Reinsurance

Reinsurance
THE TOPIC
JANUARY 2010

Reinsurance is insurance for insurance companies. It’s a way of transferring or “ceding” some of the financial risk insurance companies assume in insuring cars, homes and businesses to another insurance company, the reinsurer. Reinsurance, a highly complex global business, accounted for about 9 percent of the U.S. property/casualty insurance industry premiums in 2008, according to the Reinsurance Association of America.

The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. Most still are. Primary insurers and reinsurers can share both the premiums and losses or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking, see also Background section.

RECENT DEVELOPMENTS
Regulation: Two different approaches to streamlining and modernizing the regulation of reinsurance are being discussed. In Congress, HR 2571, the Nonadmitted and Reinsurance Reform Act of 2009, was approved by the U.S. House of Representatives early in September. The measure, now being considered by the Senate, would make regulation of a reinsurance transaction the responsibility of the reinsurer’s home state. A different approach has been developed by the National Association of Insurance Commissioners (NAIC). This proposal would create a regulatory framework for reinsurers that, the NAIC says, is closer to the model used in other countries. This gives the NAIC the power to determine which states can regulate reinsurance. Under the NAIC plan, a Reinsurance Supervision Review Board would adopt standards recommended by the NAIC for assessing, among other things, which non-U.S. jurisdictions have solvency standards and other safeguards equivalent to those in the United States and which states should be certified to regulate reinsurance. Companies that met the requirements could opt for regulation by a single state in the U.S.
Currently, U.S companies purchasing reinsurance from foreign reinsurers have protection against nonpayment when a claim is made since all foreign reinsurers must post collateral in the U.S. of at least 100 percent of their liabilities to U.S. ceding companies. Without this protection, the ceding company cannot receive credit on its financial statement for having reduced its liabilities through the purchase of reinsurance. HR 2571 retains the current collateral provision. The NAIC proposal would reduce the requirement on a sliding scale, depending on the financial rating assigned to the reinsurer. The highest rated companies would not have to post any collateral. The NAIC must develop federal legislation to implement its proposal.
The NAIC must develop federal legislation to implement its proposal. However, so far the NAIC has not found a sponsor nor has it been able to substitute the language of the House-passed bill with its own.
Some U.S. insurers oppose the NAIC proposal, fearing that a lowering of collateral requirements would make them vulnerable to an option in some foreign countries under which a solvent reinsurer can limit its potential losses for past events, such as workers’ exposure to asbestos, by entering into bankruptcy-like proceedings, known as “solvent schemes of arrangement."
Financial and Market Conditions: According to the Reinsurance Association of America (RAA), premiums for a group of 19 reinsurers dropped in the first nine months of 2009 to $18.7 billion from $19.0 billion during the same period in 2008. The combined ratio, a measure of profitability that shows what percentage of the premium dollar was spent on claims and expenses, improved by almost nine percentage points to 95.1, compared with 104.2 in the first nine months of 2008. Policyholders’ surplus, capital that represents a cushion against unexpectedly high losses, rose by $2.0 billion to $74.1 billion as of September 30 2009 from $72.1 billion a year ago.
For the full year 2008, premiums rose to $23.9 billion during the 12-month period, an increase of $1.2 billion over 2007. The combined ratio was 101.8 percent, a deterioration in profitability of more than seven percentage points. The combined ratio in 2007 was 94.7. Policyholders’ surplus stood at $64.4 billion, down from the $75.9 billion for the full year 2007. RAA members represent about two-thirds of reinsurance coverage provided by U.S. reinsurers and their affiliates.
According to Guy Carpenter, a large reinsurance broker, rates for most types of reinsurance declined during January 2010 renewal period, due to a large drop in U.S. catastrophe losses in 2009 coupled with a fast recovery from the global financial crisis.
Offshore reinsurers, companies that are domiciled outside the United States, had a 58.6 percent share of U.S. “unaffiliated” premiums in 2008, according to the RAA, up from 56.3 percent in 2007. The term “unaffiliated” refers to the relationship between companies. A primary insurer may cede business to a reinsurer affiliated with it or one that is unaffiliated. The market share of unaffiliated offshore companies and U.S. affiliates of offshore companies together rose slightly, to 83.6 percent of reinsurance premium from 83.4 percent in 2007. Insurance premiums ceded to offshore reinsurers totaled $58.2 billion in 2008, compared with 58.4 billion in 2007, a decrease of 0.3 percent. More than 2,600 offshore reinsurers assumed U.S. premiums in 2008, the RAA says.
The Transfer of Risk and the Capital Markets: The relatively high returns for assuming catastrophe risk and the fact that it is not correlated with economic conditions has spurred investor interest in so-called alternative risk transfer mechanisms. These include catastrophe (cat) bonds, which are rated securities, as well as side-cars, a relatively new investment vehicle, both of which are increasingly being used to supplement traditional forms of reinsurance. With cat bonds, investors assume the risk of a low frequency/high severity event such as a major earthquake. With side-cars, investors take a share of the risk with the reinsurer in exchange for a share in the profit or loss the business generates, enabling the reinsurer to assume more risk. Sidecars, used in the last hard market to add capacity, are often very narrowly targeted, with transactions focused on a specific geographical area or product.
The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change. In 2009, for the first time, primary insurance companies were sponsors of the majority of bond issues--about 60 percent. Industry observers say primary companies are increasingly integrating cat bonds into their core reinsurance programs as a way to diversify and increase flexibility. Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally provide multiyear coverage and may be structured in tranches that mature in successive years.
Strong investor demand encouraged several issuers to increase the size of their offerings, which, in some cases, doubled. A total of $3.4 billion in risk capital was issued through 18 bonds, making 2009 the third busiest year for the cat bond market. According to A.M. Best, total cat bond principal outstanding grew to $12.2 billion. Risk Management Solutions, a catastrophe modeling firm, predicts that 2010 will be another active year because $5 billion of the bonds are due to expire over the next few months. The year 2009 saw $150 million dedicated to Florida windstorm risk and a bond that covers hurricane risk for the North Carolina Joint Underwriting Association (the state’s FAIR Plan) and the North Carolina Insurance Underwriting Association (its Beach Plan). This is the first time that a residual market entity has accessed the capital markets to cover hurricane risk and it is the first catastrophe bond to cover risk in North Carolina.
There is growing interest in securitizing other types of risk. Life insurance portfolios based on the risk of a pandemic such as bird flu and other novel applications have emerged. This kind of deal represented a number of bonds issued in 2006 but a much smaller proportion in 2007. Since then there have been several of deals, including a $75 million bond transferring “extreme” mortality risk in the United States and the United Kingdom to the capital markets. The language of the bond, issued in November 2009, does not identify any specific causes of death so it could be triggered by a pandemic or other cause of loss such as a major terrorist attack. It is unusual in that it covers an existing event, swine flu, that turned out to be infectious but not as virulent as anticipated earlier in the year.
Mexico and MultiCat: In October 2009 the Mexican government became the first to use the World Bank’s new MultiCat bond program, when it sold$290 million in catastrophe bonds to cover potential damage from earthquakes and Pacific and Atlantic hurricanes. MultiCat provides a common documentation, legal and operational framework for issuing catastrophe bonds, the World Bank says, offering developing countries a cost-effective way to transfer disaster risk to the private sector and lessen the financial and economic impact of natural disasters. In 2006 the Mexican government issued an earthquake bond, the first time a sovereign state had issued such a bond.
In 2006, a Japanese hedge fund based in New York launched a fund that invests solely in catastrophe bonds.
Federal and State Catastrophe Funds: The Homeowners Defense Act has been reintroduced in Congress by Rep. Ron Klein, D-Boca Raton, Florida. The bill, which passed the House in 2007 but died in the Senate, would expand the federal government’s role in catastrophe disaster financing, authorizing the U.S.Treasury to guarantee the debt issued by participating states and allowing it to write reinsurance contracts covering catastrophic events. Many insurers are opposed to the provision that would turn the federal government into a provider of reinsurance coverage and to forcing taxpayers to subsidize development in catastrophe-prone areas.
BACKGROUND
Reinsurance is a way for primary insurance companies to transfer risk to another insurance entity. As an industry, reinsurance is less highly regulated than insurance for individual consumers because the purchasers of reinsurance, mostly primary insurance companies that sell car, home and commercial insurance, are considered sophisticated buyers. However, in the early 1980s, state insurance officials became increasingly concerned about the reliability of reinsurance contracts and a primary company's use of them. Following the June 1982 annual meeting of the National Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was formed to review the regulation of reinsurance transactions and parties to those transactions. A model Credit for Reinsurance Act was adopted in 1984.

