Financing Catastrophe Risk: Capital Market Solutions
January 1999
Executive Summary
Hurricane Hugo in 1989, Hurricane Andrew in 1992, and the Northridge earthquake in 1994 – the three most costly catastrophes in U.S. history – highlighted the insurance industry's exposure to unprecedented catastrophe losses.[1]1. ISO's Property Claim Services unit defines catastrophes as events that cause $25 million or more in direct insured losses to property and that affect a significant number of insureds and insurers. For this analysis, ISO adjusted the direct property losses for each catastrophic event to 1998 price levels using the Consumer Price Index. See Appendix A for definitions of other terms used in this study. More recently, sophisticated computer modeling of potential catastrophes has shown that the industry and society already face the risk of a hurricane or earthquake that could cause $75 billion, $100 billion, or more in insured property losses. Demographic projections indicate that, because of population growth in areas exposed to hurricanes and earthquakes, insurers' exposure to catastrophe losses will continue to increase.
The 1996 ISO study Managing Catastrophe Risk showed that, even taking reinsurance into account, a megacatastrophe at that time might have caused more than one-third of all insurers to become insolvent, leaving perhaps $50 billion of unpaid claims to be covered by guaranty funds, surviving insurers, and policyholders.[2]2. ISO is now updating its 1996 study to incorporate more current exposure data and newer catastrophe-modeling technology.
Recognizing the limits of insurers' and reinsurers' ability to finance catastrophe risk on their own – and the pressing need for a solution – some insurers and financial engineers have devised new ways of packaging catastrophe risk as securities that insurers and investors can buy and sell in the capital markets. That process, called securitization, enables insurers and reinsurers to share catastrophe risk with investors. This study:
- sketches the dimensions of property/casualty insurers' catastrophe exposure
- explains the different ways of securitizing catastrophe risk developed to date
- provides examples of transactions securitizing catastrophe risk
- shows how insurers and investors can evaluate the benefits of securitizing risk
- identifies changes in regulation, accounting practices, and taxation that could facilitate securitization
Dimensions of Catastrophe Risk
In 1992, when Hurricanes Andrew and Iniki struck, a record sixty-three property/casualty insurers became insolvent. Fifteen of those insolvencies were directly attributable to the losses those storms caused in Florida, Louisiana, and Hawaii. In the nine years and ten months from January 1989 to October 1998, the U.S. property/casualty industry suffered an inflation-adjusted $98.0 billion in catastrophe losses – 101.2% more than the inflation-adjusted $48.7 billion in catastrophe losses during the 39 years from January 1950 to December 1988.
A 1995 study by ISO and Risk Management Solutions, Inc. (RMS) for the Natural Disaster Coalition showed that, based on the amount of insured property at that time, some potential hurricanes could have caused more than $75 billion in insured property losses.[3]3. Risk Management Solutions, Inc., and other catastrophe modelers have updated and enhanced their proprietary models since 1995, and the amount of insured exposure and other relevant factors have changed since then. Repeating the 1995 study, but with more current technology and data, would lead to different results. A magnitude 8.5 earthquake in the New Madrid area of the central United States could have caused more than $115 billion in insured property losses.[4]4. The New Madrid area includes parts of Alabama, Arkansas, Georgia, Illinois, Indiana, Iowa, Kentucky, Missouri, Mississippi, Ohio, and Tennessee.
The population in parts of the United States exposed to hurricanes and earthquakes rose 24.5% from 1970 to 1990, as the population of other areas of the country rose 20.7%. And, based on demographic projections provided by NPA Data Services, Inc., the population of areas exposed to catastrophes will rise another 36.6% from 1990 to 2025. [5]5. NPA Data Services, Inc., established in 1985, is an economic research, forecasting, and data development firm located in Washington, D.C. The company specializes in developing and maintaining geographic databases for counties, metropolitan statistical areas, states, economic areas, regions, and the United States as a whole. Those databases contain consistent historical data and detailed projections of economic, demographic, construction, and real estate variables. Exposure growth in those areas increases potential catastrophe losses.
Both the upward trend in historical catastrophe losses and insurers' potential losses as indicated by catastrophe models have led rating agencies, such as A.M. Best and Standard & Poor's, to pay increased attention to how insurers manage their catastrophe risk. For example, A.M. Best considers an insurer's probable maximum losses from hurricanes and earthquakes when assessing the adequacy of the insurer's capital. And Standard & Poor's Insurance Ratings has built a model that it uses to assess individual insurers' ability to withstand catastrophe losses.
