Background on:

Reinsurance
In s u ra n c e In d u s t ry
No v ember 3, 201 4

IN TH IS ARTICLE

T he t o pi c

Recent Dev elo pment s

Back gr o und

A ddi t i o nal r eso ur ces

S H ARE TH IS

D OW N LOAD TO PD F

The topic
Reinsurance is insurance for insurance companies. It’s a way of transferring or “ceding” some of
the financial risk insurance companies assume in insuring cars, homes and businesses to another
insurance company, the reinsurer. Reinsurance is a highly complex global business. U.S.
professional reinsurers (companies that are formed specifically to provide reinsurance)
accounted for about 7 percent of total U.S. property/casualty insurance industry premiums
written in 2010, according to the Reinsurance Association of America.

The reinsurance business is evolving. Traditionally, reinsurance transactions were between two
insurance entities: the primary insurer that sold the original insurance policies and the reinsurer.
Most still are. Primary insurers and reinsurers can share both the premiums and losses, or
reinsurers may assume the primary company’s losses above a certain dollar limit in return for a

Background on:
Reinsurance
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Rernwnince Is Insurance for rnsuninc:e oompa,les. It's a way oftransfemng or 'cednlf some or
theflnencral ltsl< lnsur.ance companies assume In rnwrtng c.us, homes 111d businesses 10 ano111er
Insurance coml)4!ny, the re'1surer. Refnsur.anc:e Is a highly ccmplex glob.II business. U.S.
prol'e.sslon.l rehsurers (coml)4!nfes thet are formed specllcaty 10 provide refnsur.anc:e)
acx:ount.e<I for about 7 peu:mtof IIJIJII U.S. property/casual!,l lnsunmce '1duslly PrEmlums
wrlt!Bn In 2010. aocor<lng l1J the Relmsurance Auocll!tlon of Amerfca.

The rernwr.anc:e buslness ls EWMng. Tr.adllonell)I. relnsu111nce nnsac1/ons were-1>'10

Insurance entftles: the primary '1surer that sold the orlglnal '1su111nce polfcles and the refnsurer.
Mostslll a-e. Prtnmy Insurer.a end re'1suren can sha-e both the premfum.s and losses. or
rensurers may es,sume the primary compenys losaes ebo¥e a cert.afn dollar lfmltIn rell.lrn for a
 fee. However, risks of various kinds, particularly of natural disasters, are now being sold by
insurers and reinsurers to institutional investors in the form of catastrophe bonds and other
alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of
reinsurance and investment banking, see also Background section.
fee. However, risks of various kinds, particularly of natural disasters, are now being sold by
insurers and reinsurers to institutional investors in the form of catastrophe bonds and other
alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of
reinsurance and investment banking, see also Background section.

Recent Developments
Financial and Market Conditions: According to the Reinsurance Association of America
(RAA), a group of 18 reinsurers property/casualty reinsurers wrote $28.4 billion of premiums in
the first six months of 2014, compared with $13.5 billion during the same six-month period in
2013, an increase driven largely by some specific transactions reported by one of the 18
reinsurers surveyed by the RAA. The combined ratio, a measure of profitability that shows what
percentage of the premium dollar that was spent on claims and expenses, was 92.3 percent, a
deterioration from the 85.9 reported in the first six months of 2013. Policyholders’ surplus,
capital that represents a cushion against unexpectedly high losses, now stands at $142.9
billion, up from $138.7 billion at the end of first quarter 2014. Net income for the period rose to
$5.9 billion. RAA members account for about two-thirds of reinsurance coverage provided by
U.S. reinsurers and their affiliates.

Catastrophe Bonds: Industry observers predict that the catastrophe (cat) bond market will
have an extraordinarily successful year, possibly topping the previous record issuance of $7
billion set in 2007. Cat bonds issued in the second quarter alone rose to $4.5 billion, with 17
deals consummated, putting the total for the first six months of the year at about $5.7 billion,

Recent Developments 0
according to the Willis Group. Some speculate that the figure could rise to more than $8 billion
before the end of the year. The largest cat bond ever, a $1.5 billion deal, was issued by
Citizens Property Insurance Corp., Florida’s insurer of last resort, to cover the state’s hurricane
risk. Demand was so strong and pricing and conditions for cat bonds and traditional
reinsurance so favorable that Citizens was able to increase the offering twice from the original

SHARE
$400 million and nearly double last year’s reinsurance program for almost the same cost, a
spokesperson said.

Study: The Federal Insurance Office (FIO) released a long-awaited report on the reinsurance
and insurance industries in December 2013. Among its many recommendations is one that
deals with credit for reinsurance. It suggests ending a long-standing debate on the issue of
posting 100 percent collateral on reinsurance transactions with non-U.S. reinsurers by
following the National Association of Insurance Commissioner’s (NAIC) amended version of its
model law adopted at the organization’s November 2011 meeting. The NAIC’s Credit For
Reinsurance Model Law allows financially sound non-U.S. reinsurers to post less than 100
percent collateral and lets the NAIC decide which foreign jurisdictions have sufficiently rigorous
regulations for their reinsurers to be considered “qualified” and therefore permitted to post a
lower collateral amount. The law also requires insurers to notify state commissioners when the
amount that they expect to recover under their reinsurance contracts exceeds 50 percent of
their policyholders’ surplus, the financial cushion that allows insurers to pay unexpectedly high
claims. It also requires insurers to diversify their reinsurance programs to lower the risk of not

