A Market Under(writing) the Weather: A Recommendation to Increase Insurer Capacity

Property and homeowners’ insurance are difficult and expensive to procure for residents of catastrophe-prone states like Florida, several Gulf Coast states, and California. In the last two decades, many insurers have left these markets because there is not enough profit to be made. As a result, remaining insurers charge very high premiums, and state governments must get involved to ease markets (at great expense to taxpayers). In addition, the insurance industry’s capacity for loss is simply insufficient—if a large hurricane should hit Miami, for instance, insurers who provide coverage on buildings and homes in Miami will almost certainly become insolvent.Two mechanisms exist to increase insurer capacity. First, reinsurance serves as insurance for insurance companies—an insurer who covers residential homes will buy insurance on its own policies. Reinsurance is insufficient, however, to supply the necessary capacity to cover low-probability, high-risk catastrophes (such as a Category 5 hurricane). The second mechanism is Alternative Risk Transfer, which increases capacity by securitizing risk. The main example in the Note is the catastrophe (\\"cat\\") bond. These bonds are constructed by insurers to increase capitalization. The insurer will put the premiums of certain policies in a Special Purpose Vehicle (SPV), an entity set up purely for the bond’s purposes. Investors (hedge funds, pension funds, banks, etc.) will buy bonds, the capital from which goes in the SPV. The SPV then invests the capital in lowrisk securities like treasury bonds and pays investors attractive returns. In return for these high returns, the cat bond contains a trigger which may result in investors losing some or all of their capital and interest. An example of a trigger is a Category 5 hurricane hitting Miami, or causing more than $15 billion in damages—should that happen, investors lose their capital and interest, which are used to pay losses on the insurer’s policies. In order to further incentivize investment in cat bonds, this Note recommends treating investors\' returns on these bonds as tax-exempt.The Note begins by providing a background of (1) the state of the catastrophe insurance industry and its inadequate capitalization, (2) insurer incentives, basic insurance principles, and tax treatment, (3) basic principles and tax treatment of the reinsurance industry, and (4) current proposals to increase capacity in the catastrophe insurance industry. The Note then analyzes (1) the capacity shortage problem, comparing the costs and benefits of reinsurance and alternative risk transfer, (2) the various federal policies purporting to address the increasing price of homeowner insurance premiums, and (3) several alternative risk transfer devices. The Note then discusses the advantages of the cat bond, such as the adaptability of bonds to numerous circumstances. Furthermore, the Note discusses the ability of cat bonds to supplement traditional reinsurance methods of increasing capacity. Lastly, the Note analyzes the benefits of treating cat bonds as tax-free.

The full text of this Note is available to download as a PDF.