Managing Catastrophe Losses


   One way to manage the financial risk of insuring catastrophe hazards is to retain a portion of excess premium revenues collected in years when losses are low to pay claims in years when catastrophes generate large losses. Equity capital set aside to pay potential claims is called surplus. In practice, building surplus large enough to pay catastrophe losses can be difficult for private insurance companies. Owners of insurance companies expect to earn a market rate of return on their equity investments, including equity held as surplus to cover future claims. Moreover, income flowing from insurance company assets is subject to corporate income tax that effectively adds to the cost of accumulating and holding surplus.

   An alternative to using surplus to cover catastrophe losses is to transfer risk to third parties. Some insurers transfer risk directly to capital market participants such as hedge funds and institutional investors. More commonly, insurers negotiate risk-sharing agreements with specialized insurance companies called reinsurers. Reinsurers are internationally diversified companies that make a business of selling insurance to primary insurers. In a typical reinsurance arrangement, a primary insurer pays a fee to a reinsurance company that agrees to cover some of the insurer's costs in the event that claims exceed a prespecified threshold. In essence, reinsurance arrangements work much like other types of insurance. Through reinsurance a primary insurer subject to the risk of high claims caused by a catastrophe can pool its risk with other primary insurers that are exposed to different hazards. As with other types of insurance, problems of adverse selection and moral hazard can impede the efficient functioning of reinsurance markets.

   What happens if an insurance provider lacks the resources to pay claims following a catastrophe? Private-sector insurance companies that cannot afford to pay claims are usually forced into receivership. In contrast, many government-sponsored insurers can raise additional funds to pay claims after an event has occurred. Government-sponsored insurance programs often do not face the same financial constraints as private insurers because they have special rights to compel third parties such as taxpayers or private insurers to bear a portion of their financial risk. The NFIP, for example, is authorized by Congress to borrow from the U.S. Treasury, which increases taxpayer liabilities, and the Federal Government's terrorism-risk insurance program and several State-sponsored catastrophe insurance providers are empowered to levy surcharges on policies sold by private insurers.

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