• Financial and Market Conditions: According to the Reinsurance Association of America

(RM), a group of 18 reinsurers property/casualty reinsurers wrote $28.4 billion of premiums in
the first six months of 2014, compared with $13.5 billion during the same six-month period in
2013, an increase driven largely by some specific transactions reported by one of the 18
reinsurers surveyed by the RM. The combined ratio, a measure of profitability that shows what
percentage of the premium dollar that was spent on claims and expenses, was 92.3 percent, a
deterioration from the 85. 9 reported in the first six months of 2013. Policyholders' surplus,
capital that represents a cushion against unexpectedly high losses, now stands at $142.9
billion, up from $138.7 billion at the end of first quarter 2014. Net income for the period rose to
$5.9 billion. RM members account for about two-thirds of reinsurance coverage provided by
U.S. reinsurers and their affiliates.

• Catastrophe Bonds: Industry observers predict that the catastrophe (cat) bond market will
have an extraordinarily successful year, possibly topping the previous record issuance of $7
billion set in 2007. Cat bonds issued in the second quarter alone rose to $4.5 billion, with 17
deals consummated, putting the total for the first six months of the year at about $5.7 billion,
according to the Willis Group. Some speculate that the figure could rise to more than $8 billion
before the end of the year. The largest cat bond ever, a $1.5 billion deal, was issued by
Citizens Property Insurance Corp., Florida's insurer of last resort, to cover the state's hurricane
risk. Demand was so strong and pricing and conditions for cat bonds and traditional
reinsurance so favorable that Citizens was able to increase the offering twice from the original
$400 million and nearly double last year's reinsurance program for almost the same cost, a
spokesperson said.

• Study: The Federal Insurance Office (FIO) released a long-awaited report on the reinsurance
and insurance industries in December 2013. Among its many recommendations is one that
deals with credit for reinsurance. It suggests ending a long-standing debate on the issue of
posting 100 percent collateral on reinsurance transactions with non-U.S. reinsurers by
following the National Association of Insurance Commissioner's (NAIC) amended version of its
model law adopted at the organization's November 2011 meeting. The NAIC's Credit For
Reinsurance Model Law allows financially sound non-U.S. reinsurers to post less than 100
percent collateral and lets the NAIC decide which foreign jurisdictions have sufficiently rigorous
regulations for their reinsurers to be considered "qualified" and therefore permitted to post a
lower collateral amount. The law also requires insurers to notify state commissioners when the
amount that they expect to recover under their reinsurance contracts exceeds 50 percent of
their policyholders' surplus, the financial cushion that allows insurers to pay unexpectedly high
claims. It also requires insurers to diversify their reinsurance programs to lower the risk of not
 being able to collect on their reinsurance contracts.

Background C) SHARE

Reinsurance is insurance for insurance companies. Just as a homeowners or auto insurance

policy reduces the amount of cash a person must have on hand to pay for a new car after an
accident or to rebuild a home after a hurricane, a reinsurance contract can protect an insurance
being able to collect on their reinsurance contracts.

Background
Reinsurance is insurance for insurance companies. Just as a homeowners or auto insurance
policy reduces the amount of cash a person must have on hand to pay for a new car after an

company against large catastrophic losses. Reinsurance also enables an insurer to underwrite
accident or to rebuild a home after a hurricane, a reinsurance contract can protect an insurance
company against large catastrophic losses. Reinsurance also enables an insurer to underwrite
more or larger insurance policies.

When an insurance company issues an insurance policy, an auto insurance policy, for example,
it assumes responsibility for paying for the cost of any accidents that occur, within the parameters
set out in the policy.

By law, an insurer must have sufficient capital to ensure it will be able to pay all potential future
claims related to the policies it issues. This requirement protects consumers but limits the amount
of business an insurer can take on. However, if the insurer can reduce its responsibility, or
liability, for these claims by transferring a part of the liability to another insurer, it can lower the
amount of capital it must maintain to satisfy regulators that it is in good financial health and will be

more or larger insurance policies.

able to pay the claims of its policyholders. Capital freed up in this way can support more or larger
insurance policies. The company that issues the policy initially is known as the primary insurer.
The company that assumes liability from the primary insurer is known as the reinsurer. Primary
companies are said to “cede” business to a reinsurer.

Types of Reinsurance: Reinsurance can be divided into two basic categories: treaty and
facultative. Treaties are agreements that cover broad groups of policies such as all of a primary
insurer’s auto business. Facultative covers specific individual, generally high-value or hazardous
risks, such as a hospital, that would not be accepted under a treaty.

In most treaty agreements, once the terms of the contract, including the categories of risks
covered, have been established, all policies that fall within those terms – in many cases both new
and existing business—are covered, usually automatically, until the agreement is cancelled.

With facultative reinsurance, the reinsurer must underwrite the individual “risk,” say a hospital, just
as a primary company would, looking at all aspects of the operation and the hospital’s attitude to
and record on safety. In addition, the reinsurer would also consider the attitude and management
of the primary insurer seeking reinsurance coverage. This type of reinsurance is called facultative
because the reinsurer has the power or “faculty” to accept or reject all or a part of any policy
offered to it in contrast to treaty reinsurance, under which it must accept all applicable policies
once the agreement is signed.