All insurers submit financial statements to regulators who monitor their financial health. Financial health includes not assuming more risk or liability for future claims than is prudent, given the amount of capital available to support it. The principal value of reinsurance to a ceding company (the purchaser of reinsurance) for regulatory purposes is the recognition on the ceding company's financial statement of a reduction in its liabilities in terms of two accounts: its unearned premium reserve and its loss reserve. The unearned premium reserve is the amount of premiums equal to the unexpired portion of insurance policies, i.e., insurance protection that is still "owed" the policyholder and for which funds would have to be returned to the policyholder should the policyholder cancel the policy before it expired. The loss reserve is made up of funds set aside to pay future claims. The transfer of part of the insurance company’s business to the reinsurer reduces its liability for future claims and for return of the unexpired portion of the policy. The reduction in these two accounts is commensurate with the payments that can be recovered from reinsurers, known as recoverables. The insurer’s financial statement recognizes as assets on the balance sheet any payments which are due from the reinsurer for coverage paid for by the ceding company.

By statute or administrative practice, all states (but with considerable variation) recognize and grant financial statement credit for reinsurance transactions with reinsurers licensed in the same state, or reinsurers licensed in another state where the company meets the capital and surplus or solvency requirements of the state where the credit is taken. This is known as "authorized" reinsurance. In all other reinsurance transactions, for the ceding company to get credit, reinsurers not licensed in the United States, known as “alien” or offshore companies, must post collateral (such as trust funds, letters of credit, funds withheld) to secure the transaction. An alien company can also participate in the U.S. marketplace by becoming licensed in the states in which it wishes to do business.

For many years, few people outside the insurance industry were aware that such a mechanism as reinsurance existed. The public was first introduced to reinsurance in the mid-1980s during what has now become known as the liability crisis. A shortage of reinsurance was widely reported to be one of the factors contributing to the availability problems and high price of various kinds of liability insurance. A few years later, in 1989, the reinsurance business once again became a topic of interest outside the insurance industry as Congress investigated the insolvencies of several large property/casualty insurers.

These investigations culminated in a widely read report, "Failed Promises: Insurance Company Insolvencies," published in February 1990. The publicity surrounding the investigations and the poor financial condition of several major life insurance companies prompted proposals for some federal oversight of the insurance industry, particularly insurers and reinsurers based outside the United States. However, no federal law was enacted. While a large portion of the insurance industry opposes federal regulatory oversight, many U.S. reinsurers and large commercial insurers view compliance with a single federal law as preferable to compliance with the laws of 51 state jurisdictions.

