Seen at Business Insurance:
Property insurers writing both commercial and personal lines policies in New York would be required to create a catastrophe reserve fund to help pay claims caused by hurricanes and other natural disasters under a new regulation proposed by the state’s insurance department, Superintendent Eric Dinallo announced Thursday.
“There are many proposals to have government take over or subsidize hurricane insurance, as it does with flood insurance,” Mr. Dinallo said in a statement. “I believe it is better to find a private-sector solution. That’s why we are proposing a new state regulation requiring insurance companies to set aside the portion of the premium they now collect for catastrophe protection. This reserve fund will help pay the claims if and when hurricanes and other disasters do hit.[...]
Mr. Dinallo said in his statement that he is “in favor of tax-deferred reserves for hurricanes, but the industry will only achieve that change if it acts first and gains credibility. Meanwhile, we need to start building protection against the potentially huge costs of hurricanes now.”
Bravo!
The idea of cat reserve funds is one that has been tossed around for many years. The basic concept is as follows:
- In today’s world, insurers load their rates to include a provision for catastrophe risk. If there are no cats, the load flows through to the bottom line as extra profit. If there is a cat…well, the insurer will still probably suffer a loss. The extra profit from non-cat years over the long term should be enough to compensate the folks providing the capital to underwrite the risk for the additional variability in returns.
- With a cat reserve, the insurer still loads the rates for cat risk, but the loss portion of that load is placed into essentially a piggy bank. When a catastrophe strikes, the insurer taps into the piggy bank to pay (or help pay) the losses. In non-cat years, apparent profit is reduced, since funds are flowing to the account rather than to the bottom line…but that should be OK given that the results should be more stable, and investors should accept lower returns given the reduced risk.
The catch to date, noted by Dinallo, is that the IRS takes a rather short-term view of the world. If funds are not being used to pay for actual, reported losses (or at least held in reserve for losses known or suspected to have occurred), they’re profit…even if they’re being segregated and restricted to pay for future losses. That creates an extra drag on the long-term financial performance of an insurer which doesn’t exist in the salad-year/lean-year setup without reserves.
I will admit that I very quickly get a headache when I think about the accounting and systems work that will be required to make such a setup work. I will also be very interested to see what the draft regulation ends up saying about how much of a catastrophe piggy bank will be acceptable…and what happens to any amounts in excess of a prescribed threshold.
I’m also intrigued by the potential “warm and fuzzy” aspects of the idea. If executed correctly, the use of cat reserve funds deflates consumer advocates’ claims of insurer profiteering on cat-exposed business. If we raise rates to cover cat risk, the additional revenue flows into a bank account, not to our profit figures. If insurers’ financials appear more stable, the pure profit provision in the rates can theoretically be relaxed, and perhaps cat exposed business doesn’t necessarily look quite as scary.
This is an idea that would be better done countrywide, and taxing the reserve does create an unnecessary drag on operations…but like Dinallo notes, someone has to start the process.
And, it is a far more sensible idea than (say) the state becoming a reinsurer without fully funding its activities in that regard.
