in Tropical Cyclone Number, Duration, and Intensity in a Warming 

Environment.” Science 309 (September 16): 1844-46. 

Wharton Risk Management and Decision Processes Center (in conjuction with Georgia State University 

and the Insurance Information Institute). 2008. Managing Large-Scale Risks in a New Era of 

Catastrophes. Philadelphia, PA: Wharton School, University of Pennsylvania (March). 

www.opim.wharton.upenn.edu/risk/library/wharton_LargeScaleRisks_FullReport_2008.pdf. 

Wilson, James Q. 2007. “A Real Insurance Fraud.” American Enterprise Institute, Washington, DC 

(November 28). www.aei.org/publication27158.