A critical tool for evaluating solvency is the annual "convention" statement, the detailed financial statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the annual statement required insurers ceding liability to unauthorized reinsurers (those not licensed or approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR) losses in addition to known and reported losses. (IBNR losses are losses associated with events that have already occurred where the full cost will not be known and reported to the insurer until some later date.) This requirement reflects regulators' concern that all liabilities are identified and determined actuarially, including IBNR losses, and that IBNR losses are secured by the reinsurer with additional funds or a larger letter of credit than otherwise would have been required.

Related to solvency is the issue of reinsurance "recoverables, payments due from the reinsurer." In the mid-1980s, some reinsurance companies that had entered the reinsurance business during the period of high interest rates in the early 1980s left the market, due to insolvency or other problems. (When interest rates are high, some insurance/reinsurance companies seek to increase market share in order to have more premiums to invest. Those that fail to pay attention to the riskiness of the business they are underwriting may end up undercharging for coverage and going bankrupt as a result.) Consequently, some of the insurers that reinsured their business with these now-defunct companies were unable to recover monies due to them on their reinsurance contracts.

To enable regulators, policyholders and investors to assess a company's financial condition more accurately, the NAIC now requires insurance companies to deduct 20 percent of anticipated reinsurance recoverables from their policyholders’ surplus on their financial statements—surplus is roughly equivalent to capital—when amounts are overdue by more than 90 days. The rule helps regulators identify problem reinsurers for regulatory actions and encourages insurers to purchase reinsurance from companies that are willing and able to pay reinsured losses promptly.

Concern about reinsurance recoverables led to other changes in the annual financial statement filed with state regulators, including changes that improve the quality and quantity of reinsurance data available to enhance regulatory oversight of the reinsurance business.

After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position, which in turn caused primary companies to reconsider their catastrophe reinsurance needs.

Where reinsurance prices were high and capacity scarce because of the high risk of natural disasters, some primary companies turned to the capital markets for innovative financing arrangements.

The shortage and high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining interest rates, which sent investors looking for higher yields, prompted interest in securitization of insurance risk. Among the precursors to so-called true securitization were contingency financing bonds such as those issued for the Florida Windstorm Association in 1996, which provided cash in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes—an agreement with a bank or other lender that in the event of a megadisaster that would significantly reduce policyholders’ surplus, funds would be made available at a predetermined price. Funds to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes are not considered debt, therefore do not hamper an insurer's ability to write additional insurance. In addition, there were equity puts, through which an insurer would receive a sum of money in the event of a catastrophic loss in exchange for stock or other options.

A catastrophe bond is a specialized security that increases insurers’ ability to provide insurance protection by transferring the risk to bond investors. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business. Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose. These bonds have complicated structures and are typically created offshore where tax and regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or reinsurance company and the principal from investors and hold them in a trust in the form of U.S. Treasuries or other highly rated assets, using the investment income to pay interest on the principal. Catastrophe bonds pay high interest rates but if the trigger event occurs, investors lose the interest and sometimes the principal, depending on the structure of the bond, both of which may be used to cover the insurer’s disaster losses. Bonds may be issued for a one-year term or multiple years, often three.

Of the many new ways of financing catastrophe risk that have been developed over the past decade or two, catastrophe bonds are best known outside the insurance industry. One lesser-known alternative is the industry loss warranty contract or “ILW.” Unlike traditional reinsurance, where the reinsurer pays a portion of the primary company’s losses according to an agreed upon formula, the ILW is triggered by an agreed-upon industry loss. The contract “warrants” that the reinsurer will pay up to $100 million toward the buyer’s losses if the industry suffers a predetermined loss amount, say $5 billion or more.

Another recent innovation is the side-car. These are relatively simple agreements that allow a reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited and specific risk, such as the risk of an earthquake or hurricane in a given geographic area over a specific period of time. Side-car deals are much smaller and less complex than catastrophe bonds and are usually privately placed rather than tradable securities. In side-cars, investors share in the profit or loss the business produces along with the reinsurer. While a catastrophe bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an infrequent but potentially highly destructive event, side-cars are similar to reinsurance treaties where the reinsurer and primary insurer share in the results.

An insurance company’s willingness to offer disaster coverage is often determined by the availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew, they were expected to gain industrywide acceptance as an alternative to traditional catastrophe reinsurance, which was then in short supply, but they still represent a small, albeit growing, portion of the worldwide catastrophe reinsurance market, about 0.5 percent, according to Swiss Re, a pioneer in this field.

Initially, catastrophe bonds were designed to indemnify the insurer or reinsurer for the actual losses incurred—half of all hurricane losses up to a certain maximum, for example, similar to a traditional reinsurance agreement. Now they tend to be indexed products where the loss of principal is tied to formulas that take into account the severity of a catastrophe and its location, such as an earthquake of a certain intensity in California, instead of the actual losses suffered by the issuer. Other formulas are based on data generated by loss models or historical data.

Several of the first attempts at true securitization were withdrawn because of time constraints—the hurricane season had begun before work on the transaction could be completed, for example—and lack of sufficient interest on the part of investors. The first deals were consummated in December 1996, one by a U.S. reinsurer, St Paul Re, and the second by Winterthur, a Swiss insurer which issued convertible bonds to pay auto damage claims stemming from hailstorms. This was the first large transaction in which insurance risk was sold to the public markets. The company said that it did not need to finance hailstorm damage in this way but sold the bonds to test the market for securitizing insurance risks. Six months later there was strong investor interest in a bond offering that provided USAA with catastrophe reinsurance to pay homeowners losses arising from a single hurricane in eastern coastal states, proving for the first time that insurance risk could be sold to institutional investors on a large scale.