Treaty and facultative reinsurance agreements can be structured on a “pro rata” (proportional) or
“excess-of-loss” (non proportional) basis, depending on the arrangement by which losses are
apportioned between the two insurers.

When an insurance company issues an insurance policy, an auto insurance policy, for example,
it assumes responsibility for paying for the cost of any accidents that occur, within the parameters
set out in the policy.

By law, an insurer must have sufficient capital to ensure it will be able to pay all potential future
claims related to the policies it issues. This requirement protects consumers but limits the amount
of business an insurer can take on. However, if the insurer can reduce its responsibility, or
liability, for these claims by transferring a part of the liability to another insurer, it can lower the
amount of capital it must maintain to satisfy regulators that it is in good financial health and will be
able to pay the claims of its policyholders. Capital freed up in this way can support more or larger
insurance policies. The company that issues the policy initially is known as the primary insurer.
The company that assumes liability from the primary insurer is known as the reinsurer. Primary
companies are said to "cede" business to a reinsurer.

Types of Reinsurance: Reinsurance can be divided into two basic categories: treaty and
facultative. Treaties are agreements that cover broad groups of policies such as all of a primary
insurer's auto business. Facultative covers specific individual, generally high-value or hazardous
risks, such as a hospital, that would not be accepted under a treaty.

In most treaty agreements, once the terms of the contract, including the categories of risks
covered, have been established, all policies that fall within those terms - in many cases both new
and existing business-are covered, usually automatically, until the agreement is cancelled.

With facultative reinsurance, the reinsurer must underwrite the individual "risk," say a hospital, just
as a primary company would, looking at all aspects of the operation and the hospital's attitude to
and record on safety. In addition, the reinsurer would also consider the attitude and management
of the primary insurer seeking reinsurance coverage. This type of reinsurance is called facultative
because the reinsurer has the power or "faculty" to accept or reject all or a part of any policy
offered to it in contrast to treaty reinsurance, under which it must accept all applicable policies
once the agreement is signed.

Treaty and facultative reinsurance agreements can be structured on a "pro rata" (proportional) or
"excess-of-loss" (non proportional) basis, depending on the arrangement by which losses are
apportioned between the two insurers.
 In a proportional agreement, most often applied to property coverages, the reinsurer and the
primary company share both the premium from the policyholder and the potential losses.

In an excess of loss agreement, the primary company retains a certain amount of liability for
losses (known as the ceding company's retention) and pays a fee to the reinsurer for coverage
above that amount, generally subject to a fixed upper limit. Excess of loss agreements may apply
to individual policies, to an event such as a hurricane that affects many policyholders or to the
primary insurer's aggregate losses above a certain amount, per policy or per year.

A primary company's reinsurance program can be very complex. Simply put, if it were
diagrammed, it might look like a pyramid with ascending dollar levels of coverage for increasingly
In a proportional agreement, most often applied to property coverages, the reinsurer and the
primary company share both the premium from the policyholder and the potential losses.

In an excess of loss agreement, the primary company retains a certain amount of liability for
losses (known as the ceding company’s retention) and pays a fee to the reinsurer for coverage
above that amount, generally subject to a fixed upper limit. Excess of loss agreements may apply
to individual policies, to an event such as a hurricane that affects many policyholders or to the
primary insurer’s aggregate losses above a certain amount, per policy or per year.

remote events, split among a number of reinsurance companies each assuming a portion. It
A primary company’s reinsurance program can be very complex. Simply put, if it were
diagrammed, it might look like a pyramid with ascending dollar levels of coverage for increasingly
remote events, split among a number of reinsurance companies each assuming a portion. It
would include layers of proportional and excess of loss treaties and possibly a facultative excess
of loss layer at the top.

Regulation: As an industry, reinsurance is less highly regulated than insurance for individual
consumers because the purchasers of reinsurance, mostly primary companies that sell car,
home and commercial insurance, are considered sophisticated buyers. However, in the early
1980s, state insurance officials became increasingly concerned about the reliability of
reinsurance contracts – the ability of the reinsurer to meet its contractual obligations — and a
primary company's use of them. Following the June 1982 annual meeting of the National
Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was

would include layers of proportional and excess of loss treaties and possibly a facultative excess
formed to review the regulation of reinsurance transactions and parties to those transactions. A
model Credit for Reinsurance Act was adopted in 1984.

All insurers submit financial statements to regulators who monitor their financial health. Financial
health includes not assuming more risk or liability for future claims than is prudent, given the
amount of capital available to support it, i.e., to pay claims. The principal value of reinsurance to a
ceding company (the purchaser of reinsurance) for regulatory purposes is the recognition on the
ceding company's financial statement of a reduction in its liabilities in terms of two accounts: its
unearned premium reserve and its loss reserve. The unearned premium reserve is the amount
of premiums equal to the unexpired portion of insurance policies, i.e., insurance protection that is
still "owed" to the policyholder and for which funds would have to be returned to the policyholder
should the policyholder cancel the policy before it expired. The loss reserve is made up of funds
set aside to pay future claims. The transfer of part of the insurance company’s business to the

of loss layer at the top.

reinsurer reduces its liability for future claims and for return of the unexpired portion of the policy.
The reduction in these two accounts is commensurate with the payments that can be recovered
from reinsurers, known as recoverables. The insurer’s financial statement recognizes as assets
on the balance sheet any payments that are due from the reinsurer for coverage paid for by the
ceding company.

