H.R. 737, bill proposing state catastrophe bonds, languishes in Congress

A U.S. house bill proposing the pooling of risks from state natural catastrophe re/insurance providers in order to facilitate better reinsurance and risk transfer, including through instruments such as catastrophe bonds, is languishing in a Congress committee.

H.R. 737, or the Homeowners’ Defense Act of 2013, is a re-introduction of a House of Congress bill from the 112th Congress, which had failed to be passed during that last legislative session. Now, with the 113th Congress well underway this bill has so far not made any meaningful progress since it was introduced in February 2013.

The bill, if passed, would establish the National Catastrophe Risk Consortium, a non-federal, non-profit entity, which would be tasked with ensuring the availability and affordability of homeowners’ insurance cover for natural catastrophe events.

Membership of this consortium would be open to any state which has established a reinsurance fund, operates a residual market insurance entity or which has state-sponsored catastrophe insurance providers. The consortium would be tasked with using a variety of methods to try to fend off large rate rises post-catastrophe event and to ensure continuity in the availability of insurance.

The bill directs the consortium, if established, to:

1. Work with states to gather and maintain an inventory of catastrophe risk obligations held by any state catastrophe funds or catastrophe re/insurance providers.
2. At the discretion of the affected members and on a conduit basis, issue securities and other financial instruments linked to the catastrophe risks insured or reinsured through members of the Consortium in the capital markets.
3. Coordinate reinsurance contracts between participating, qualified reinsurance funds and private parties.
4. Act as a centralized repository of State risk information that can be accessed by private-market participants seeking to participate in the transactions described in paragraphs (2) and (3) of this section.
5. Establish a catastrophe risk database to perform research and analysis that encourages standardization of the risk-linked securities market.
6. Perform any other functions, other than assuming risk or incurring debt, that are deemed necessary to aid in the transfer of catastrophe risk from participating States to private parties.
7. Submit annual reports to Congress describing the activities of the Consortium for the preceding year, and the first such annual report shall include an assessment of the costs to States and regions associated with catastrophe risk and an analysis of the costs and benefits, for States not participating in the Consortium, of such nonparticipation.

In many ways this consortium sounds like it would be similar to the Florida Catastrophe Risk Capital Access Facility, which was a feature of a bill introduced in the Florida Senate earlier this year (read our coverage on that bill). In a similar way, the National Catastrophe Risk Consortium if created would assist the transfer of risk to capital markets sources of capacity, through the use of instruments such as catastrophe bonds or insurance derivatives.

As well as facilitating transfer of catastrophe risks from states to private parties, be that reinsurers, capital markets investors or dedicated ILS funds, this bill also seeks to increase transparency, and as a result liquidity, in the market for catastrophe risk.

According to a recently published Congressional research paper (available in PDF format here), the consortium would hope to improve transparency, standardization and liquidity by:

To facilitate catastrophe risk securitization, the consortium would use an integrated risk valuation method that identifies, tracks, and publicizes the risks embedded in financial transactions. The insurance risk securitization, serialization, bundling, and re-bundling of risk-adjusted assets within a single transaction process will be transferred to the capital market through a catastrophe risk interactive exchange platform.

In theory, the consortium would standardize natural catastrophe peril bond terms, tranches, and pay out formulae, which, in turn, would enhance the marketability/liquidity of risk-linked securities, such as catastrophe bonds structured to attract more capital. Credit rating agencies would rate the various tranches according to their expected loss. The consortium would issue catastrophe bonds, and other innovative financial instruments, using an electronic platform with a common legal structure and documentation. Securities would be issued by the consortium in an SEC 144A private placement to investors who are Qualified Institutional Buyers or similar classes of investors, and who sign an Investor Awareness Letter. Reinsurance credit would be granted by the insurance regulator based on the full collateralization of the reinsurance contract within a Regulation 112 trust, with suitable investment restrictions.

The consortium would transfer the catastrophe risk directly to international catastrophe reinsurance and capital markets on competitive terms. States would presumably grant reinsurance credit based on the full collateralization of the reinsurance contract within a Regulation 112 trust, with suitable investment restrictions. The consortium is structured to overcome regulatory and tax constraints to catastrophe risk transfer through securitization. Removal of regulatory and tax constraints associated with catastrophe bonds and other alternative financial instruments issued by the National Catastrophe Risk Consortium could, in theory, increase the capacity of the private capital market to assume more catastrophe risk.

Now, while this sounds extremely promising in terms of the direction of thinking being shown by politicians in the U.S., the question that arises is whether a consortium like this, which is non-profit and non-federal, is really the right model. If the aim is for it to launch an electronic exchange for catastrophe risk, it may come into direct competition with private market initiatives and sometimes the private market is a more appropriate home for this type of centralised market player.

It also has to be asked whether the stated aim of a consortium like this should be to keep insurance costs down. Market forces will dictate pricing, if indeed it is allowed to operate as a true market player, so the direction of pricing will be dictated by perceived risk and availability plus cost of capital.

On both these points, whether it should be a private initiative and whether it should seek to control pricing, the private reinsurance and ILS market is currently doing a very good job, with pricing of peak catastrophe risks down, thanks to capital availability and peak catastrophe risk transfer becoming every more streamlined.

It is very interesting however and this bill, if it makes it out of the House Financial Services Committee, where it has languished since February, could be a step forwards in terms of transferring state catastrophe risks into the private market and would also be welcomed by institutional investors looking for catastrophe risk to invest in.

H.R. 737 is not the only U.S. government initiative looking at transferring catastrophe risks to the capital markets. A number of other bills and initiatives have been submitted for discussion this year as well. As the profile of the ILS, catastrophe bond and the capital markets as risk transfer counterparty has grown in stature it is to be expected that this issue, of using the capital markets for catastrophe risk transfer, will be raised again.