While insurers assume some risk when they write policies, they employ various strategies to manage overall risks so that they may earn profits, limit potential financial exposures, and build capacity—generally, equity capital that would be used to pay claims. For example, they charge premiums for the coverage provided and establish underwriting standards such as (1) refusing coverage to customers who may represent unacceptable levels of risk or (2) limiting coverage offered in particular areas. Establishing underwriting standards also allows insurers to minimize the adverse consequences of “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 to the insurer.” To manage potential financial exposures and also enhance their capacity, insurance companies may also purchase reinsurance. Reinsurers generally cover specific portions of the risk the primary insurer carries. For example, a reinsurance contract could cover 50 percent of all claims associated with a single event up to $100 million from a hurricane over a specified time period in a specified geographic area. This type of contract, which specifies payments based on the insurer’s actual incurred claims, is called indemnity coverage. In turn, reinsurers act to limit their risks and moral hazard on the part of primary insurers by charging premiums, establishing underwriting standards, and maintaining close business relationships with insurers that generally have been maintained over a long period. In contrast to other types of insurance risks, catastrophic risk poses unique challenges for primary insurers and reinsurers. To establish their exposures and price insurance and reinsurance premiums, insurance companies need to be able to predict with some reliability the frequency and severity of insured losses. For example, the incidence of most property insurance claims, such as automobile insurance claims, is fairly predictable, and losses generally do not occur to large numbers of policyholders at the same time. However, catastrophes are infrequent events that may affect many households, businesses, and public infrastructure across large areas and thereby result in substantial losses that can impair insurer capital levels. Given the higher levels of capital that reinsurers must hold to address major catastrophic events (for example, hurricanes or earthquakes with expected annual occurrences of no more than 1 percent), reinsurers generally charge higher premiums and restrict coverage for such events. Further, as previously noted, in the wake of catastrophic events reinsurers and insurers may sharply increase premiums and significantly restrict coverage. The reinsurance market disruptions associated with the Andrew and Northridge catastrophes provided an impetus for insurance companies and others to find different ways of raising capital to help cover catastrophic risk. The mid-1990s saw the development of catastrophe bonds, a capital market alternative to reinsurance (in the sense that other parties assume some of the insurer’s risks). Catastrophe bonds generally (1) are sold to qualified institutional investors such as pension or mutual funds; (2) provide coverage for relatively severe types of events such as hurricanes with an annual expected occurrence of 1 percent; and (3) pay relatively high rates of interest and have less than investment-grade ratings (because in some cases, investors may risk all of their principal if a specified catastrophe occurs). Catastrophe bonds also potentially expose investors to moral hazard because, absent the business relationships that typically characterize primary insurers and reinsurers, investors may lack information on insurer underwriting standards or the claims payment process. That is, an insurer that has issued a catastrophe bond may have incentives to lower its underwriting standards and offer coverage to riskier insureds because investors have less ability to monitor the insurers’ risk- taking than would a reinsurer with whom the insurer has done business for years. To minimize moral hazard, most catastrophe bonds are triggered by objective measures (also referred to as “nonindemnity” based coverage) such as wind speed during a hurricane or ground movement during an earthquake rather than insurer loss experience (indemnity-based). However, nonindemnity based coverage exposes insurers to “basis risk,” which is the risk that the proceeds from the catastrophe bond will not be related to the insurer’s loss experience. For example, if a hurricane with a specified wind speed occurs, the insurer would automatically receive the proceeds of the catastrophe bond, which may be either higher or lower than its actual losses. See appendix III for additional information on the structure of catastrophe bonds. Because insurance markets have been severely disrupted by catastrophic events, state and federal governments also have taken a variety of steps to enhance the capacity of insurers to address catastrophic risk. For example, Florida established FHCF to address hurricane risk, and California established CEA to address earthquake risk. Although these programs cover different risks and use different strategies as described in this report, they share a similar goal in ensuring that insurers can withstand catastrophic events and continue to make coverage available. Similarly, Congress enacted TRIA in 2002 to ensure the continued availability of terrorism insurance subsequent to the September 11 attacks. TRIA was designed as a temporary program that would remain in place until the end of 2005, when it was expected that