The field has gradually evolved to the point where some investors and insurance company issuers are beginning to feel comfortable with the concept, with some coming back to the capital markets each year. In addition to the high interest rates catastrophe bonds pay, their attraction to investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The returns on most other securities are tied to economic activity rather than natural disasters.

The National Association of Insurance Commissioners (NAIC), which oversees insurance company investments and sets the rules that influence insurers’ investment strategies, classifies these new types of catastrophe risk securities as bonds rather than equities. Equities are considered riskier under formulas that dictate how much capital must be set aside to support various liabilities. In addition, at its June 1999 meeting, the NAIC approved a so-called “protected cell” model act that makes it easier to transact deals in the United States. Up to then, most securitization deals had been conducted offshore through special entities created for this purpose. The protected cells, separate units within an insurance company, protect investors from losses incurred by the insurer.

In addition to catastrophe bonds, catastrophe options were developed but the market for these options never took off. Another alternative is the exchange of risk where individual companies in different parts of the world swap a certain amount of losses. Payment is triggered by the occurrence of an agreed upon event at a certain level of magnitude.

Congress looked into the adequacy of insurance capacity in areas vulnerable to natural disasters, including the market for catastrophe bonds, in response to a request from the U.S. House Financial Services Committee. The General Accountability Office (GAO) presented its findings on catastrophe bonds and barriers to their wider use in 2002.

The GAO said there were several barriers to more widespread use of catastrophe bonds. The first has to do with transfer risk from the insurance company to the reinsurer. As mentioned earlier, insurers get credit on their balance sheet for indemnity-based reinsurance in the form of a reduction in the amount of risk-based capital they have to set aside since the reinsurer will pay for losses covered by reinsurance. Indemnity-based deals are based on the insurer’s own book of business. They are not subject to basis risk, which is the mismatch between the company’s business and the index to which the transaction is linked. It is difficult, the GAO said, to assess how much credit to give for reinsurance that is not indemnity-based and may not fully reflect the company’s actual losses. The GAO said that accounting for risk-linked securities that are not based on actual losses would be a challenge for regulators, but a necessary step.

Disaster Recovery Bonds and Regional Pools: Disaster recovery bonds serve much the same purpose as a business income insurance policy, helping the government entity/policyholder get back on track after a catastrophic event.

In developing countries insurance penetration is low, meaning that few individuals and businesses have insurance, so the burden of recovering from a disaster falls almost entirely on the government. Traditionally, developing countries have relied on post-disaster funding to finance recovery efforts, including donations from developed countries, international emergency aid and humanitarian relief organizations. A faster and more reliable way to fund the recovery is prefinancing in the form of reinsurance, catastrophe bonds or other alternative risk transfer mechanisms.

One example of prefunding is the Caribbean Catastrophe Risk Insurance Facility, the first regional insurance fund. CCRIF provides hurricane and earthquake catastrophe coverage to its member nations, so that in the aftermath of a disaster they can quickly fund immediate recovery needs and continue providing essential services.

In 2004 hurricanes severely damaged the economy of several small Caribbean islands, causing losses in excess of $4 billion. This prompted Caribbean governments to request the help of the World Bank in facilitating access to catastrophe insurance. The CCRIF started operations in June 2007, after two years of planning.

The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks into a diversified portfolio and purchase reinsurance or other risk transfer products on the international financial markets at a saving of up to 50 percent over what it would cost each country if they purchased catastrophe protection individually. In addition, since a hurricane or earthquake only affects one to three countries in the Caribbean on average in any given year, each country contributes less to the reserve pool than would be required if each had its own reserves.

The CCRIF was initially capitalized by its members with help from donor partners—developed countries, the World Bank and the Caribbean Development Bank. Its members pay premiums based on their probable use of the pool’s funds. As countries raise building standards to provide better protection against disasters, premiums will decrease.

Because the CCRIF uses what has become known as parametric insurance to calculate claim payments, claims are paid quickly. Under a parametric system, claim payments are triggered by the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by actual losses measured by an adjuster, a process that can take months to complete.

Payout amounts are derived from models that estimate the financial impact of the disaster. As a form of deductible that encourages risk mitigation, participating governments are only allowed to purchase coverage for up to 20 percent of their estimated losses, an amount believed to be sufficient to cover initial needs.

Post-September 11: The terrorist attacks on the World Trade Center left their mark on the reinsurance business in many ways. First, the huge losses incurred accelerated rate hikes over a broad spectrum of coverages, unlike the aftermath of Hurricane Andrew, the most costly disaster prior to September 11, where only catastrophe insurance, a property coverage, was in short supply. Furthermore, the reinsurers that are now offering some terrorism coverage look at the business they are being offered from an accumulation-of-loss viewpoint in addition to traditional considerations, particularly in areas that may be terrorism targets. Computer programs are now being developed that not only estimate likely terrorism losses but also enable companies to determine more easily what other businesses they have reinsured in the same neighborhood.

Legislation known as the federal reinsurance backstop, the Terrorism Insurance Act of 2002, was passed in November 2002 and extended in 2005 to December 2007, and extended once again through December 2014. The Act does not cover reinsurers, see report on terrorism insurance.

KEY SOURCES OF ADDITIONAL INFORMATION

"Reinsurance: Fundamentals and New Challenges," Insurance Information Institute, 2004.

© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED

THE TOPIC
JANUARY 2010

Reinsurance is insurance for insurance companies. It’s a way of transferring or “ceding” some of the financial risk insurance companies assume in insuring cars, homes and businesses to another insurance company, the reinsurer. Reinsurance, a highly complex global business, accounted for about 9 percent of the U.S. property/casualty insurance industry premiums in 2008, according to the Reinsurance Association of America.

The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. Most still are. Primary insurers and reinsurers can share both the premiums and losses or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking, see also Background section.

RECENT DEVELOPMENTS
Regulation: Two different approaches to streamlining and modernizing the regulation of reinsurance are being discussed. In Congress, HR 2571, the Nonadmitted and Reinsurance Reform Act of 2009, was approved by the U.S. House of Representatives early in September. The measure, now being considered by the Senate, would make regulation of a reinsurance transaction the responsibility of the reinsurer’s home state. A different approach has been developed by the National Association of Insurance Commissioners (NAIC). This proposal would create a regulatory framework for reinsurers that, the NAIC says, is closer to the model used in other countries. This gives the NAIC the power to determine which states can regulate reinsurance. Under the NAIC plan, a Reinsurance Supervision Review Board would adopt standards recommended by the NAIC for assessing, among other things, which non-U.S. jurisdictions have solvency standards and other safeguards equivalent to those in the United States and which states should be certified to regulate reinsurance. Companies that met the requirements could opt for regulation by a single state in the U.S.
Currently, U.S companies purchasing reinsurance from foreign reinsurers have protection against nonpayment when a claim is made since all foreign reinsurers must post collateral in the U.S. of at least 100 percent of their liabilities to U.S. ceding companies. Without this protection, the ceding company cannot receive credit on its financial statement for having reduced its liabilities through the purchase of reinsurance. HR 2571 retains the current collateral provision. The NAIC proposal would reduce the requirement on a sliding scale, depending on the financial rating assigned to the reinsurer. The highest rated companies would not have to post any collateral. The NAIC must develop federal legislation to implement its proposal.
The NAIC must develop federal legislation to implement its proposal. However, so far the NAIC has not found a sponsor nor has it been able to substitute the language of the House-passed bill with its own.
Some U.S. insurers oppose the NAIC proposal, fearing that a lowering of collateral requirements would make them vulnerable to an option in some foreign countries under which a solvent reinsurer can limit its potential losses for past events, such as workers’ exposure to asbestos, by entering into bankruptcy-like proceedings, known as “solvent schemes of arrangement."
Financial and Market Conditions: According to the Reinsurance Association of America (RAA), premiums for a group of 19 reinsurers dropped in the first nine months of 2009 to $18.7 billion from $19.0 billion during the same period in 2008. The combined ratio, a measure of profitability that shows what percentage of the premium dollar was spent on claims and expenses, improved by almost nine percentage points to 95.1, compared with 104.2 in the first nine months of 2008. Policyholders’ surplus, capital that represents a cushion against unexpectedly high losses, rose by $2.0 billion to $74.1 billion as of September 30 2009 from $72.1 billion a year ago.
For the full year 2008, premiums rose to $23.9 billion during the 12-month period, an increase of $1.2 billion over 2007. The combined ratio was 101.8 percent, a deterioration in profitability of more than seven percentage points. The combined ratio in 2007 was 94.7. Policyholders’ surplus stood at $64.4 billion, down from the $75.9 billion for the full year 2007. RAA members represent about two-thirds of reinsurance coverage provided by U.S. reinsurers and their affiliates.
According to Guy Carpenter, a large reinsurance broker, rates for most types of reinsurance declined during January 2010 renewal period, due to a large drop in U.S. catastrophe losses in 2009 coupled with a fast recovery from the global financial crisis.
Offshore reinsurers, companies that are domiciled outside the United States, had a 58.6 percent share of U.S. “unaffiliated” premiums in 2008, according to the RAA, up from 56.3 percent in 2007. The term “unaffiliated” refers to the relationship between companies. A primary insurer may cede business to a reinsurer affiliated with it or one that is unaffiliated. The market share of unaffiliated offshore companies and U.S. affiliates of offshore companies together rose slightly, to 83.6 percent of reinsurance premium from 83.4 percent in 2007. Insurance premiums ceded to offshore reinsurers totaled $58.2 billion in 2008, compared with 58.4 billion in 2007, a decrease of 0.3 percent. More than 2,600 offshore reinsurers assumed U.S. premiums in 2008, the RAA says.
The Transfer of Risk and the Capital Markets: The relatively high returns for assuming catastrophe risk and the fact that it is not correlated with economic conditions has spurred investor interest in so-called alternative risk transfer mechanisms. These include catastrophe (cat) bonds, which are rated securities, as well as side-cars, a relatively new investment vehicle, both of which are increasingly being used to supplement traditional forms of reinsurance. With cat bonds, investors assume the risk of a low frequency/high severity event such as a major earthquake. With side-cars, investors take a share of the risk with the reinsurer in exchange for a share in the profit or loss the business generates, enabling the reinsurer to assume more risk. Sidecars, used in the last hard market to add capacity, are often very narrowly targeted, with transactions focused on a specific geographical area or product.
The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change. In 2009, for the first time, primary insurance companies were sponsors of the majority of bond issues--about 60 percent. Industry observers say primary companies are increasingly integrating cat bonds into their core reinsurance programs as a way to diversify and increase flexibility. Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally provide multiyear coverage and may be structured in tranches that mature in successive years.
Strong investor demand encouraged several issuers to increase the size of their offerings, which, in some cases, doubled. A total of $3.4 billion in risk capital was issued through 18 bonds, making 2009 the third busiest year for the cat bond market. According to A.M. Best, total cat bond principal outstanding grew to $12.2 billion. Risk Management Solutions, a catastrophe modeling firm, predicts that 2010 will be another active year because $5 billion of the bonds are due to expire over the next few months. The year 2009 saw $150 million dedicated to Florida windstorm risk and a bond that covers hurricane risk for the North Carolina Joint Underwriting Association (the state’s FAIR Plan) and the North Carolina Insurance Underwriting Association (its Beach Plan). This is the first time that a residual market entity has accessed the capital markets to cover hurricane risk and it is the first catastrophe bond to cover risk in North Carolina.
There is growing interest in securitizing other types of risk. Life insurance portfolios based on the risk of a pandemic such as bird flu and other novel applications have emerged. This kind of deal represented a number of bonds issued in 2006 but a much smaller proportion in 2007. Since then there have been several of deals, including a $75 million bond transferring “extreme” mortality risk in the United States and the United Kingdom to the capital markets. The language of the bond, issued in November 2009, does not identify any specific causes of death so it could be triggered by a pandemic or other cause of loss such as a major terrorist attack. It is unusual in that it covers an existing event, swine flu, that turned out to be infectious but not as virulent as anticipated earlier in the year.
Mexico and MultiCat: In October 2009 the Mexican government became the first to use the World Bank’s new MultiCat bond program, when it sold$290 million in catastrophe bonds to cover potential damage from earthquakes and Pacific and Atlantic hurricanes. MultiCat provides a common documentation, legal and operational framework for issuing catastrophe bonds, the World Bank says, offering developing countries a cost-effective way to transfer disaster risk to the private sector and lessen the financial and economic impact of natural disasters. In 2006 the Mexican government issued an earthquake bond, the first time a sovereign state had issued such a bond.
In 2006, a Japanese hedge fund based in New York launched a fund that invests solely in catastrophe bonds.
Federal and State Catastrophe Funds: The Homeowners Defense Act has been reintroduced in Congress by Rep. Ron Klein, D-Boca Raton, Florida. The bill, which passed the House in 2007 but died in the Senate, would expand the federal government’s role in catastrophe disaster financing, authorizing the U.S.Treasury to guarantee the debt issued by participating states and allowing it to write reinsurance contracts covering catastrophic events. Many insurers are opposed to the provision that would turn the federal government into a provider of reinsurance coverage and to forcing taxpayers to subsidize development in catastrophe-prone areas.
BACKGROUND
Reinsurance is a way for primary insurance companies to transfer risk to another insurance entity. As an industry, reinsurance is less highly regulated than insurance for individual consumers because the purchasers of reinsurance, mostly primary insurance companies that sell car, home and commercial insurance, are considered sophisticated buyers. However, in the early 1980s, state insurance officials became increasingly concerned about the reliability of reinsurance contracts and a primary company's use of them. Following the June 1982 annual meeting of the National Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was formed to review the regulation of reinsurance transactions and parties to those transactions. A model Credit for Reinsurance Act was adopted in 1984.

