Most catastrophe losses, whether caused by natural perils or other events, represent unbudgeted demands on public finances, according to Guy Carpenter's new report, Protecting our Planet and the Public Purse. Money spent to replace critical infrastructure (for example) inevitably draws money and resources away from other important community initiatives.
Fortunately, the reinsurance market’s ability and desire to innovate has seen it emerge as a capable private partner for public sector risk at a time when governments worldwide are looking to transfer risks from public to private balance sheets. A number of public-private partnerships have already been brought to market to help alleviate the burden from governments.
U.S. Federal Emergency Management Agency (FEMA) & The National Flood Insurance Program (NFIP)
After Hurricane Katrina struck Louisiana in 2005 and caused USD 160 billion in economic damages, the financial burden on FEMA increased significantly. The situation was compounded when Superstorm Sandy hit the East Coast of the United States in 2012, resulting in the NFIP’s deficit rising to USD 24 billion at the time (1). By current statute, the NFIP is required to repay this debt to the U.S. Treasury. Numerous reports have been written questioning FEMA’s ability to do this, given the exposure held by the program and the NFIP’s available finances. The annual cost to service its debt currently exceeds USD 400 million.
In consultation with the U.S. Congress, FEMA turned to the reinsurance market in 2014 to explore the feasibility of risk transfer to offset mounting losses within the NFIP. FEMA completed this work as part of the “Flood Insurance Risk Study,” which included an in depth analysis of the NFIP’s insurance portfolio around which it developed a sophisticated risk transfer program to share a portion of flood risk with private markets.
Traditional Private Reinsurance
In early 2017, FEMA became the first U.S. federal agency to purchase private reinsurance (with a program limit of just over USD 1 billion). Total premium for this first of its kind placement was USD 150 million. The key terms meant the program would be triggered if a natural catastrophe caused flooding-related losses falling between USD 4 billion and USD 8 billion, with FEMA entitled to recover 26 percent of any amount between these two thresholds.
Months after this landmark policy was placed, Hurricane Harvey struck Houston and its surrounding areas in 2017. Total damages from the hurricane reached USD 125 billion and FEMA’s NFIP policyholders suffered almost USD 10 billion in losses.
A full payout (of just over USD 1 billion) from the private reinsurance market was triggered within weeks of the hurricane coming ashore in Texas. The net result represented a significant return on the investment of USD 150 million in premium. More importantly, it provided immediate funding to pay claims to flood-insured survivors affected by Harvey. Ultimately, FEMA’s reinsurance program saved U.S. taxpayers over USD 850 million; money that would otherwise have added to FEMA’s deficit and related interest payments.
Importantly, underwriters on the program continued their participations when FEMA’s program renewed two months later. As a result, FEMA expanded the size of the program to USD 1.46 billion in January 2018. Over the course of that year, through the issuance of its first catastrophe bond, FEMA had nearly doubled its program limit to USD 1.92 billion, at a cost of USD 297 million (2).
Catastrophe Bonds
FEMA has supplemented its traditional reinsurance protection through the placement of USD 800 million of catastrophe bonds over the past two years. These bonds, a form of insurance-linked securities (ILS), pay capital market investors a set return against the risk that a natural catastrophe of a specific amount or severity occurs within the term of the bond (in FEMA’s case each bond has been issued with a three-year term) (3).
The process of developing a risk transfer program provided valuable insights to NFIP leadership in supporting its efforts to create a sound financial framework. Today, the NFIP still spends more than USD 1 million a day to service more than USD 20 billion in debt. Reinsurance has helped to minimize the need for additional borrowing and allowed the program to share losses with private market investors. While broader reforms are still required to address the challenges associated with the NFIP’s debt, this stable risk transfer program represents an initial step to create greater stability and sustainability.
Footnotes: 1. https://fas.org/sgp/crs/homesec/IN10784.pdf. 2. https://www.fema.gov/nfip-reinsurance-program 3. “National Flood Insurance Program’s (NFIP) Reinsurance Program,” FEMA, last modified November 7, 2019, accessed December 4, 2019, https://www.fema.gov/nfip-reinsurance-program.