2. Reinsurance and Its Role in the National Flood Insurance Program: A Primer for Public Policy Makers
Robert W. Klein, Ph.D.
Georgia State University

3. Overview Motivation for the NFIP’s use of reinsurance
Reinsurance basics
What is reinsurance and how does it work?
Catastrophe excess of loss reinsurance contracts
Review and discussion of the NFIP’s reinsurance arrangement
Alternative devices for the transfer and financing of the NFIP’s catastrophic risk
Concluding thoughts

4. Motivation for the NFIP’s Use of Reinsurance
In recent years, the NFIP has been subject to very large losses from “extreme” events, e.g., Hurricanes Katrina and Ike, Superstorm Sandy.
The losses from these events have far exceeded the NFIP’s financial capacity and are primarily responsible for the program’s accumulated debt to the Treasury.
It is reasonable to expect that will be more of these events in future years.
The purchase of catastrophe reinsurance by the NFIP is one way the program can bolster its financial capacity and reduce its borrowings from the Treasury.
In 2012, the Biggert-Waters Flood Insurance Reform Act authorized the NFIP to use reinsurance for this purpose.

5. Rising Flood Losses in the U.S.

6. Total Coverage in Force by Calendar Year: 1978-2015

7. NFIP Losses Paid & Premiums Earned by Calendar Year: 1978-2015

8. NFIP Debt: Fiscal Years 1981 - 2016

9. What is Reinsurance?
Reinsurance is a contractual agreement under which the primary insurer transfers some or all of its loss exposures to a reinsurer.
Primary
Insurer
Reinsurer
Retrocessionaire ?

10. Fundamental Elements of Reinsurance Contracts
There are various types of reinsurance contracts that are designed to serve different purposes; our interest is in catastrophe excess of loss contracts.
An insurance company purchasing reinsurance is known as the “ceding carrier” or “cedent”.
An insurer may purchase reinsurance from one or more reinsurers to transfer all or portion of the risk it has assumed at a primary level.
The ceding carrier pays a ceding commission or premium to the reinsurer(s) to cover the expected losses, expenses, and cost of capital of the reinsurer(s).
Treaty reinsurance
The reinsurer is obligated to accept all business that falls within the terms of the treaty.
A reinsurance contract will contain various terms and conditions that pertain to the exposures covered under the contract, claims settlement, etc.

11. The Reinsurance Market
Suppliers of reinsurance include both domestic U.S. reinsurers and non-U.S. reinsurers.
Some firms solely provide reinsurance; others provide both primary coverage and reinsurance.
The reinsurance market is subject to cycles & fluctuations in supply or capacity and underwriting/pricing.
Historically, long-term relationships between primary insurers and reinsurers provided stability.
As these relationships have eroded, the reinsurance market has become more volatile.

12. Catastrophe Excess of Loss Reinsurance
In an excess of loss or non-proportional reinsurance contract, the ceding carrier transfers all or a portion of its losses that exceed a certain amount (retention level) up to a limit set in the contract.
This type of contract can be issued on a per risk or per policy basis, an occurrence basis or an aggregate basis.
Per occurrence contract
The contract will “trigger” if the ceding insurer’s losses from “one event,” e.g., a named hurricane, exceed the retention level in the contract.
The reinsurer(s) will typically pay 90-95% of reinsured losses; this helps to mitigate moral hazard.
Aggregate excess contract
The contract will trigger if the ceding insurer’s losses (from one or more events) over some defined period exceed the retention level in the contract.