By statute or administrative practice, all states (but with considerable variation) recognize and
grant credit on the financial statement for the reduced financial responsibility that reinsurance
transactions provide. When reinsurers are not licensed in the United States, (these are known as
“alien” or offshore companies) they must post collateral (such as trust funds, letters of credit,

Regulation: As an industry, reinsurance is less highly regulated than insurance for individual
consumers because the purchasers of reinsurance, mostly primary companies that sell car,
home and commercial insurance, are considered sophisticated buyers. However, in the early
1980s, state insurance officials became increasingly concerned about the reliability of
reinsurance contracts -the ability of the rein surer to meet its contractual obligations - and a
primary company's use of them. Following the June 1982 annual meeting of the National
Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was
formed to review the regulation of reinsurance transactions and parties to those transactions. A
model Credit for Reinsurance Act was adopted in 1984.

All insurers submit financial statements to regulators who monitor their financial health. Financial
health includes not assuming more risk or liability for future claims than is prudent, given the
amount of capital available to support it, i.e., to pay claims. The principal value of reinsurance to a
ceding company (the purchaser of reinsurance) for regulatory purposes is the recognition on the
ceding company's financial statement of a reduction in its liabilities in terms of two accounts: its
unearned premium reserve and its loss reserve. The unearned premium reserve is the amount
of premiums equal to the unexpired portion of insurance policies, i.e., insurance protection that is
still "owed" to the policyholder and for which funds would have to be returned to the policyholder
should the policyholder cancel the policy before it expired. The loss reserve is made up of funds
set aside to pay future claims. The transfer of part of the insurance company's business to the
rein surer reduces its liability for future claims and for return of the unexpired portion of the policy.
The reduction in these two accounts is commensurate with the payments that can be recovered
from reinsurers, known as recoverables. The insurer's financial statement recognizes as assets
on the balance sheet any payments that are due from the reinsurer for coverage paid for by the
ceding company.

By statute or administrative practice, all states (but with considerable variation) recognize and
grant credit on the financial statement for the reduced financial responsibility that reinsurance
transactions provide. When reinsurers are not licensed in the United States, (these are known as
"alien" or offshore companies) they must post collateral (such as trust funds, letters of credit,
 funds withheld) to secure the transaction. An alien company can also participate in the U.S.
marketplace by becoming licensed in the states in which it wishes to do business.

For many years, few people outside the insurance industry were aware that such a mechanism
as reinsurance existed. The public was first introduced to reinsurance in the mid-1980s, during
what has now become known as the liability crisis. A shortage of reinsurance was widely
reported to be one of the factors contributing to the availability problems and high price of
various kinds of liability insurance. A few years later, in 1989, the reinsurance business once
again became a topic of interest outside the insurance industry as Congress investigated the
insolvencies of several large property/casualty insurers.

These investigations culminated in a widely read report, "Failed Promises: Insurance Company
Insolvencies," published in February 1990. The publicity surrounding the investigations and the
poor financial condition of several major life insurance companies prompted proposals for some
funds withheld) to secure the transaction. An alien company can also participate in the U.S.
marketplace by becoming licensed in the states in which it wishes to do business.

federal oversight of the insurance industry, particularly insurers and reinsurers based outside the
For many years, few people outside the insurance industry were aware that such a mechanism
as reinsurance existed. The public was first introduced to reinsurance in the mid-1980s, during
what has now become known as the liability crisis. A shortage of reinsurance was widely
reported to be one of the factors contributing to the availability problems and high price of
various kinds of liability insurance. A few years later, in 1989, the reinsurance business once
again became a topic of interest outside the insurance industry as Congress investigated the
insolvencies of several large property/casualty insurers.

These investigations culminated in a widely read report, "Failed Promises: Insurance Company
Insolvencies," published in February 1990. The publicity surrounding the investigations and the
poor financial condition of several major life insurance companies prompted proposals for some
federal oversight of the insurance industry, particularly insurers and reinsurers based outside the
United States. However, no federal law was enacted. While a large portion of the insurance

United States. However, no federal law was enacted. While a large portion of the insurance
industry opposes federal regulatory oversight, many U.S. reinsurers and large commercial
insurers view compliance with a single federal law as preferable to compliance with the laws of 51
state jurisdictions.

A critical tool for evaluating solvency is the annual "convention" statement, the detailed financial
statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the annual
statement required insurers ceding liability to unauthorized reinsurers (those not licensed or
approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR)
losses in addition to known and reported losses. (IBNR losses are losses associated with events
that have already occurred where the full cost will not be known and reported to the insurer until
some later date.) This requirement reflects regulators' concern that all liabilities are identified and
determined actuarially, including IBNR losses, and that IBNR losses are secured by the reinsurer
with additional funds or a larger letter of credit than otherwise would have been required.

industry opposes federal regulatory oversight, many U.S. reinsurers and large commercial
Related to solvency is the issue of reinsurance "recoverables,” payments due from the reinsurer.
In the mid-1980s, some reinsurance companies that had entered the reinsurance business
during the period of high interest rates in the early 1980s left the market, due to insolvency or
other problems. (When interest rates are high, some insurance/reinsurance companies seek to
increase market share in order to have more premiums to invest. Those that fail to pay attention
to the riskiness of the business they are underwriting may end up undercharging for coverage
and going bankrupt as a result.) Consequently, some of the insurers that reinsured their business
with these now-defunct companies were unable to recover monies due to them on their
reinsurance contracts.

