Natural catastrophes have a low probability of occurrence, but when they do occur the consequences can be of high severity. Insurance companies face catastrophe risk associated with their provision of property-casualty insurance. Major reinsurers are insurance companies with global insurance and reinsurance operations. Insurers and reinsurers are subject to “moral hazard,” which is “the incentive created by insurance that induces those insured to undertake greater risk than if they were uninsured, because the negative consequences are passed through to the insurer.” Therefore, reinsurers have incentives to limit the possibility that ceding insurers take actions that would create negative consequences for the reinsurer. Indemnity reinsurance contracts have the potential to increase a reinsurer’s risk exposure to the extent that the reinsurer might be unaware of the underwriting and claims settlement practices of the ceding insurer. Traditional reinsurance is generally indemnity-based and tailored to the needs of the ceding company because traditional reinsurance depends, in part, on well-developed contractual and business relationships between insurers and reinsurers. When reinsurance coverage is not indemnity- based, the ceding insurer is exposed to basis risk—the risk that there may be a difference between the payment received from the reinsurance coverage and the actual accrued claims of the ceding insurance company. Property-casualty reinsurance agreements are typically single-event, excess of loss contracts. A single-event contract means that the reinsurer’s obligations are specific to an event, such as a hurricane in a contractually specified geographic area. Excess of loss means that the reinsurer makes payments that are based on a contractually specified share of claims in excess of a minimum amount, subject to a maximum claim payment. The financial industry has developed instruments through which primary financial products, such as lending or insurance, can be funded in the capital markets. Lenders and insurers continue to provide the primary products to the customers, but these financial instruments allow the funding of the products to be “unbundled” from the lending and insurance business; instead, the funding comes from securities sold to capital market investors. This process, called securitization, can give insurers access to the large financial resources of the capital markets. With respect to funding catastrophe risk in property-casualty insurance, the risk of investing is tied to the potential occurrence of a specified catastrophic event and to the quality of underwriting by insurers and reinsurers. In evaluating risk, capital market investors face the issue of moral hazard because in the absence of well-developed contractual and business relationships with primary market insurers, capital market investors might be unable to monitor the primary insurance company’s underwriting and claims settlement practices that can act to increase risk. Nonindemnity- based coverage is a means to limit moral hazard for the investor by tying payment to industry loss indexes, parametric measures, and models of claims payments rather than actual claims that could be affected by lax underwriting standards or lax settlement of claims by the ceding insurer. However, such coverage introduces basis risk for the sponsoring insurance company. Insurance companies are not regulated at the federal level but are to comply with the laws of the states in which they operate. The insurance regulators of the 50 states, the District of Columbia, and U.S. territories have created NAIC to coordinate regulation of multistate insurers. NAIC serves as a forum for the development of uniform policy, and its committees develop model laws and regulations governing the U.S. insurance industry. Although not required to do so, most states either adopt model laws or modify them to meet their specific needs and conditions. NAIC also has established statutory accounting standards, which are intended for use by insurance departments, insurers, and auditors when state statutes or regulations are silent. If not in conflict with state statutes and regulation, or in cases when the state statutes are silent, statutory accounting standards promulgated by NAIC are intended to apply. In addition to statutory accounting standards, insurers use GAAP, which are promulgated by FASB and are designed to meet the varying needs of both insurance and noninsurance companies. Although NAIC’s statutory accounting standards use the framework established by GAAP, GAAP stresses the measurement of earnings from period to period, while NAIC’s standards stress the measurement of ability to pay claims in the future. NAIC has also developed the Risk-Based Capital for Insurers Model Act, adopted in some form in all states, which imposes automatic requirements on insurers to file plans of action when their capital falls below minimum standards. Natural catastrophes are infrequent events that can cause severe financial losses. Traditional reinsurance helps insurance companies respond to severe losses by limiting their individual liability on specific risks and thereby increases individual insurers’ capacity. However, insurance companies have been faced with higher reinsurance premiums for certain coverage following significant past natural catastrophes. Higher costs of reinsurance helped spur the development of risk-linked securities as an alternative to traditional reinsurance. Although