Emergence of Capital Market Solutions
Only two sources may be able to provide the capacity necessary to finance very large catastrophe risks – the federal government, with its power to tax, and the $26 trillion capital market. Government has been reluctant to take on additional catastrophe risk. But innovative insurers and financial engineers have developed ways of securitizing catastrophe risk to attract additional capital from investors. To date, the principal forms of securitization include catastrophe or "act of God" bonds, contingent surplus notes, exchange-traded catastrophe options, and catastrophe equity puts.[6]6. Some insurers have also used swaps to spread their catastrophe risk. Swaps are contracts whereby parties agree to exchange assets or cash flows. In a catastrophe swap, an insurer agrees to make periodic payments to another party, and the other party agrees to make payments to the insurer which are based on a measure of catastrophe losses. Through September 1998, investors had committed at least $2.7 billion to those vehicles for securitizing insurance risk.
Catastrophe Bonds
Catastrophe bonds are corporate bonds with special language that requires the bondholders to forgive or defer some or all payments of interest or principal if actual catastrophe losses surpass a specified amount, or trigger. When that happens, an insurer or reinsurer that issued catastrophe bonds can pay claims with the funds that would otherwise have gone to the bondholders. And, to the extent that bondholders forgive repayment of principal, the insurer or reinsurer can write down its liability for the bonds, boosting surplus and potentially staving off insolvency.
At least ten insurers have used catastrophe bonds to obtain protection against losses caused by hurricanes, earthquakes, or other perils. For example, in 1997, a special-purpose reinsurer, Residential Re, sold $477 million in catastrophe bonds and used the proceeds to provide reinsurance protection to the United Services Automobile Association (USAA). That same year, another special-purpose reinsurer, SR Earthquake Fund, Ltd., issued $137 million in catastrophe bonds and provided reinsurance for California earthquake losses to Swiss Reinsurance Company. In 1998, the special-purpose reinsurer Trinity Re, Ltd., issued $83.6 million in catastrophe bonds and sold reinsurance to Centre Solutions (Bermuda) Ltd.[7] Later that year, Residential Re sold another $450 million in catastrophe bonds and again used the proceeds to provide reinsurance to USAA.
Contingent Surplus Notes
Contingent surplus notes (CSNs) are surplus notes that an insurer has purchased the right to issue in the future to investors at preset terms in exchange for cash or liquid assets.[8]8. Surplus notes are a highly subordinated form of debt. In general, an insurer needs a regulator's approval to issue surplus notes and to make related payments of interest and principal. The right to issue the surplus notes may be contingent on specified events taking place, or it may be unconditional. Under Statutory Accounting Practices, issuing surplus notes adds to an insurer's net worth or surplus. Insurers can use the proceeds from issuing surplus notes to pay catastrophe losses or for any other purpose. In 1995, Nationwide Mutual Insurance Company used contingent surplus notes to obtain $400 million in standby financing.
Exchange-Traded Catastrophe Options
As the glossary in Appendix A states, call options are, in general, securities that give the buyer the right, but not the obligation, to buy a certain amount of a specified asset from the seller of the option for a predetermined price and for a specified period. Typically, exchanges act as intermediaries, and buyers and sellers are unaware of each other's identity. Exchange-traded catastrophe options are standardized contracts that give the purchaser the right to a cash payment if a specified index of catastrophe losses for a specific period reaches a specified level – the strike price. An insurer that wants to use this form of securitization to hedge catastrophe risk can buy catastrophe options from investors. If catastrophe losses cause the index used in settling a catastrophe option to equal or exceed the strike price specified in the option, the investors must pay the insurer an amount based on the terms of the contract. Insurers and investors can trade catastrophe options on the Chicago Board of Trade and the Bermuda Commodities Exchange.
Catastrophe Equity Puts
In general, put options are securities that give the buyer the right, but not the obligation, to sell a certain amount of a specified asset to the seller of the option for a predetermined price and for a specified period. Catastrophe equity puts are put options that enable stock insurers to sell shares of their stock to investors at prenegotiated prices when catastrophe losses exceed the levels specified in the options. Catastrophe equity puts thus provide insurers with access to additional equity in the wake of catastrophe losses. In 1996, RLI Corporation bought catastrophe equity puts giving it $50 million in contingent financing. In 1997, LaSalle Re and Horace Mann Educators Corporation bought catastrophe equity puts giving each $100 million in contingent financing.
