When the Government Is Your Reinsurer
June 2007
Insurers and reinsurers are part of the fabric
of a vibrant free economy based on private enterprise. The reinsurance market
ebbs and flows as supply and demand fluctuates between the needs of insurers
to spread their risk and protect their surplus, and the available capital capacity
of the reinsurers.
by Larry
P. Schiffer1
LeBoeuf,
Lamb, Greene & MacRae LLP
This dynamic, however, has been affected by the insinuation of governmental
reinsurance programs into the insurance and reinsurance market. Whether that
is good or bad depends on your point of view.
Background to Governmental Intervention
Government insurance and reinsurance programs are nothing new. Various government
programs exist to cover risks where there is no available private insurance
market. These include various assigned risk pools for automobile liability,
mandatory pools for medical malpractice coverage, property insurance programs
in low-income neighborhoods, and the National Flood Insurance Program (NFIP).
Most government insurance programs exist to fill a gap in the voluntary marketplace.
Since the third quarter of 2005, when a second straight year of record hurricane
losses buffeted property/casualty underwriters, an availability/affordability
of property insurance crisis developed throughout the Gulf Coast and other costal
communities. To help ease affordability and availability problems for coastal
home and business owners, various legislative proposals for insurance reform
have been implemented and suggested. Among them are proposals that have the
government directly subsidizing of the purchase of insurance from the private
market, providing primary insurance to policyholders; or reinsuring private
insurers that sell their insurance policies at subsidized rates.
In early 2007, the Florida legislature expanded the role of the Florida Hurricane
Catastrophe Fund to provide significantly more reinsurance to insurers writing
property business in Florida and substantially lower rates than the market.
Rather than purchasing all their reinsurance in the private marketplace, Florida
property insurers can purchase low-cost reinsurance at layers previously covered
by private reinsurance.
The increasing costs associated with the heightened frequency and severity
of natural and man-made catastrophes have significantly impacted the insurance
industry. Of the 11 most costly catastrophes in United States history, 7, occurring
in the last 3 years, were hurricanes. Catastrophic disaster losses throughout
the Gulf Coast and southeastern seaboard are likely to escalate in the foreseeable
future as the density and cost of residential and commercial development in
these coastal areas increase and as more and more forecasters and modelers predict
stronger and more frequent storms.
The private reinsurance industry, however, has responded to these storms
in various ways. Large catastrophic property losses, while draining the surplus
of many existing property reinsurers, often spawn the creation of new property
reinsurers whose capitalization is funded by those who wish to ride the crest
of increased rates following a period of significant losses. The creation of
the many Bermuda reinsurers over the past two decades has been a direct result
of the industry's response to hurricanes and other major catastrophic losses.
What is perhaps different about the government programs already implemented
or being discussed to address catastrophic property losses for the Gulf Coast
region is that while the private reinsurance market has the capacity and willingness
to provide reinsurance, the cost of that reinsurance and its effect on policyholder
premiums is not something the government wishes to impose upon its constituents.
How Government Reinsurance Affects the Market
Insuring against catastrophic economic loss in highly developed coastal areas
poses significant challenges to the insurance and reinsurance industry as well
as to the federal and state governments. Private market reinsurers can spread
a localized risk throughout the global financial markets through reinsurance.
In contrast, government insurance/reinsurance programs assume local or regional
concentrations of risk without spreading the risk of loss throughout the market.
A primary cause for concern with public-sector involvement in the insurance
industry offering below market rates on insurance and reinsurance is that the
government will supplant private insurance/reinsurance and deter private insurers
from charging a rate high enough to cover expected losses, purchase reinsurance,
or maintain a surplus adequate to cover catastrophic losses. Public-sector participation
in the catastrophe insurance/reinsurance industry may effectively flood the
market with excess capacity. The concern is that this excess capacity will be
offered at below market rates, which artificially suppresses rates from rising
in tandem with loss forecasts.