13. Examples of Excess of Loss Reinsurance Contracts
Example A:
The ABC Insurance Company has an excess of loss reinsurance contract that is a per occurrence contract with a retention level of $500M and a contract limit of $2B; the reinsurer assumes 90% of covered losses.
ABC pays $1B in losses arising from a severe hurricane.
ABC will retain the first $500M in losses plus 10% of the second $500M in losses; ABC retains $600M in losses and the reinsurer pays $400M to ABC.
Example B:
The XYZ Insurance Company has an excess of loss reinsurance contract that is an aggregate excess contract with a retention level of $1B and a contract limit of $4B; the reinsurer assumes 95% of covered losses.
XYZ pays $3B in losses over the contract period; there is not one single event that causes XYZ to incur losses above $1B from that event.
XYZ will retain the first $1B in losses plus 5% of its remaining $2B in losses; XYZ retains $1.1B in losses and the reinsurer pays $1.9B to XYZ.

14. The NFIP’s Reinsurance Transaction
Under the terms of this transaction, 25 reinsurers have agreed to indemnify the NFIP on a per occurrence basis for 26% of its losses from a single event, with a retention level of $4B and a contract limit of $8B.
The maximum amount that the reinsurers will be obligated to pay under the contract is $1.042B.
The contract is in effect for the period of January 1, 2017 through January 1, 2018.
The NFIP is paying a ceding commission or premium of $150M.
Guy Carpenter brokered the deal.

15. Discussion
Purchasing this amount of reinsurance is a major step forward for the NFIP; last year it purchased $1M of reinsurance to set the foundation for this year’s transaction.
Beyond bolstering its financial capacity, purchasing reinsurance should enable the NFIP, in future years, to incorporate the cost of reinsurance into its pricing of flood policies at a primary level.
In this transaction, the NFIP is helping to establish a market for its future reinsurance transactions; as reinsurers become more comfortable with providing reinsurance to the NFIP, it should be able to negotiate future transactions on favorable terms.
It is likely that the NFIP will purchase larger amounts of reinsurance in future years.

16. Discussion continued …
All of this said, $1B in reinsurance in and of itself, would fall far short of covering the NFIP’s losses from a major event on the scale of Hurricane Katrina or Superstorm Sandy.
Consider the cases of Hurricane Katrina where the NFIP paid $16B in flood claims, or $19.3B adjusted for inflation, and Superstorm Sandy where the NFIP paid $8.75B in flood claims, or $9.3B adjusted for inflation.
Under the terms of its current reinsurance contract, for an event on the scale of Katrina, the NFIP would retain a little less than $18B in losses; its reinsurers would pay $1.042B.
For an event on the scale of Sandy, the NFIP would retain about $7B in losses; its reinsurers would pay $1.042B.
Other observations
Under the current transaction, the NFIP is retaining the lion’s share of its losses between $4B and $8B; in future transactions the NFIP could transfer a greater share of its losses.
The current contract is occurrence based; an aggregate excess contract could offer certain advantages to the NFIP but such a contract may be infeasible for various reasons.

17. Catastrophe Bonds
Insurance (and reinsurance) companies use other financial instruments to transfer a portion of their catastrophe risk; this is commonly known as securitization.
A popular form of securitization is a catastrophe bond.
How do catastrophe bonds work?
An insurer (or other entity) issues bonds with interest equal to a risk-free rate + a risk premium = basis points (for 1% probability loss).
Investors receive principal plus interest if no triggering event occurs.
All or portion of the interest and principal are forgiven if the triggering event occurs. The issuer uses the funds from the bonds to help cover its losses.
Catastrophe bonds have been issued with parametric or non-parametric triggers, or a combination of both.
The NFIP could be a good candidate for catastrophe bonds that it could use to supplement its reinsurance.

18. Typical Structure of Cat Bond with Special Purpose Reinsurer

19. Concluding Thoughts
In recent years, the NFIP has suffered large losses from severe events that have greatly exceeded its financial capacity.
There is a good chance that there will be more of these events in the years to come.
The NFIP has taken a big step forward with its first major reinsurance transaction.
This transaction will set the stage for future transactions on favorable terms that will enable it to further bolster its financial capacity and help protect itself against large losses.
A catastrophe bond is another instrument that the NFIP might use to augment its reinsurance.

20. Contact Information
Frank Tomasello
Griffin Foundation
Robert Klein
Georgia State University