Insurers Are Subject to 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.1 Note: This figure creates a price index set equal to 100 in 1989 normalized prices. We could not obtain information to assess the reliability of the price data. Source: Guy Carpenter & Company, Inc., a subsidiary of Marsh & McLennan Companies. RAA commented that property catastrophe events have led to the creation of the Bermuda property reinsurance market that has played a major role in introducing new capacity into the marketplace after a major event. 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. 16 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. 18 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 RAA commented that the private reinsurance market provides reinsurance to many primary companies in Florida. "Froot, Kenneth A. and Paul G.J. O'Connell, "The Pricing of U.S. Catastrophe Reinsurance," in Kenneth A. Froot, ed., The Financing of Catastrophe Risk, National Bureau of Economic Research Project Report, (Chicago: Univ. of Chicago Press, 1999). We did not verify the reliability of the data used nor the authors' methodology. The authors relied on Guy Carpenter & Company pricing data for the years 1970 through 1994. 18BMA commented that reinsurance prices in the United States are influenced by events in other parts of the world. catastrophic risk and helped spur the development of risk-linked securities and other alternatives to traditional reinsurance. Catastrophe Risk Can Be Catastrophe risk securitization began in 1992 with the introduction of index-linked catastrophe loss futures and options contracts by the Chicago Board of Trade (CBOT). For more information on catastrophe options, see Appendix II. Other risk-linked securities, especially catastrophe bonds, were created and used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake. During this time, traditional reinsurance prices were relatively high compared with other time periods. While the most direct means for insurance companies to raise capital in the capital market is issuing company stock, an investor in an insurance company's stock is subject to the risks of the entire company. Therefore, an investor's decision to purchase stock will depend on an assessment of the insurance company's management, quality of operations, and overall risk exposures from all perils. In contrast, an investor in an indemnity-based, risk-linked security can face risk associated with the insurance company's underwriting standards but does not take on the risk of the overall insurance (or reinsurance) company's operations. The cost of issuing risklinked securities, such as catastrophe bonds, includes the legal, accounting, and information costs that are necessary to issue securities and market them to investors who do not have contractual and/or business relationships with the insurance company receiving coverage. The market test for a securitized financial instrument, such as a catastrophe bond, depends, in part, on how well investors can evaluate the probability and severity of loss that may affect returns from the investment. However, the willingness of capital market investors to purchase instruments that securitize catastrophe risk, such as catastrophe bonds, and therefore the yields they will require, depends on a number of factors, including the investors' capacity to evaluate risk and the degree to which the investment can facilitate diversification of overall investment portfolios.19 Demand for risk-linked securities by insurance and reinsurance company sponsors will depend, in part, on the basis risk faced and the ability of sponsors to hedge20 this basis risk. Although issuance of risk-linked securities has been limited, many of the catastrophe bonds issued to date have provided reinsurance coverage for catastrophe risk with the lowest probability and highest financial severity. Insurance industry officials we interviewed told us that their use of risklinked securities has lowered the cost of some catastrophe protection. In addition, one official told us that the presence of risk-linked securities as a potential funding option has helped lower the cost of obtaining catastrophe protection covering low-probability, high-severity catastrophes from traditional reinsurers. According to the Swiss Reinsurance Company, in 2000, risk-linked securities represented less than 0.5 percent of worldwide catastrophe insurance and, according to estimates provided by Swiss Re and Goldman Sachs, between 1996 and August 2002, about $11 to $13 billion in risklinked securities had been issued worldwide." As of August 2002, over 70 risk-linked securitizations had been done, according to Goldman Sachs. Risk-linked securities have covered perils that include earthquakes, 19BMA commented that there are often compelling reasons for sponsors of risk-linked securities to use nonindemnity-based structures, including that they (1) more effectively shield the confidentiality of the sponsor's underwriting criteria, (2) may provide for more streamlined deal structuring and deal execution, and (3) may facilitate a more rapid payout in response to triggering events. 20 A hedge is a strategy used to offset risk. For example, investors can hedge against inflation by purchasing assets that they believe will rise in value faster than inflation. Estimates of the number and dollar amount of risk-linked securities vary. These estimates are published by various industry sources, such as investment banks, insurance brokers, and rating agencies. The estimates differ because some of these data, such as those for privately placed catastrophe bonds, are not generally available and because the sources differ in how they define the instruments and transactions included as risk-linked securities. For example, an instrument called contingent equity may be included by some sources and not by other sources. BMA commented that about $6 to $7 billion in catastrophe-related, risk-linked securities were issued during this time period. hurricanes, and windstorms in the United States, France, Germany, and Japan. Risk-Linked Securities 22 Catastrophe options offered by CBOT beginning in 1995 were among the first attempts to market risk-linked securities. The contracts covered exposures on the basis of a number of broad regional indexes that exposed insurers to basis risk, and trading in CBOT catastrophe options ceased in 1999 due to lower-than-expected demand (see app. II). Insurance companies and investment banks developed catastrophe bonds, and the bonds are offered through the SPRVS. Recent catastrophe bonds have been nonindemnity-based to limit moral hazard; therefore, they expose the sponsor to basis risk. The SPRVs are usually established offshore to take advantage of lower minimum required levels of capital, favorable tax treatment, and a generally reduced level of regulatory scrutiny. Currently most risk-linked securities are catastrophe bonds. Most catastrophe bonds issued to date have been noninvestment-grade bonds.28 Catastrophe bonds achieved recognition in the mid-1990s. They offered several advantages that catastrophe options did not, among them customizable offerings and multiyear pricing. Catastrophe bonds, to date, have been offered as private placements only to qualified institutional buyers. 24 A catastrophe bond offering is made through an SPRV that is sponsored by an entity that may be an insurance or reinsurance company.25 The SPRV provides reinsurance to a sponsoring insurance or reinsurance company and is backed by securities issued to investors. The SPRVs are similar in purpose to the special purpose entities (SPE) that banks and For a description of other capital market instruments used to manage catastrophe risk, see U.S. General Accounting Office, Insurers' Ability to Pay Catastrophe Claims, GAO/GGD00-57R (Washington, D.C.: Feb. 8, 2000). 23Some catastrophe bonds contain tranches that have received investment grade ratings. BMA commented that a small but growing percentage of newly issued, risk-linked securities have been investment grade. "A private placement is a sale of a security to an institutional investor that does not have to be registered with SEC. Here, an institutional investor is defined by Rule 144A. This SEC rule provides an exemption for limited secondary market trading of privately placed securities. 25 A noninsurance business that has catastrophe exposure can also sponsor catastrophe bonds through a similar entity, a special purpose vehicle. |