What To Do about Catastrophic Loss: Cats and Other Felines

January 2006

Let's think about the ongoing problem of catastrophic loss, especially in light of 2005's hurricane season, which might well be repeated next year or in years to come. This fall there has been a call by a variety of the regulatory community and others for a national catastrophic fund to fall under the auspices of the U.S. government. Do we really want the federal government involved in this? And, more importantly, should it be?

by Peter M. Polstein

Has the insurance industry, whose cat models haven't been right once in who knows how long, finally decided that it can't underwrite this risk and is willing to concede its inadequate underwriting and rating to the government? You have to wonder, is there no thought process outside of the box?

At the risk of being tarred and feathered and ridden out of town on a rail, let me offer what I believe is a rather interesting alternative, whose author is a longtime good friend, Dan Bense, of Wachovia Insurance Services in Atlanta, who has spent over 35 years as both senior broker and underwriter. Consider a real estate assessment percentage for those properties located in areas subject to catastrophic loss by either wind or water. And, as an important aside, coverage would be for "storm damage" without question of wave wash, high tide, flood, overflow, etc. This model excludes earthquake. Much of this thought process and formula, is predicated on some suppositions which might be inaccurate as to the numbers, but the theory, I think, makes sense.

The tax would assessed on the fair market value of the real property at the time of purchase and would escalate, or perhaps devalue, according to market analysis on an annual basis. This isn't difficult; it is part of every local and state government tax roll. There would be a deductible of say 10 percent of the ultimate adjusted value at the date of loss, thereby those who own property in high-risk, or catastrophic areas would be placed into a national response pool. Thus, a perpetual fund is created which would be replenished, paid for by so called at-risk ownership, and would no longer be a financial burden to citizens at large nor an incalculable risk to the insurance industry.

For the purpose of this illustration, we have used a 3.5 percent assessment percentage, which might well be too high, for the National Response Pool. The formula would look like this:

• A x B x C = D x .90 = E x 3.5% = National Response Pool.

• A = Fair market value at the time of purchase.

• B = Realty annual reevaluation.

• C = Probability of % at location catastrophic model.

• D = Annual assessable value.

• Deductible = 10% of adjusted Fair Market Value or .90%

• E = Recovery.

Assume a beachfront home with a $1,000,000 value. Loss adjustment would be $1,000,000 x 1.055 (adjustment) = $1,055,000 x .75% (cat model) = $791,250 Recovery.

Therefore, on a $1,000,000 basic value home, you would recover a net of 71 percent, the remainder would be covered by private insurance. Under the National Response Pool formula, the cost on this property @ 3.5 percent would be $24,925, with the formula amended on an annual basis.

Let us further assume for argument's sake, that the presumed catastrophic pool nationally was $50 trillion. If that was so, then running the formula above, would work out like this:

• $ 50,000,000,000,000 x 1.055(*) = $52,750,000,000,000 x .35 (**) = $18,462,500,000,000

• x .90 = $16,616,250,000,000 x 3.5% = $5,815,687,500,000 National Response Pool Fund.

Notes:

(*) Assume average catastrophic potential property with value escalation.
(**) Assumed catastrophic % nationwide.

One might assume that the insurance industry could find a reasonable methodology to underwrite the differential. It goes without saying that there is no actuarial basis by which anyone can proffer an accurate loss cost assessment. If the assessment was only 1 percent, not 3.5 percent, this model would appear to be able to adequately handle the potential for catastrophic loss.

How would this fund be handled? Quite simply, through the U.S. banking industry, as part of the monthly charges for mortgage (taxes and insurance, assuming the bank was responsible). Banks would deposit into the National Pool on say a quarterly basis, all funds collected. Where no mortgage exists, a designated bank would still be used as a conduit for these collections, and would deposit funds to the National Pool on a quarterly basis. Why would banks want any part of this? Well, it would be in their best interests, as it guarantees continuance of their individual mortgage account, and they would have the ability to earn interest for the time that funds were held, prior to disposal to the National Pool.

Is this a workable solution? Perhaps, but at least it is thinking outside of the box, which is less about insurance and more about facilitating a method to solve a problem. Finally, with the unprecedented amount of new capital coming into the catastrophic marketplace, primarily offshore, this scheme would capture and retain, a substantial amount of capital within the United States.

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