To enable regulators, policyholders and investors to assess a company's financial condition more
accurately, the NAIC now requires insurance companies to deduct 20 percent of anticipated

insurers view compliance with a single federal law as preferable to compliance with the laws of 51
reinsurance recoverables from their policyholders’ surplus on their financial statements—surplus
is roughly equivalent to capital—when amounts are overdue by more than 90 days. The rule
helps regulators identify problem reinsurers for regulatory actions and encourages insurers to

state jurisdictions.

A critical tool for evaluating solvency is the annual "convention" statement, the detailed financial
statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the annual
statement required insurers ceding liability to unauthorized reinsurers (those not licensed or
approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR)
losses in addition to known and reported losses. (IBNR losses are losses associated with events
that have already occurred where the full cost will not be known and reported to the insurer until
some later date.) This requirement reflects regulators' concern that all liabilities are identified and
determined actuarially, including IBNR losses, and that IBNR losses are secured by the reinsurer
with additional funds or a larger letter of credit than otherwise would have been required.

Related to solvency is the issue of reinsurance "recoverables," payments due from the reinsurer.
In the mid-1980s, some reinsurance companies that had entered the reinsurance business
during the period of high interest rates in the early 1980s left the market, due to insolvency or
other problems. (When interest rates are high, some insurance/reinsurance companies seek to
increase market share in order to have more premiums to invest. Those that fail to pay attention
to the riskiness of the business they are underwriting may end up undercharging for coverage
and going bankrupt as a result.) Consequently, some of the insurers that rein sured their business
with these now-defunct companies were unable to recover monies due to them on their
reinsurance contracts.

To enable regulators, policyholders and investors to assess a company's financial condition more
accurately, the NAIC now requires insurance companies to deduct 20 percent of anticipated
reinsurance recoverables from their policyholders' surplus on their financial statements-surplus
is roughly equivalent to capital-when amounts are overdue by more than 90 days. The rule
helps regulators identify problem reinsurers for regulatory actions and encourages insurers to
 purchase reinsurance from companies that are willing and able to pay reinsured losses promptly.

Concern about reinsurance recoverables led to other changes in the annual financial statement
filed with state regulators, including changes that improve the quality and quantity of reinsurance
data available to enhance regulatory oversight of the reinsurance business.

After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the
time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for
property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion
was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position,
which in turn caused primary companies to reconsider their catastrophe reinsurance needs.

When reinsurance prices were high and capacity scarce because of the high risk of natural
disasters, some primary companies turned to the capital markets for innovative financing
arrangements.

Catastrophe Bonds and Other Alternative Risk Financing Tools: The shortage and
high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining
purchase reinsurance from companies that are willing and able to pay reinsured losses promptly.

Concern about reinsurance recoverables led to other changes in the annual financial statement
filed with state regulators, including changes that improve the quality and quantity of reinsurance
data available to enhance regulatory oversight of the reinsurance business.

After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the

interest rates, which sent investors looking for higher yields, prompted interest in securitization of
time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for
property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion
was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position,
which in turn caused primary companies to reconsider their catastrophe reinsurance needs.

When reinsurance prices were high and capacity scarce because of the high risk of natural
disasters, some primary companies turned to the capital markets for innovative financing
arrangements.

Catastrophe Bonds and Other Alternative Risk Financing Tools: The shortage and
high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining
interest rates, which sent investors looking for higher yields, prompted interest in securitization of
insurance risk. Among the precursors to so-called true securitization were contingency financing

insurance risk. Among the precursors to so-called true securitization were contingency financing
bonds such as those issued for the Florida Windstorm Association in 1996, which provided cash
in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes — an
agreement with a bank or other lender that in the event of a megadisaster that would significantly
reduce policyholders’ surplus, funds would be made available at a predetermined price. Funds
to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes
are not considered debt, therefore do not hamper an insurer's ability to write additional
insurance. In addition, there were equity puts, through which an insurer would receive a sum of
money in the event of a catastrophic loss in exchange for stock or other options.

A catastrophe bond is a specialized security that increases insurers’ ability to provide insurance
protection by transferring the risk to bond investors. Commercial banks and other lenders have
been securitizing mortgages for years, freeing up capital to expand their mortgage business.
Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer

bonds such as those issued for the Florida Windstorm Association in 1996, which provided cash
known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose.
These bonds have complicated structures and are typically created offshore, where tax and
regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or
reinsurance company and the principal from investors and hold them in a trust in the form of U.S.
Treasuries or other highly rated assets, using the investment income to pay interest on the
principal. Catastrophe bonds pay high interest rates but if the trigger event occurs, investors lose
the interest and sometimes the principal, depending on the structure of the bond, both of which
may be used to cover the insurer’s disaster losses. Bonds may be issued for a one-year term or
multiple years, often three.

Increasingly, catastrophe bonds are being developed for residual market government entities
and state-backed wind pools. Taking advantage of the growing popularity of catastrophe bonds

in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes - an
agreement with a bank or other lender that in the event of a megadisaster that would significantly
reduce policyholders' surplus, funds would be made available at a predetermined price. Funds
to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes
are not considered debt, therefore do not hamper an insurer's ability to write additional
insurance. In addition, there were equity puts, through which an insurer would receive a sum of
money in the event of a catastrophic loss in exchange for stock or other options.

