Last month, as we entered the heart of the 2007 hurricane season, several ideas for insuring catastrophic storms began forming like tropical depressions off Cape Verde. Whether any coalesces into a lasting solution for the insurance industry's biggest problem remains to be seen, but all the attention is certainly welcome.

The different ideas all seek a way to more widely spread catastrophe risks while having someone other than taxpayers shoulder them. That's a welcome change from the approach taken by individual states like Florida, which is using a state-run insurer to sell wind coverage at low rates and put the resulting risk primarily on state residents.
Fittingly, the first proposal came from two Florida congressmen, Ron Klein and Tim Mahoney, who on Aug. 3 introduced H.R. 3355, the Homeowners' Defense Act of 2007. The legislation would create the “National Catastrophe Consortium,” an entity into which “participating states' reinsurance funds, risk pools, or primary insurance corporations” could pool their catastrophe exposures. They could then transfer away that exposure by purchasing reinsurance or selling catastrophe bonds to private financial markets.
H.R. 3355 also would create the “National Homeowners' Insurance Stabilization Program,” which would authorize the U.S. Treasury to act as the consortium's financial backstop by making “liquidity loans and catastrophic loans” to state or regional reinsurers under certain conditions.
The plan drew the support of the Independent Insurance Agents & Brokers of America. Insurers, while backing the idea of spreading catastrophe risks, were less than thrilled with the idea of increasing state insurers' role in the wind market. “If history is any measure, government-mandated insurance pools of any kind are inherently and exponentially more susceptible to being underfunded, oversubscribed and prone to deficit spending,” Marc Racicot, president of the American Insurance Association, said in a press release.
If some insurers threw bricks at H.R. 3355, at least one also offered an alternative. In an article that appeared in the Wall Street Journal, Jay S. Fishman, chairman and CEO of the Travelers Cos., outlined a plan for a federally regulated “Coastal Hurricane Zone,” which would extend from Maine to Texas. The feds would not take on a risk-bearing role under Fishman's plan, but they would “regulate and oversee most aspects of wind underwriting by private insurers, including pricing.”
Meanwhile, Fishman's plan would eliminate state regulation of wind coverage in coastal areas, which he says “historically has led to regulatory inconsistency and unpredictability, for insurers and customers alike, in the aftermath of major storms. This lack of consistency has been a key factor in driving insurers out of coastal markets, decreasing supply and increasing costs.”
In the Coastal Hurricane Zone, rates would be adjusted up or down following major hits or periods of calm. “The goals here are to ensure customers receive rates that are fair and sound–and to avoid the sense that insurers are 'winning' and customers are 'losing,'” Fishman said. If low-income residents need help to pay for coverage, he said they could receive tax credits, subsidized by more affluent coastal residents, during a 10- to 15-year transition period.
The most intriguing idea for covering hurricanes (or other natural disasters), however, came from outside the insurance industry. In the Aug. 26 issue of The New York Times Magazine, best-selling author and former bond salesman Michael Lewis made the case for transferring much of the nation's catastrophe exposure to the financial markets–in essence, let the hedge funds handle it.
I'll try to summarize the lengthy article. The world's financial risk from natural disasters has rapidly become extremely concentrated, with most of it lying along the U.S. eastern, Gulf and California coastlines. Insurers' exposure, perhaps $500 billion going into Katrina, has become too big for the U.S. insurance industry, with its $490 billion or so in surplus, to absorb, even with traditional reinsurance. “Wealth had become far too concentrated in a handful of extraordinarily treacherous places,” Lewis writes.
Insurers have had no idea how to rationally price catastrophe coverage, and have essentially operated on the assessment model. Up until Hurricane Andrew in 1992, insurers were lucky and the approach worked reasonably well. Since then, rates have skyrocketed after major storms, as insurers attempt to recoup their losses and reprice coverage, overcompensating out of fear. Some even abandon markets. Then rates fall, as markets soften. Meanwhile, catastrophe-modeling companies began to spring up. While holding out the hope of helping insurers eventually get a handle on catastrophic risks, they also concluded, following Katrina, that the risks were twice as high as previously thought.
The way out for insurers? Shift their exposures to the financial markets by issuing more catastrophe bonds–the securities that also were cited in H.R. 3355. Lewis says global stock markets have $59 trillion in assets. “The losses caused by even the biggest natural disaster would be a drop in the bucket to the broader capital markets,” he says.
Two things have made this idea feasible, Lewis says. The first is the continued refinement of catastrophe risk models, which, while still far from precise, can predict expected losses with acceptable accuracy. The second is the development of mathematical models that give potential catastrophe bond buyers an idea of how much they should pay for them. The article implies that this price will lead to acceptable returns for investors over the long run while ultimately leading to lower, more stable premiums for policyholders–in other words, that this market would be more efficient than the insurance market is.
Do any of these plans have the answer, or is it still blowing in the wind?