Proposal calls for government backed reinsurer US Re, to hold catastrophe risk at lowest cost

A proposal has been published today calling for the establishment of a United States government backed reinsurance entity named US Re, which would be designed to assume natural catastrophe risks at the most extreme tail of the loss distribution, holding catastrophe risk at the lowest cost possible.

The proposal made by the Hamilton Project at Brookings Institution, calls for a US federal property reinsurer to be formed, to help in supporting both insurance and reinsurance market delivery of more consistent and affordable homeowners insurance coverage in the country.

With climate and natural disaster costs rising the US insurance industry has been challenged, driving higher costs for policyholders, market exits by insurers, as well as cyclical and volatile reinsurance marketplace, the Hamilton Project team explains in the proposal.

It states, “We propose a federal reinsurance entity, “US Re,” that would sell reinsurance contracts to providers of U.S. homeowners insurance and reinsurance to cover the most extreme weather events. Because the federal government can borrow substantially and at attractive rates, US Re could credibly and reliably pay claims without being subject to the same high and volatile costs as the private reinsurance market. As a result, US Re could help households maintain more consistent and affordable coverage, contribute to resilience and disaster recovery, and help stabilize mortgage and housing markets.”

The idea is to bring in US Re in the tail of the catastrophe loss distribution, where the researchers believe it could have the greatest effect.

“Competitive markets also create natural price discipline and encourage innovation in a way that would be difficult to replicate in a public reinsurer. Thus, it is desirable that private insurance and reinsurance markets continue to bear a substantial share of U.S. disaster risk,” the proposal explains.

Saying that, “US Re’s role is to hold severe catastrophe risk at a lower cost than any other entity ever could, which creates two benefits in the premium calculation that will lower and stabilize the cost of home insurance. The first benefit is that it lowers and stabilizes the cost of capital charge. The U.S. government can raise more funds and at a lower rate than the reinsurance industry. Moreover, even severe natural disasters do not threaten the solvency of the federal government. Second, US Re could take a risk-neutral role regarding climate uncertainty, reducing or eliminating uncertainty loads.”

They explain that US Re would be a third-tier in the market, after primary insurance and reinsurance, “US Re’s role would create a new third tier, at the most extreme tail of the loss distribution. Its entry, with its lower capital costs and insulation from insolvency risk, provides the greatest price-reducing benefits.”

The researchers cite examples including Pool Re, Citizens, the FHCF, etc, noting that like these US Re would need to organise funding to cover its obligations (which could include retrocession, although the paper does not mention any risk transfer for US Re).

They propose reserves as the first loss tier for US Re, after which comes a potential contingent claims structure and then contingent debt. Seemingly not seeing any role for private risk transfer markets in supporting this proposed reinsurer.

US Re should set relatively high attachment points in the reinsurance contracts it provides to the market, “so that insurer retention remains high enough to leave a meaningful role for private reinsurance.”

But, like many other proposals for government backed reinsurance facilities, US Re could have implications for the reinsurance market and insurance-linked securities, depending on how far out in the tail it operated.

That would depend on the benefits it could deliver, through capital efficient protection, and whether re/insurers would feel the need to buy coverage way out in the tail like that, where today some might not buy much if any coverage at all.

Often these proposals can appear likely to drive a reversal of risk-privatisation trends, if implemented too low down or thought through without collaboration from private markets.

Effectively, if not implemented thoughtfully, government backed schemes can end up putting the government’s cost-of-capital in direct competition with the private re/insurance market, at certain points on the risk-curve where the two sources of capital might both want to compete.

Which is why, typically, government backed reinsurance has tended to be most effective in areas where the private market alone cannot, or will not, fulfil the coverage needs of people living in a location, or for a peril like terrorism risk where the private market would not have the appetite to take on all of the exposure alone.

In this case, the proposal does seem more focused on reducing insurance costs for consumers, than filling any unmet coverage needs.

In fact, it is perhaps more appropriate to see it as a proposal to meet coverage needs at lower-cost by using the government’s low cost-of-capital, than as any type of backstop.

The higher layers of natural and climate disaster risk the proposal calls for US Re to cover, could all be priced and covered in private reinsurance and capital markets it seems, if the demand for protection at these tail risk levels was there.

By holding catastrophe risk at a lower-cost that traditional reinsurance or ILS markets could perhaps manage, US Re could therefore be seen as in direct conflict with the private market, rather than being supportive of closing protection gaps, or fulfilling a coverage need, like other government backed reinsurance entities around the world are most typically mandated.

There is another way to look at it though, that by stabilising and lowering the costs of financing risks of the largest catastrophic events, the benefits would ultimately flow down to enable traditional insurance and reinsurance markets to do more and do better on price for consumers.

We’re certainly not against any proposals of this kind, we’re also greatly simplifying the researchers work (find the link to the full proposal at the bottom, which we encourage you to read).

But we do feel it’s important to raise the potential for conflicts between private and public, if an entity such as US Re were not designed with ultimate goals of stabilising the private market, making its cost-of-capital more efficient and enabling it to grow into these exposures, so seeking to support and encourage more private market participation over-time in catastrophe risks even out in the tail, not less.

It ultimately does seem to come down to the thesis that the government can bear catastrophe risk more cheaply than any other capital source, reinsurance or insurance-linked securities. That’s impossible to deny, although some will say this ultimately shifts  the burden to taxpayers.

In fact, the researchers write on catastrophe bonds that their capital cost might make them uncompetitive with US Re, it seems.

The proposal states, “One approach to pricing would be for US Re to use market prices to infer expected losses. For example, US Re could issue a catastrophe bond to private investors for a small share of its portfolio and use the resulting market rates as a basis for setting its own prices. This approach—while a tempting way to utilize market prices—may ultimately run into the same capital market frictions that motivate US Re in the first place. The rates on any catastrophe bonds US Re issues would reflect both expected losses and capital costs, making those rates an inappropriate benchmark given US Re’s lower cost of capital.”

The full proposal can be accessed here.