A catastrophe bond is a specialized security that increases insurers' ability to provide insurance
protection by transferring the risk to bond investors. Commercial banks and other lenders have
been securitizing mortgages for years, freeing up capital to expand their mortgage business.
Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer
known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose.
These bonds have complicated structures and are typically created offshore, where tax and
regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or
reinsurance company and the principal from investors and hold them in a trust in the form of U.S.
Treasuries or other highly rated assets, using the investment income to pay interest on the
principal. Catastrophe bonds pay high interest rates but if the trigger event occurs, investors lose
the interest and sometimes the principal, depending on the structure of the bond, both of which
may be used to cover the insurer's disaster losses. Bonds may be issued for a one-year term or
multiple years, often three.

Increasingly, catastrophe bonds are being developed for residual market government entities
and state-backed wind pools. Taking advantage of the growing popularity of catastrophe bonds
 as investments, Florida's Citizens Property Insurance Corp. issued bonds through the special
purpose vehicle, Everglades Re. Bonds were issued by the Massachusetts Property Insurance
Underwriting Association, two North Carolina pools (the Fair Plan and Beach Plan) and the
Alabama wind pool. In addition, the California State Compensation Insurance Fund issued a bond
to cover workers compensation losses in the event of a catastrophic earthquake. Other bonds
have been created to cover extreme mortality and medical benefit claim levels.

The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change.
In 2009, for the first time, primary insurance companies were sponsors of the majority of bond
issues-about 60 percent. Industry observers say primary companies are increasingly integrating
cat bonds into their core reinsurance programs as a way to diversify and increase flexibility.
Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally
provide multiyear coverage and may be structured in tranches that mature in successive years.

Of the many new ways of financing catastrophe risk that have been developed over the past
decade or two, catastrophe bonds are best known outside the insurance industry. One lesser-
known alternative is the industry loss warranty contract (ILW). Unlike traditional reinsurance,
where the rein surer pays a portion of the primary company's losses according to an agreed
upon formula, the ILW is triggered by an agreed-upon industry loss. The contract "warrants" that
the rein surer will pay up to $100 million toward the buyer's losses if the industry suffers a
predetermined loss amount, say $5 billion or more.
as investments, Florida’s Citizens Property Insurance Corp. issued bonds through the special
purpose vehicle, Everglades Re. Bonds were issued by the Massachusetts Property Insurance
Underwriting Association, two North Carolina pools (the Fair Plan and Beach Plan) and the
Alabama wind pool. In addition, the California State Compensation Insurance Fund issued a bond
to cover workers compensation losses in the event of a catastrophic earthquake. Other bonds
have been created to cover extreme mortality and medical benefit claim levels.

The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change.
In 2009, for the first time, primary insurance companies were sponsors of the majority of bond
issues–about 60 percent. Industry observers say primary companies are increasingly integrating
cat bonds into their core reinsurance programs as a way to diversify and increase flexibility.
Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally
provide multiyear coverage and may be structured in tranches that mature in successive years.

Of the many new ways of financing catastrophe risk that have been developed over the past

Another recent innovation is the side-car. These are relatively simple agreements that allow a
decade or two, catastrophe bonds are best known outside the insurance industry. One lesser-
known alternative is the industry loss warranty contract (ILW). Unlike traditional reinsurance,
where the reinsurer pays a portion of the primary company’s losses according to an agreed
upon formula, the ILW is triggered by an agreed-upon industry loss. The contract “warrants” that
the reinsurer will pay up to $100 million toward the buyer’s losses if the industry suffers a
predetermined loss amount, say $5 billion or more.

Another recent innovation is the side-car. These are relatively simple agreements that allow a
reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited
and specific risk, such as the risk of an earthquake or hurricane in a given geographic area over
a specific period of time. Side-car deals are much smaller and less complex than catastrophe
bonds and are usually privately placed rather than tradable securities. In side-cars, investors
share in the profit or loss the business produces along with the reinsurer. While a catastrophe

reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited
bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an
infrequent but potentially highly destructive event, side-cars are similar to reinsurance treaties
where the reinsurer and primary insurer share in the results.

An insurance company’s willingness to offer disaster coverage is often determined by the

availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew,
they were expected to gain industrywide acceptance as an alternative to traditional catastrophe
reinsurance, which was then in short supply, but they still represent a small, albeit growing,
portion of the worldwide catastrophe reinsurance market.

Several of the first attempts at true securitization were withdrawn because of time constraints —
the hurricane season had begun before work on the transaction could be completed, for
example — and lack of sufficient interest on the part of investors. The first deals were

and specific risk, such as the risk of an earthquake or hurricane in a given geographic area over
consummated in December 1996, one by a U.S. reinsurer, St Paul Re, and the second by
Winterthur, a Swiss insurer which issued convertible bonds to pay auto damage claims stemming
from hailstorms. This was the first large transaction in which insurance risk was sold to the public
markets. The company said that it did not need to finance hailstorm damage in this way but sold

a specific period of time. Side-car deals are much smaller and less complex than catastrophe
bonds and are usually privately placed rather than tradable securities. In side-cars, investors
share in the profit or loss the business produces along with the reinsurer. While a catastrophe
bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an
infrequent but potentially highly destructive event, side-cars are similar to reinsurance treaties
where the reinsurer and primary insurer share in the results.