natural catastrophes occur relatively infrequently compared with other insured events, they can affect large numbers of persons as well as their property. The U.S. property and casualty insurance industry has paid, on average, $9.7 billion in catastrophe-related claims per year from 1989 through 2001, and the amount of claims paid can be highly variable. More than 68 million Americans now live in hurricane-vulnerable coastal areas. Eighty percent of Californians live near active faults. When natural disasters occur they cause damage and destruction, which may or may not be covered by insurance. The four most costly types of insured catastrophic perils in the United States are earthquakes, hurricanes, tornadoes, and hailstorms, although earthquakes and hurricanes pose the most significant catastrophe risk in insurance markets. Figure 1 shows the combined relative risk of these hazards across the United States. In August 1992, Hurricane Andrew swept ashore in Florida south of Miami and at the time set a new record for insured losses. As shown in figure 2, estimated losses from Andrew were about $30 billion, of which $15.5 billion was insured. Payments of claims stemming from Andrew reduced the capital of affected insurance companies and sharply reduced their capacity to issue new policies. Some of Florida’s largest homeowner insurance companies had to be rescued by their parent companies and others had to tap their surpluses to pay claims. Eleven property-casualty insurance companies went into bankruptcy. In January 1994, an earthquake occurred about 20 miles northwest of downtown Los Angeles in the Northridge area of the San Fernando Valley. Also shown in figure 2, estimated losses from the Northridge earthquake were about $30 billion, of which approximately $12.5 billion was insured. Earthquake insurance coverage availability declined precipitously after the Northridge earthquake. Losses from the Kobe, Japan, earthquake and the September 11, 2001, terrorist attack on the World Trade Center also are included in figure 2 to illustrate the global nature of the insurance capacity problem and to provide perspective on the size of losses. For many individuals and organizations, insurance is the most practical and effective way of handling a major risk such as a natural catastrophe. By obtaining insurance, individuals and organizations spread risk so that no single entity receives a financial burden beyond its ability to pay. But catastrophic loss presents special problems for insurers in that large numbers of those insured incur losses at the same time. Reinsurance helps insurance companies underwrite large risks, limit liability on specific risks, increase capacity, and share liability when claims overwhelm the primary insurer’s resources. In reinsurance transactions, one or more insurers agree, for a premium, to indemnify another insurer against all or part of the loss that an insurer may sustain under its policies. Figure 3 illustrates traditional insurance, reinsurance, and retrocessional transactions. Reinsurance is a global business. According to RAA, almost half of all U.S. reinsurance premiums were paid to foreign reinsurance companies. Catastrophe reinsurance has experienced cycles in prices, both nationally and in specific geographic areas. Figure 4 presents a national reinsurance price index since 1989, which shows that, overall, reinsurance prices increased both before and after Hurricane Andrew and decreased after the Northridge earthquake. The price trend presented in figure 4 does not reflect the situations specific to Florida and California, where insurers refused to continue writing catastrophe coverage. In 1993, the Florida state legislature responded by establishing the Florida Hurricane Catastrophe Fund to provide reinsurance for insurance companies operating in Florida. Also, the Northridge earthquake raised serious questions about whether insurers could pay earthquake claims for any major earthquake. In 1994, insurers representing about 93 percent of the homeowners insurance market in California severely restricted or refused to write new homeowners policies. In 1996, the California state legislature responded by establishing the California Earthquake Authority (CEA) to sell earthquake insurance to homeowners and renters. Appendix III more fully discusses the mechanisms established by Florida and California to deal with the risks posed by such catastrophes. In one comprehensive study analyzing the pricing of U.S. catastrophe reinsurance, the authors concluded that a catastrophic event, such as a hurricane, reduced capital available to cover nonhurricane catastrophe reinsurance, thereby affecting reinsurance prices. This finding is consistent with the “bundled” nature of capital investment in traditional reinsurance (i.e., capital investors face both the risks associated with company management and the various perils covered by the insurance company). Therefore, the finding suggests that price and availability swings for catastrophe reinsurance covering one peril are affected by catastrophes involving all other perils. Given the cyclic nature of the reinsurance market, investors have incentives to look for alternative capital sources. Hurricane Andrew and the Northridge earthquake provided an impetus for insurance companies and others to find different ways of raising capital to help cover catastrophic risk and helped spur the development of risk-linked securities and other alternatives to traditional reinsurance.