All insurers submit financial statements to regulators who monitor their financial health. Financial health includes not assuming more risk or liability for future claims than is prudent, given the amount of capital available to support it. The principal value of reinsurance to a ceding company (the purchaser of reinsurance) for regulatory purposes is the recognition on the ceding company's financial statement of a reduction in its liabilities in terms of two accounts: its unearned premium reserve and its loss reserve. The unearned premium reserve is the amount of premiums equal to the unexpired portion of insurance policies, i.e., insurance protection that is still "owed" the policyholder and for which funds would have to be returned to the policyholder should the policyholder cancel the policy before it expired. The loss reserve is made up of funds set aside to pay future claims. The transfer of part of the insurance company’s business to the reinsurer reduces its liability for future claims and for return of the unexpired portion of the policy. The reduction in these two accounts is commensurate with the payments that can be recovered from reinsurers, known as recoverables. The insurer’s financial statement recognizes as assets on the balance sheet any payments which are due from the reinsurer for coverage paid for by the ceding company.

By statute or administrative practice, all states (but with considerable variation) recognize and grant financial statement credit for reinsurance transactions with reinsurers licensed in the same state, or reinsurers licensed in another state where the company meets the capital and surplus or solvency requirements of the state where the credit is taken. This is known as "authorized" reinsurance. In all other reinsurance transactions, for the ceding company to get credit, reinsurers not licensed in the United States, known as “alien” or offshore companies, must post collateral (such as trust funds, letters of credit, funds withheld) to secure the transaction. An alien company can also participate in the U.S. marketplace by becoming licensed in the states in which it wishes to do business.

For many years, few people outside the insurance industry were aware that such a mechanism as reinsurance existed. The public was first introduced to reinsurance in the mid-1980s during what has now become known as the liability crisis. A shortage of reinsurance was widely reported to be one of the factors contributing to the availability problems and high price of various kinds of liability insurance. A few years later, in 1989, the reinsurance business once again became a topic of interest outside the insurance industry as Congress investigated the insolvencies of several large property/casualty insurers.

These investigations culminated in a widely read report, "Failed Promises: Insurance Company Insolvencies," published in February 1990. The publicity surrounding the investigations and the poor financial condition of several major life insurance companies prompted proposals for some federal oversight of the insurance industry, particularly insurers and reinsurers based outside the United States. However, no federal law was enacted. While a large portion of the insurance industry opposes federal regulatory oversight, many U.S. reinsurers and large commercial insurers view compliance with a single federal law as preferable to compliance with the laws of 51 state jurisdictions.

