Government intervention in private insurance markets could be hindering cat bonds

The U.S. Governments intervention in private insurance and reinsurance markets, specifically (although not uniquely) in natural catastrophe risks, places an unsustainable burden on tax payers that could be removed if the private market was allowed to participate more, according to a report published by Lloyd’s of London yesterday.

“The private insurance market has a crucial role to play in helping communities and economies recover from disaster,” said Sean McGovern, Director, North America at Lloyd’s. “We need to go back to first principles and redraw the boundaries between government intervention and the private market. The cost to the US taxpayer is huge and is not sustainable.”

Lloyd’s say that the problem is illustrated by the current fight over losses from hurricane Irene, they say that lawmakers can’t agree on where aid should come from and whether aid should be offset by cuts to other federal programs which is obviously detrimental to taxpayers. There are also issues such as the National Flood Insurance Program which could be better managed in the private sector or as a public-private partnership and the Florida Hurricane Catastrophe Fund which could struggle to raise debt to pay claims after an event, again this could be better managed in the private sector.

The report from Lloyd’s called ‘Managing the Escalating Risks of Natural Catastrophes in the United States‘ recommends greater cooperation between government, re/insurers and planners in the U.S. to ensure a greater emphasis on managing and mitigating disaster risks.

They say that allowing a healthy private market to price risk is essential; “Insurance is not sustainable if it is offered at rates below what is required by sound, risk-based actuarial practices,” added McGovern “When insurance is not risk-based, the wrong price signals are sent and there is little or no incentive to mitigate risk.” This is such a good point, if risks are not priced correctly and insurance is discounted a market cannot flourish and sensible risk management best practice tends to be forgotten. It also leaves no room for new risk transfer techniques to participate and help to remove the burden from taxpayers as they just can’t be priced competitively.

Here’s the problem for catastrophe bonds. Discounted insurance and the lack of a private, correctly priced reinsurance market, makes it near impossible for cat bonds or insurance-linked securities to be used to hedge these risks. Cat bonds could form a core part of a national disaster insurance plan to remove the burden from government and taxpayers and pass those risks on to capital markets investors. However the discounting that occurs on these risks makes cat bonds unattractive and difficult to price competitively.

Lloyd’s has proposed nine principles for managing natural catastrophe risk in the U.S.:

1. The first step in protecting US property owners from natural catastrophe losses is ensuring there is a healthy, private insurance market
2. Government intervention in insurance markets should be kept to a minimum
3. Risk-based pricing is the fairest and most sustainable solution
4. Specialist international insurers and reinsurers add value to US natural catastrophe market through additional capacity and expertise
5. Government and insurers must respond to changing trends in the frequency and severity of losses
6. The Government has an important role to play in helping develop risk mitigation measures and rewarding adaptation to reduce the overall costs to the economy
7. The insurance industry has a key role to play in helping build more resilient communities
8. Good quality data and hazard mapping is critical to robust underwriting
9. We believe in encouraging a responsible approach to risk in society

We could add a tenth principle; encouraging the use of risk transfer to the capital markets to diversify the sources of reinsurance and further reduce the burden on taxpayers, risks of accumulation in the re/insurance market and potential for failure of participating re/insurers.

Cat bonds could play a massive role if the government stepped back from disaster insurance and encouraged a private market to flourish. By providing a diversified source of reinsurance from the capital markets they could even help to negate the concerns about price rises from policyholders.

We’d like to know your thoughts, how do you feel (currently Federal) disaster insurance is best managed and what role do you think capital markets risk transfer has to play?