This certainly has happened to some extent in Florida, where the expansion
of the Florida Hurricane Catastrophe Fund has essentially displaced substantial
capital from the private reinsurance market. This could create a strong incentive
for insurers to limit their catastrophe risk exposure by withdrawing from high-risk
markets and product lines. The unintended effect of a governmental insurance/reinsurance
program, designed with the well-intentioned goal of keeping insurance prices
low, may be to lower the availability of insurance. Additionally, insurers and
reinsurers with excess capacity may move to write property business in other
regions or even write other lines of business, which could soften rates elsewhere.
Yet, by displacing reinsurance capacity, the Florida program has opened up
opportunities for property insurers to purchase catastrophe reinsurance for
the 1 in 100-year storm from those reinsurers cut out of the lower layers of
the Florida catastrophe market. This allows insurers with significant accumulation
of risk in Florida to use their savings on the low cost reinsurance provided
by the Florida Hurricane Catastrophe Fund to purchase protection from a mega-storm.
Who Will Pay When Disaster Strikes?
Another major area of concern with governmental insurance and reinsurance
programs in the catastrophic risk arena is who will pay when the disaster strikes?
It may be the taxpayers who will wind up subsidizing insurance rates for the
benefit of a relatively small group of people in states or regions categorized
as high-risk areas. A government fund that concentrates risk within a particular
state or region would hit property owners with assessments on their insurance
bills to replenish the revenue shortfall caused by low, upfront, below-market
premiums if a series of catastrophes depletes the fund.
For example, the Florida Hurricane Catastrophe Fund was depleted in 2004
after Florida was battered by four consecutive hurricanes and was forced to
tap Florida property owners to replenish the fund. Similarly, the National Flood
Insurance Program borrowed $16 billion from the Treasury to cover 2005 losses.
This cost will be borne, in large part, by taxpayers nationwide, many of whom
are not exposed to flood risks and do not receive coverage under the program.
Florida's expanded Catastrophe Fund, if wiped out again by a series of storms,
will require the Florida taxpayer to make up any shortfall.
The financial consequences of obligating taxpayers to keep governmental insurers
solvent pose significant concerns. Taxpayer replenishment of depleted government
insurance funds essentially results in the purchase of double coverage—taxpayers
are effectively buying coverage twice. Insurance companies pay a reduced reinsurance
premium because they are not paying for the full loss while taxpayers ultimately
wind up paying for losses that they thought they had paid for through insurance
premiums. This cost burden-shifting back to the taxpayer is further exacerbated
among policyholders from all lines of insurance, including those in low-risk
areas, who would also be required to make up these deficits.
Allowing insurers to purchase reinsurance from a state or federal catastrophe
fund produces savings by increasing the amount of risk that the state or federal
government is assuming, ultimately placing a greater burden on the taxpayers
in the event that a major catastrophic natural disaster depletes the fund.
Should Government Support Development in High-Risk Areas?
Governmental insurance programs may be aimed at alleviating the property
insurance availability and affordability crisis in certain regions, but by providing
lower cost insurance and reinsurance it encourages development in high-risk
areas. In Florida, for example, where 80 percent of property lies in coastal
areas and the insurance crisis is seen as a threat to the state’s economy, the
state expects to gain more than 1,000 new residents a day and new condominiums
and high-rise luxury developments right on the water are being built unabated.
Yet, government insurance and reinsurance programs provide no disincentive for
homeowners in high-risk areas to mitigate their risk exposure or take full economic
responsibility for their choice to live in a high-risk area.
Instead, property owners in high-risk areas are beginning to expect a government
bailout should disaster strike. A government reinsurance program that undermines
economic incentives to mitigate risks would likely distort premium rates from
their actuarial values. Individuals would be encouraged to assume inappropriate
risk levels because they themselves would not bear the full expected costs of
damages incurred.
Conclusion
The debate over the expansion of the Florida Hurricane Catastrophe Fund and
over other regional and national catastrophe initiatives will continue for some
time. From the reinsurance perspective, displacing capacity from one of the
largest catastrophe risk markets in the world has its economic ups and downs,
depending on your perspective.
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