An insurance company's willingness to offer disaster coverage is often determined by the

availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew,
they were expected to gain industrywide acceptance as an alternative to traditional catastrophe
reinsurance, which was then in short supply, but they still represent a small, albeit growing,
portion of the worldwide catastrophe reinsurance market.

Several of the first attempts at true securitization were withdrawn because of time constraints -
the hurricane season had begun before work on the transaction could be completed, for
example - and lack of sufficient interest on the part of investors. The first deals were
consummated in December 1996, one by a U.S. reinsurer, St Paul Re, and the second by
Winterthur, a Swiss insurer which issued convertible bonds to pay auto damage claims stemming
from hailstorms. This was the first large transaction in which insurance risk was sold to the public
markets. The company said that it did not need to finance hailstorm damage in this way but sold
 the bonds to test the market for securitizing insurance risks. Six months later there was strong
investor interest in a bond offering that provided USM with catastrophe reinsurance to pay
homeowners losses arising from a single hurricane in eastern coastal states, proving for the first
time that insurance risk could be sold to institutional investors on a large scale.

The field has gradually evolved to the point where some investors and insurance company
issuers are beginning to feel comfortable with the concept, with some coming back to the capital
markets each year. In addition to the high interest rates catastrophe bonds pay, their attraction to
investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The
returns on most other securities are tied to economic activity rather than natural disasters.

The National Association of Insurance Commissioners (NAIC), which oversees insurance

company investments and sets the rules that influence insurers' investment strategies, classifies
these new types of catastrophe risk securities as bonds rather than equities. Equities are
considered riskier under formulas that dictate how much capital must be set aside to support
various liabilities. In addition, at its June 1999 meeting, the NAIC approved a so-called "protected
cell" model act that makes it easier to transact deals in the United States. Up to then, most
securitization deals had been conducted offshore through special entities created for this
purpose. The protected cells, separate units within an insurance company, protect investors from
losses incurred by the insurer.

In addition to catastrophe bonds, catastrophe options were developed but the market for these
options never took off. Another alternative is the exchange of risk where individual companies in
different parts of the world swap a certain amount of losses. Payment is triggered by the
occurrence of an agreed upon event at a certain level of magnitude.
the bonds to test the market for securitizing insurance risks. Six months later there was strong
investor interest in a bond offering that provided USAA with catastrophe reinsurance to pay
homeowners losses arising from a single hurricane in eastern coastal states, proving for the first
time that insurance risk could be sold to institutional investors on a large scale.

The field has gradually evolved to the point where some investors and insurance company
issuers are beginning to feel comfortable with the concept, with some coming back to the capital
markets each year. In addition to the high interest rates catastrophe bonds pay, their attraction to
investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The
returns on most other securities are tied to economic activity rather than natural disasters.

The National Association of Insurance Commissioners (NAIC), which oversees insurance

company investments and sets the rules that influence insurers’ investment strategies, classifies
these new types of catastrophe risk securities as bonds rather than equities. Equities are
considered riskier under formulas that dictate how much capital must be set aside to support
various liabilities. In addition, at its June 1999 meeting, the NAIC approved a so-called “protected
cell” model act that makes it easier to transact deals in the United States. Up to then, most
securitization deals had been conducted offshore through special entities created for this
purpose. The protected cells, separate units within an insurance company, protect investors from
losses incurred by the insurer.

Disaster Recovery Bonds and Regional Pools: Disaster recovery bonds serve much the
In addition to catastrophe bonds, catastrophe options were developed but the market for these
options never took off. Another alternative is the exchange of risk where individual companies in
different parts of the world swap a certain amount of losses. Payment is triggered by the
occurrence of an agreed upon event at a certain level of magnitude.

Disaster Recovery Bonds and Regional Pools: Disaster recovery bonds serve much the
same purpose as a business income insurance policy, helping the government
entity/policyholder get back on track after a catastrophic event.

In developing countries insurance penetration is low, meaning that few individuals and
businesses have insurance, so the burden of recovering from a disaster falls almost entirely on
the government. Traditionally, developing countries have relied on post-disaster funding to
finance recovery efforts, including donations from developed countries, international emergency

same purpose as a business income insurance policy, helping the government

aid and humanitarian relief organizations. A faster and more reliable way to fund the recovery is
prefinancing in the form of reinsurance, catastrophe bonds or other alternative risk transfer
mechanisms.

One example of prefunding is the Caribbean Catastrophe Risk Insurance Facility, the first
regional insurance fund. CCRIF provides hurricane and earthquake catastrophe coverage to its
member nations, so that in the aftermath of a disaster they can quickly fund immediate recovery
needs and continue providing essential services.

In 2004 hurricanes severely damaged the economy of several small Caribbean islands, causing
losses in excess of $4 billion. This prompted Caribbean governments to request the help of the

entity/policyholder get back on track after a catastrophic event.

In developing countries insurance penetration is low, meaning that few individuals and
businesses have insurance, so the burden of recovering from a disaster falls almost entirely on
the government. Traditionally, developing countries have relied on post-disaster funding to
finance recovery efforts, including donations from developed countries, international emergency
aid and humanitarian relief organizations. A faster and more reliable way to fund the recovery is
prefinancing in the form of reinsurance, catastrophe bonds or other alternative risk transfer
mechanisms.