insurers and reinsurers would have had time to establish a market for terrorism insurance. However, Congress is currently considering extending the 2005 deadline due to concerns about whether insurers will offer terrorism insurance after the act’s expiration. See appendix II for more information about TRIA. Despite steps taken in recent years to strengthen insurer capacity for catastrophic risk, the industry has not yet been tested by a major catastrophic event or series of events. Overall, insurers increased their equity capital—financial resources available to cover catastrophic and other types of claims that exceed premium and investment income—from 1990 through 2003, but this measure of capacity has limitations, and therefore, the extent to which capacity has increased is not clear. For example, insurers’ exposures in risk-prone coastal and other areas have also increased over time, which could partially offset the increase in equity capital. However, state governments and insurers have taken other steps to enhance industry capacity for catastrophic risk such as establishing state authorities, implementing stronger building codes, and reportedly implementing stronger underwriting standards. Several of these changes appear to have facilitated the industry’s ability to withstand the 2004 hurricanes better than the impacts of Hurricane Andrew in 1992, but a more severe catastrophe or catastrophes could have significant financial consequences for insurers and their customers. The insurance industry’s equity capital levels commonly are used to assess capacity to cover catastrophic risk. As shown in figure 1, the Insurance Services Office, Inc. (ISO) found that from 1990 through 2003 industry equity capital increased from $194.8 billion to $347 billion on an inflation- adjusted basis. After steadily increasing for 18 years, insurers’ equity capital actually declined from 1999 to 2002 before rebounding in 2003. Capital levels declined for a variety of reasons including a series of natural catastrophes in the late 1990s, declining stock prices that particularly affected the investments of large European reinsurers, and the losses associated with the September 11 attacks. Insurer capital increased in 2003 for several reasons that include lower losses associated with natural catastrophes. According to information from ISO, the industry’s capital level did not decline in 2004 even though insurers experienced significant losses associated with the 2004 hurricane season. Although insurers’ equity capital has generally increased over time, it is difficult to determine whether the growth in insurer equity capital has resulted in a material increase in the industry’s relative capacity to pay claims. Insurers may also face significant financial exposure in areas prone to natural catastrophes such as the southeastern United States, which could partially offset the increase in insurer capital over the years. However, individual insurers do not make publicly available specific information about the extent to which they write policies in risk-prone areas, the terms offered on these policies, or the level of reinsurance that they purchase to help cover these risks, which complicates assessments of insurer capacity. We have also identified other limitations to using equity capital as a measure of insurance industry capacity. First, in any given catastrophe, only a portion of the industry’s capital (and its other resources, such as catastrophe reinsurance) is available to pay disaster claims because the insurance industry as a whole does not pay catastrophe claims. Instead, individual insurance companies pay claims on the basis of the damage that particular catastrophes inflict on the properties they insure. An insurer writing policies only in one state would not have to pay any claims if a catastrophe occurred in another state. Second, only a portion of equity capital would be available to cover catastrophe claims because the capital may also be needed to pay claims from all of the other types of risk that insurers have assumed should the experience of those risks prove unfavorable. To better understand insurers’ capacity to address natural catastrophe risks, we contacted two rating agencies that monitor the insurance industry. According to one rating agency official, most insurance companies the agency rated in 2003 were financially secure. The rating agency determines the financial strength of insurance companies and their ability to meet ongoing obligations to policyholders by analyzing companies’ balance sheets, operating performance, and business profiles. According to officials from one rating agency, when establishing an insurance company’s rating, the agency considers an insurer secure if the company would have enough capital after a catastrophic event to maintain the same rating. In other words, to maintain a secure rating, insurers must demonstrate that they are able to absorb losses from a hurricane with a 1 percent chance of occurring annually or an earthquake with a .4 percent chance of occurring annually. Officials from one rating agency told us that of the 1,058 ratings it issued in 2003, 904 companies obtained secure ratings, meaning that they would be able to meet ongoing obligations to policyholders and withstand adverse economic conditions, such as major catastrophes, over a long period of time. Conversely, 164 insurance companies obtained vulnerable ratings, meaning that they might have only a current ability to pay claims or not be able to meet the current obligations of policyholders at all.