Advantages and Disadvantages
Each approach to securitizing catastrophe risk has unique advantages and disadvantages. For example, an individual insurer can use the customized approaches to securitizing catastrophe risk – catastrophe bonds, contingent surplus notes, and catastrophe equity puts – to obtain financing tailored to meet its unique needs. But an insurer may encounter high transaction costs when using the customized approaches. Standardized, exchange-traded catastrophe options may offer lower transaction costs. But an insurer using index-based catastrophe options faces basis risk – the risk that the options will be a poor hedge against catastrophe losses because the index used in the options does not correlate with the insurer's loss experience.[9]9. Generally, basis risk is the risk that the value of a derivative security, such as an option or a future, does not move precisely with the value of the underlying hedged security. For an insurer using catastrophe options, basis risk is the risk that the value of the catastrophe options will not move precisely with the insurer's catastrophe experience. Insurers using catastrophe bonds with triggers based on catastrophe loss indices also face basis risk.
Through June 1998, investors had committed at least $2.7 billion to catastrophe bonds, contingent surplus notes, catastrophe options, and catastrophe equity puts. Though that amount is small compared with potential catastrophe losses, access to the capital market may one day play a significant role in many insurers' strategies for financing risk.
Illustrative Evaluation of Securitization
In the long run, securitizing catastrophe risk will succeed only if:
- Insurers find that securitization is a cost-effective means of spreading their risk.
- Investors find that securitizing catastrophe risk enhances the performance of their portfolios.
The Insurers' Perspective
An insurer can use computer models and information about the business the insurer has written to determine its potential catastrophe losses and how much capital the insurer would need to finance that risk on its own. The insurer could then compare the cost of using its own capital with the cost of reinsurance and the cost of securitizing risk. And, with optimization algorithms, the insurer could determine the combination of capital, reinsurance, and securitization that minimizes its overall cost of financing catastrophe risk.
This study shows how each of three different insurers might minimize its cost of financing catastrophe risk by using a combination of the insurer's own capital, excess-of-loss catastrophe reinsurance, and hypothetical catastrophe options resembling those traded on the Bermuda Commodities Exchange.
For each of the three insurers, the optimal amount and mix of risk financing depends on the relative costs of capital, reinsurance, and catastrophe options, and on each insurer's unique characteristics. The amount of business each insurer writes, the geographic distribution of that business, and other factors determine the variance in the insurer's losses. That variance and the insurer's tolerance for risk affect the overall amount of risk financing that the insurer should have.
How effectively an insurer can use catastrophe options to hedge its catastrophe risk depends on how the insurer's loss experience compares with the catastrophe index used in settling the options. The absence of a high correlation between an insurer's loss experience and the performance of the catastrophe index – basis risk – can reduce the effectiveness of the options as a hedge against catastrophe losses.
Payouts for the options in the illustrative analysis depend on a catastrophe index based on aggregate experience for a combination of fifty insurers.[10]10. In applying this analytical framework to actual risk-financing problems, ISO could modify this analysis to incorporate other catastrophe indices, other ways of securitizing risk, or other forms of reinsurance. The more an insurer's exposure distribution resembles that underlying the index, the more likely it is that the options will provide funds when the insurer needs them to cover catastrophe losses. That is, the more an insurer's exposures resemble those underlying the catastrophe index, the lower the insurer's basis risk. Thus, the geographic distribution of each insurer's book of business affects how effectively it can use catastrophe options and what role options should play in the insurer's overall risk-financing strategy.
Insurer #1 is a medium-sized national insurer with an exposure distribution resembling that of the fifty insurers included in the catastrophe index. Insurer #2 is a large national insurer with an exposure distribution less similar than that of Insurer #1 to the exposure distribution of the fifty insurers in the index. Insurer #3 is a regional insurer with an exposure distribution notably different from that of the fifty insurers.[11]11. ISO adjusted the data to mask the identities of the three insurers in this analysis. The best combinations of risk-financing alternatives for those three insurers are:
- Insurer #1 can minimize its cost of financing catastrophe risk by using $243 million of its own capital, plus $15 million of reinsurance in excess of a $126 million retention and a package of nearly 340,000 options with strike prices ranging from 5 to 100. That combination cuts the insurer's cost of financing catastrophe risk by 16.1% compared with relying solely on the insurer's own capital.
- Insurer #2 can minimize its cost of financing catastrophe risk by using $718 million of its own capital, plus $35 million of reinsurance in excess of a $460 million retention and a package of nearly 1.49 million options with strike prices ranging from 5 to 100. That combination cuts the insurer's cost of financing catastrophe risk by 8.6% compared with relying solely on the insurer's own capital.
