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Catastrophe Funds and Reinsurance

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Catastrophe Funds and Reinsurance

Frequently Asked Questions

Nearly every region of
America has to deal with the risk of natural disasters. From New
Orleanians girding for hurricane season to Los Angelenos worrying about
out-of-control summer wildfires, everyone knows that certain events can
result in massive loss of homes, businesses, and lives. Almost all
observers agree that the current system for dealing with catastrophes
places large burdens on state governments, does not do enough to
encourage people to secure structures against the worst, and poses
significant financial risks to the insurance industry.

Everybody
concerned with catastrophe-related insurance issues agrees that
mitigation efforts to strengthen homes, businesses, and communities
against natural disasters deserve more attention than they have gotten
in recent years. Beyond that, however, widespread disagreement exists.
This paper deals with that disagreement. All of these issues have
significant implications for the type of insurance that insurers
buy—reinsurance.

Discussions in Congress, state capitals,
and at insurance industry events have revolved around proposals to
transfer some or all “catastrophic” risk to the federal government.
(Nobody has defined “catastrophic;” insurers have proposed everything
from $10 billion to $300 billion as a catastrophic risk.) Most recent
disasters have involved hurricanes, so for the most part, the issue is
intertwined with the long-standing National Flood Insurance Program
(NFIP).

Proponents of transferring some responsibility for
wind insurance to the federal government—including several very large
insurance companies, some emergency management professionals, and
elected officials from hurricane-prone areas—argue that the private
sector simply cannot deal with certain risks. They believe that only
the government is big enough to take care of certain risks and that
having the government take on these risks would protect both
individuals and corporate owners.

Opponents of such risk
transfers—including environmentalists, free market groups, some
insurance companies, and nearly all reinsurance companies—argue that
the private sector can handle these things on its own and that
government-backed reinsurance would encourage unwise development.

During
the 110th Congress, the Democratic-controlled House of Representatives
passed measures that would have added wind coverage to the National
Flood Insurance Program and established a public-private consortium to
provide reinsurance to states and private companies. The measures,
however, did not move forward in the Senate. President-elect Obama also
supports the idea of national reinsurance. However, for the most part,
positions on reinsurance break down along regional rather than party
lines: Prominent supporters of government-run reinsurance almost all
come from hurricane- or earthquake-prone areas and draw equally from
both parties.

This paper answers a number of questions
about reinsurance in general, the types of legislation that Congress
has considered in the past and may consider in the future, and
alternative methods for improving America’s regulation of reinsurance.
Finally, it cautions against rushing into new government-run mechanisms
for addressing problems related to reinsurance.