A critical tool for evaluating solvency is the annual "convention" statement, the detailed financial statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the annual statement required insurers ceding liability to unauthorized reinsurers (those not licensed or approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR) losses in addition to known and reported losses. (IBNR losses are losses associated with events that have already occurred where the full cost will not be known and reported to the insurer until some later date.) This requirement reflects regulators' concern that all liabilities are identified and determined actuarially, including IBNR losses, and that IBNR losses are secured by the reinsurer with additional funds or a larger letter of credit than otherwise would have been required.

Related to solvency is the issue of reinsurance "recoverables, payments due from the reinsurer." In the mid-1980s, some reinsurance companies that had entered the reinsurance business during the period of high interest rates in the early 1980s left the market, due to insolvency or other problems. (When interest rates are high, some insurance/reinsurance companies seek to increase market share in order to have more premiums to invest. Those that fail to pay attention to the riskiness of the business they are underwriting may end up undercharging for coverage and going bankrupt as a result.) Consequently, some of the insurers that reinsured their business with these now-defunct companies were unable to recover monies due to them on their reinsurance contracts.

To enable regulators, policyholders and investors to assess a company's financial condition more accurately, the NAIC now requires insurance companies to deduct 20 percent of anticipated reinsurance recoverables from their policyholders’ surplus on their financial statements—surplus is roughly equivalent to capital—when amounts are overdue by more than 90 days. The rule helps regulators identify problem reinsurers for regulatory actions and encourages insurers to purchase reinsurance from companies that are willing and able to pay reinsured losses promptly.

Concern about reinsurance recoverables led to other changes in the annual financial statement filed with state regulators, including changes that improve the quality and quantity of reinsurance data available to enhance regulatory oversight of the reinsurance business.

After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position, which in turn caused primary companies to reconsider their catastrophe reinsurance needs.

Where reinsurance prices were high and capacity scarce because of the high risk of natural disasters, some primary companies turned to the capital markets for innovative financing arrangements.

The shortage and high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining interest rates, which sent investors looking for higher yields, prompted interest in securitization of insurance risk. Among the precursors to so-called true securitization were contingency financing bonds such as those issued for the Florida Windstorm Association in 1996, which provided cash in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes—an agreement with a bank or other lender that in the event of a megadisaster that would significantly reduce policyholders’ surplus, funds would be made available at a predetermined price. Funds to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes are not considered debt, therefore do not hamper an insurer's ability to write additional insurance. In addition, there were equity puts, through which an insurer would receive a sum of money in the event of a catastrophic loss in exchange for stock or other options.

A catastrophe bond is a specialized security that increases insurers’ ability to provide insurance protection by transferring the risk to bond investors. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business. Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose. These bonds have complicated structures and are typically created offshore where tax and regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or reinsurance company and the principal from investors and hold them in a trust in the form of U.S. Treasuries or other highly rated assets, using the investment income to pay interest on the principal. Catastrophe bonds pay high interest rates but if the trigger event occurs, investors lose the interest and sometimes the principal, depending on the structure of the bond, both of which may be used to cover the insurer’s disaster losses. Bonds may be issued for a one-year term or multiple years, often three.

Of the many new ways of financing catastrophe risk that have been developed over the past decade or two, catastrophe bonds are best known outside the insurance industry. One lesser-known alternative is the industry loss warranty contract or “ILW.” Unlike traditional reinsurance, where the reinsurer pays a portion of the primary company’s losses according to an agreed upon formula, the ILW is triggered by an agreed-upon industry loss. The contract “warrants” that the reinsurer will pay up to $100 million toward the buyer’s losses if the industry suffers a predetermined loss amount, say $5 billion or more.

Another recent innovation is the side-car. These are relatively simple agreements that allow a reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited and specific risk, such as the risk of an earthquake or hurricane in a given geographic area over a specific period of time. Side-car deals are much smaller and less complex than catastrophe bonds and are usually privately placed rather than tradable securities. In side-cars, investors share in the profit or loss the business produces along with the reinsurer. While a catastrophe bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an infrequent but potentially highly destructive event, side-cars are similar to reinsurance treaties where the reinsurer and primary insurer share in the results.

An insurance company’s willingness to offer disaster coverage is often determined by the availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew, they were expected to gain industrywide acceptance as an alternative to traditional catastrophe reinsurance, which was then in short supply, but they still represent a small, albeit growing, portion of the worldwide catastrophe reinsurance market, about 0.5 percent, according to Swiss Re, a pioneer in this field.

Initially, catastrophe bonds were designed to indemnify the insurer or reinsurer for the actual losses incurred—half of all hurricane losses up to a certain maximum, for example, similar to a traditional reinsurance agreement. Now they tend to be indexed products where the loss of principal is tied to formulas that take into account the severity of a catastrophe and its location, such as an earthquake of a certain intensity in California, instead of the actual losses suffered by the issuer. Other formulas are based on data generated by loss models or historical data.

Several of the first attempts at true securitization were withdrawn because of time constraints—the hurricane season had begun before work on the transaction could be completed, for example—and lack of sufficient interest on the part of investors. The first deals were consummated in December 1996, one by a U.S. reinsurer, St Paul Re, and the second by Winterthur, a Swiss insurer which issued convertible bonds to pay auto damage claims stemming from hailstorms. This was the first large transaction in which insurance risk was sold to the public markets. The company said that it did not need to finance hailstorm damage in this way but sold the bonds to test the market for securitizing insurance risks. Six months later there was strong investor interest in a bond offering that provided USAA with catastrophe reinsurance to pay homeowners losses arising from a single hurricane in eastern coastal states, proving for the first time that insurance risk could be sold to institutional investors on a large scale.