- Insurer #3 can minimize its cost of financing catastrophe risk by using $65 million of its own capital, plus $105 million of reinsurance in excess of a $54 million retention and 6,300 options with strike prices ranging from 25 to 40. That combination cuts the insurer's cost of financing catastrophe risk by 20.0% compared with relying solely on the insurer's own capital.
The differences in the best combinations of capital, reinsurance, and catastrophe options for the three insurers highlight the importance of considering an individual insurer's unique characteristics when selecting a risk-financing strategy. For example, because of the differences between the exposure distribution for Insurer #3 and the exposure distribution underlying the index in the illustrative catastrophe options, the options are a poor hedge for Insurer #3's catastrophe risk. So, purchasing those options would play a relatively minor role in the best risk-financing strategy for Insurer #3.
The Investors' Perspective
This study also shows how investors could use catastrophe models and exposure data to determine the rates of return they could expect from selling catastrophe options to insurers. With models and data, an investor can determine the probability that the actual value for a catastrophe index will surpass the strike price for a given catastrophe option. With knowledge of that probability and information about the prices for catastrophe options, an investor can calculate the rate of return he or she could expect from selling catastrophe options to insurers.
The probability that the actual value for a catastrophe index will equal or exceed the strike price for a catastrophe option also provides a measure of the risk taken by investors selling the option. With knowledge of that probability, investors can identify comparably risky investments and then weigh their rates of return against the rates of return on catastrophe options.
Catastrophe options, catastrophe bonds, and other forms of securitization also offer investors a new means of reducing portfolio risk through diversification. The results of investments securitizing catastrophe risk depend on catastrophe loss experience, while bankruptcy and default rates for most other investments generally depend on economic conditions. Therefore, the results of investments securitizing catastrophe risk do not correlate with the results of other investments. And, as a result, adding catastrophe bonds or catastrophe options to an investment portfolio can improve the performance of the portfolio, making it more profitable, less risky, or both.
Regulatory, Accounting, and Tax Considerations
Current solvency regulation, accounting practices, and tax laws largely predate the development of catastrophe bonds, contingent surplus notes, standardized catastrophe options, and catastrophe equity puts. Changing solvency regulation, accounting practices, and tax laws could help alleviate impediments to the securitization of catastrophe risk.
Traditional reinsurance transactions qualify for accounting treatment that improves a number of the financial ratios regulators and rating agencies use to evaluate insurers' solvency. Transactions securitizing catastrophe risk do not qualify for accounting treatment similar to that for traditional reinsurance transactions. The difference in accounting discourages securitization of catastrophe risk.
The National Association of Insurance Commissioners (NAIC) has developed risk-based capital calculations for regulators' use in determining when to take action against insurers that may have insufficient capital. The risk-based capital calculations recognize that insurers face the possibility of adverse underwriting results, and the amount of capital that an insurer should have (according to the calculations) increases in proportion to the insurer's loss reserves and net written premium. Insurers can deduct the cost of reinsurance from their gross written premium when calculating their net written premium, but insurers cannot deduct the cost of securitizing catastrophe risk. Thus, the risk-based capital calculations make it appear that an insurer should hold more capital when it securitizes catastrophe risk than when it instead uses traditional reinsurance.
Recognizing that the values of invested assets may decline, the NAIC's risk-based capital calculations increase each insurer's required capital based on the amount and mix of the insurer's invested assets. Since insurers carry exchange-traded catastrophe options on their balance sheets as invested assets, the risk-based capital calculations discourage use of those options even though the exchanges where the options trade guarantee them. This aspect of the risk-based capital calculations also discourages the use of catastrophe bonds, to the extent that insurers invest the proceeds from issuing such bonds in securities not guaranteed by the U.S. government.
Insurers can deduct reinsurance premiums from their taxable income, immediately lowering their income tax bills. But insurers cannot deduct the cost of buying standardized catastrophe options until they calculate their capital gains or losses when the options settle. The difference in tax deductibility decreases the attractiveness of catastrophe options compared with traditional reinsurance.
Insurers and investment bankers have developed ways of alleviating some of the impediments to securitizing catastrophe risk. For example, they have established special-purpose reinsurers offshore. Those reinsurers issue catastrophe bonds and then sell reinsurance, subject to local regulations, to insurers. That permits insurers to take advantage of the accounting treatment for reinsurance transactions. But establishing and using special-purpose reinsurers adds to the cost and complexity of using catastrophe bonds. Changing solvency regulation, accounting practices, and tax laws could make securitizing risk easier and less expensive by eliminating the need for special-purpose reinsurers.
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