One example of prefunding is the Caribbean Catastrophe Risk Insurance Facility, the first
regional insurance fund. CCRIF provides hurricane and earthquake catastrophe coverage to its
member nations, so that in the aftermath of a disaster they can quickly fund immediate recovery
needs and continue providing essential services.

In 2004 hurricanes severely damaged the economy of several small Caribbean islands, causing
losses in excess of $4 billion. This prompted Caribbean governments to request the help of the
 World Bank in facilitating access to catastrophe insurance. The CCRIF started operations in June
2007, after two years of planning.

The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks
into a diversified portfolio and purchase reinsurance or other risk transfer products on the
international financial markets at a saving of up to 50 percent over what it would cost each
country if they purchased catastrophe protection individually. In addition, since a hurricane or
earthquake only affects one to three countries in the Caribbean on average in any given year,
each country contributes less to the reserve pool than would be required if each had its own
reserves.

The CCRIF was initially capitalized by its members with help from donor partners - developed
countries, the World Bank and the Caribbean Development Bank. Its members pay premiums
based on their probable use of the pool's funds. As countries raise building standards to provide
better protection against disasters, premiums will decrease.

Because the CCRIF uses what has become known as parametric insurance to calculate claim
payments, claims are paid quickly. Under a parametric system, claim payments are triggered by
the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a
certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by
actual losses measured by an adjuster, a process that can take months to complete.

Payout amounts are derived from models that estimate the financial impact of the disaster. As a
form of deductible that encourages risk mitigation, participating governments are only allowed to
purchase coverage for up to 20 percent of their estimated losses, an amount believed to be
sufficient to cover initial needs.

Post-September 11: The terrorist attacks on the World Trade Center left their mark on the
World Bank in facilitating access to catastrophe insurance. The CCRIF started operations in June

reinsurance business in many ways. First, the huge losses incurred accelerated rate hikes over a
2007, after two years of planning.

The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks
into a diversified portfolio and purchase reinsurance or other risk transfer products on the
international financial markets at a saving of up to 50 percent over what it would cost each
country if they purchased catastrophe protection individually. In addition, since a hurricane or
earthquake only affects one to three countries in the Caribbean on average in any given year,
each country contributes less to the reserve pool than would be required if each had its own
reserves.

The CCRIF was initially capitalized by its members with help from donor partners — developed
countries, the World Bank and the Caribbean Development Bank. Its members pay premiums
based on their probable use of the pool’s funds. As countries raise building standards to provide

broad spectrum of coverages, unlike the aftermath of Hurricane Andrew, the most costly disaster
better protection against disasters, premiums will decrease.

Because the CCRIF uses what has become known as parametric insurance to calculate claim
payments, claims are paid quickly. Under a parametric system, claim payments are triggered by
the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a
certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by
actual losses measured by an adjuster, a process that can take months to complete.

Payout amounts are derived from models that estimate the financial impact of the disaster. As a
form of deductible that encourages risk mitigation, participating governments are only allowed to
purchase coverage for up to 20 percent of their estimated losses, an amount believed to be
sufficient to cover initial needs.

prior to September 11, where only catastrophe insurance, a property coverage, was in short
Post-September 11: The terrorist attacks on the World Trade Center left their mark on the
reinsurance business in many ways. First, the huge losses incurred accelerated rate hikes over a
broad spectrum of coverages, unlike the aftermath of Hurricane Andrew, the most costly disaster
prior to September 11, where only catastrophe insurance, a property coverage, was in short
supply. Furthermore, the reinsurers that are now offering some terrorism coverage look at the
business they are being offered from an accumulation-of-loss viewpoint in addition to traditional
considerations, particularly in areas that may be terrorism targets. Computer programs are now
being developed that not only estimate likely terrorism losses but also enable companies to
determine more easily what other businesses they have reinsured in the same neighborhood.

Legislation known as the federal reinsurance backstop, the Terrorism Insurance Act of 2002,
was passed in November 2002 and extended in 2005 to December 2007 and extended once
again through December 2014. The act does not cover reinsurers, see report on terrorism

supply. Furthermore, the reinsurers that are now offering some terrorism coverage look at the
insurance.

Additional resources
The Essential Guide to Reinsurance: Solutions to 21st Century Challenges.
Challenges. Swiss Re, 2012. A

business they are being offered from an accumulation-of-loss viewpoint in addition to traditional
considerations, particularly in areas that may be terrorism targets. Computer programs are now
being developed that not only estimate likely terrorism losses but also enable companies to
determine more easily what other businesses they have reinsured in the same neighborhood.

Legislation known as the federal reinsurance backstop, the Terrorism Insurance Act of 2002,
was passed in November 2002 and extended in 2005 to December 2007 and extended once
again through December 2014. The act does not cover reinsurers, see report on terrorism
insurance.

Additional resources 0 SHARE

The Essential Guide to Reinsurance: Solutions to 21st Century Challenges. Swiss Re, 2012. A
 guide to the concepts of reinsurance and its contributions to the economy and society.

"Reinsurance: Fundamentals and New Challenges," Insurance Information Institute, 2004.

© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED

Back to top

guide to the concepts of reinsurance and its contributions to the economy and society.

"Reinsurance: Fundamentals and New Challenges," Insurance Information Institute, 2004.

© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED

Back to top