The field has gradually evolved to the point where some investors and insurance company issuers are beginning to feel comfortable with the concept, with some coming back to the capital markets each year. In addition to the high interest rates catastrophe bonds pay, their attraction to investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The returns on most other securities are tied to economic activity rather than natural disasters.

The National Association of Insurance Commissioners (NAIC), which oversees insurance company investments and sets the rules that influence insurers’ investment strategies, classifies these new types of catastrophe risk securities as bonds rather than equities. Equities are considered riskier under formulas that dictate how much capital must be set aside to support various liabilities. In addition, at its June 1999 meeting, the NAIC approved a so-called “protected cell” model act that makes it easier to transact deals in the United States. Up to then, most securitization deals had been conducted offshore through special entities created for this purpose. The protected cells, separate units within an insurance company, protect investors from losses incurred by the insurer.

In addition to catastrophe bonds, catastrophe options were developed but the market for these options never took off. Another alternative is the exchange of risk where individual companies in different parts of the world swap a certain amount of losses. Payment is triggered by the occurrence of an agreed upon event at a certain level of magnitude.

Congress looked into the adequacy of insurance capacity in areas vulnerable to natural disasters, including the market for catastrophe bonds, in response to a request from the U.S. House Financial Services Committee. The General Accountability Office (GAO) presented its findings on catastrophe bonds and barriers to their wider use in 2002.

The GAO said there were several barriers to more widespread use of catastrophe bonds. The first has to do with transfer risk from the insurance company to the reinsurer. As mentioned earlier, insurers get credit on their balance sheet for indemnity-based reinsurance in the form of a reduction in the amount of risk-based capital they have to set aside since the reinsurer will pay for losses covered by reinsurance. Indemnity-based deals are based on the insurer’s own book of business. They are not subject to basis risk, which is the mismatch between the company’s business and the index to which the transaction is linked. It is difficult, the GAO said, to assess how much credit to give for reinsurance that is not indemnity-based and may not fully reflect the company’s actual losses. The GAO said that accounting for risk-linked securities that are not based on actual losses would be a challenge for regulators, but a necessary step.

Disaster Recovery Bonds and Regional Pools: Disaster recovery bonds serve much the same purpose as a business income insurance policy, helping the government entity/policyholder get back on track after a catastrophic event.

In developing countries insurance penetration is low, meaning that few individuals and businesses have insurance, so the burden of recovering from a disaster falls almost entirely on the government. Traditionally, developing countries have relied on post-disaster funding to finance recovery efforts, including donations from developed countries, international emergency aid and humanitarian relief organizations. A faster and more reliable way to fund the recovery is prefinancing in the form of reinsurance, catastrophe bonds or other alternative risk transfer mechanisms.

One example of prefunding is the Caribbean Catastrophe Risk Insurance Facility, the first regional insurance fund. CCRIF provides hurricane and earthquake catastrophe coverage to its member nations, so that in the aftermath of a disaster they can quickly fund immediate recovery needs and continue providing essential services.

In 2004 hurricanes severely damaged the economy of several small Caribbean islands, causing losses in excess of $4 billion. This prompted Caribbean governments to request the help of the World Bank in facilitating access to catastrophe insurance. The CCRIF started operations in June 2007, after two years of planning.

The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks into a diversified portfolio and purchase reinsurance or other risk transfer products on the international financial markets at a saving of up to 50 percent over what it would cost each country if they purchased catastrophe protection individually. In addition, since a hurricane or earthquake only affects one to three countries in the Caribbean on average in any given year, each country contributes less to the reserve pool than would be required if each had its own reserves.

The CCRIF was initially capitalized by its members with help from donor partners—developed countries, the World Bank and the Caribbean Development Bank. Its members pay premiums based on their probable use of the pool’s funds. As countries raise building standards to provide better protection against disasters, premiums will decrease.

Because the CCRIF uses what has become known as parametric insurance to calculate claim payments, claims are paid quickly. Under a parametric system, claim payments are triggered by the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by actual losses measured by an adjuster, a process that can take months to complete.

Payout amounts are derived from models that estimate the financial impact of the disaster. As a form of deductible that encourages risk mitigation, participating governments are only allowed to purchase coverage for up to 20 percent of their estimated losses, an amount believed to be sufficient to cover initial needs.

Post-September 11: The terrorist attacks on the World Trade Center left their mark on the reinsurance business in many ways. First, the huge losses incurred accelerated rate hikes over a broad spectrum of coverages, unlike the aftermath of Hurricane Andrew, the most costly disaster prior to September 11, where only catastrophe insurance, a property coverage, was in short supply. Furthermore, the reinsurers that are now offering some terrorism coverage look at the business they are being offered from an accumulation-of-loss viewpoint in addition to traditional considerations, particularly in areas that may be terrorism targets. Computer programs are now being developed that not only estimate likely terrorism losses but also enable companies to determine more easily what other businesses they have reinsured in the same neighborhood.

Legislation known as the federal reinsurance backstop, the Terrorism Insurance Act of 2002, was passed in November 2002 and extended in 2005 to December 2007, and extended once again through December 2014. The Act does not cover reinsurers, see report on terrorism insurance.

KEY SOURCES OF ADDITIONAL INFORMATION

"Reinsurance: Fundamentals and New Challenges," Insurance Information Institute, 2004.

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