property /casualty insurance
A Tax-Deferred Catastrophe Account
The huge potential for property catastrophe in the U.S. demands a
new way of building surplus capacity and better performance
measures dealing with catastrophe lines of business.
By Michael A. Walters
T he U.S. insurance industry has suffered a
significant depletion of surplus from the
September 11 terrorist attacks. The hardening
How the Account Would Work. Exhibit 1
shows how a long-term cat account would
work if the cat return period were 16 years. In
reinsurance market, even for natural catastro- the example, the insurer has identified 6% of its
phe (cat) coverage, is causing some primary total premium as catastrophe and accounts for
insurers to retain more risk. Future catastro- it separately. At first, there are no cat losses, so
phes — both natural and otherwise — will the net of premiums and reinsurance and other
severely test market capacity. expenses enables the insurer to accumulate $40
million a year in a separate surplus account, tax
Michael A. Walters is a Furthermore, the current tax treatment of cat
principal of Tillinghast –
Towers Perrin in
premiums hurts the ability of carriers to build
Jacksonville. He surplus to cover future catastrophes. IRS rules, For any small cat losses in the early years, only
specializes in strategic relying on U.S. accounting standards for p/c the net gain would flow into the long-term cat
planning, market analysis insurance, still count the absence of a catastro- account. Net losses would be tax deductible
and pricing for personal phe in a single year as a “profit,” even though against regular income, and tax-deferred
lines. A graduate of
Fordham University, he
the premiums were based on a very long return account accumulation would be tabled until
also has a master’s in period for that coverage. The tax carryforwards net gains appeared.
mathematics from the and carrybacks do not rectify this situation
University of Notre because the return periods for cats are much At the end of 15 years, the insurer has accumu-
Dame. Mr. Walters is a longer than the tax statutes allow, and tax lated $600 million in the cat surplus account.
fellow and past president Without this special cat fund, the insurer
of the Casualty Actuarial
adjustments are not helpful to a carrier that is
Society and a member of rendered insolvent by a catastrophe. would have paid more than $200 million as
the American Academy of extra corporate income taxes.
Actuaries. For example, if an insurer retained all the cat
risk, and a hurricane occurred every 25 years, In year 16, a large catastrophe occurs ($500
federal taxes would deplete a large portion of million in losses, net of reinsurance). The cat
the funds needed to pay for the losses. This is surplus account pays these losses, leaving a net
clearly a disincentive to insurers to provide cat account surplus of $140 million.
future catastrophe coverage.
In year 17, the company is sold, triggering the
The Need for a Long-Term Cat Account. paydown of the rest of the tax-deferred cat sur-
A better approach would be to permit insurers plus. Because the company is still ahead by
to use a 401(k)-type fund for cat premiums to $140 million in this account, it owes the IRS
allow a tax-deferred buildup of surplus. The an additional $49 million, plus a 10% penalty
carrier would pay federal income taxes when it of $14 million.
took funds out of that special account. Of
■ Interest Is Also Tax Deferred. Interest on
course, when the accumulated funds were used
to pay for cat losses, those losses would be tax net retained cat premiums would also accumu-
deductible. Analogous to a 401(k), a 10% late tax deferred as it does in 401(k) accounts.
penalty could be imposed for early withdrawal This helps build surplus and gives insurers
for reasons other than cat loss payments, with more capacity. Interest credited could be from
exceptions for insolvency or impairment. specifically earmarked securities related to the
cat account or be imputed average interest
from all bonds held by the carrier.
■ A Limit on Accumulation. To avoid an Exhibit 1
indefinite period for surplus to accumulate, a An Example of a Tax-Deferred Cat Account
limit of 40 or 50 years could apply. If no signif-
icant catastrophe occurred by then, insurers
would have to start drawing down the account Year Total Non-Cat Cat
(and paying taxes) over ten or 15 years, similar 1 1 Beginning Surplus 500 500 0
to a standard IRA requiring liquidation begin- 2 Premiums 1,000 940 60
ning at age 70. If a large cat occurred during 3 Losses 600 600 0
the drawdown period, the fund could still pay 4 Expenses: Cat Reinsurance 10 0 10
losses tax deductible. 5 Other 310 300 10
6 Total 320 300 20
■ Reinsurers Also Qualify. Reinsurers would 7 Underwriting Profit 40 40 N/A
also have long-term cat accounts segregated in 8 Federal Income Tax 14 14 0
surplus, representing their retained cat premi- 9 Net Profit 26 26 N/A
ums net of retrocessions, expenses and losses. 10 Surplus Addition 66 26 40
11 Ending Surplus 566 526 40
■ Other Rules Might Change. If surplus is
enhanced by the tax-deferred cat account, reg- 2–15 12 Same as Year 1 500 500 0
ulators and rating agencies should revise their 13 Surplus Addition 990 390 600
surplus measurement ratios by using the federal 15-Year Total 14 Ending Surplus 1,490 890 600
tax rate on the accumulated cat surplus funds. 16 15 Premiums 1,000 940 60
16 Losses 600 500
The Benefits of a Cat Account. A tax- 17 Drawdown of Cat Surplus -500
deferred cat account would offer the following
Large Catastrophe in Year 16
18 Net Loss 600 600 0
19 Expenses: Cat Reinsurance 10 0 10
■ More Insurance Availability and Lower 20 Other 310 300 10
Premiums. The greater surplus to pay for cat 21 Total 320 300 20
losses should make insurers more willing to 22 Underwriting Profit 40 40 N/A
provide cat coverage to customers. Another 23 Federal Income Tax 14 14 0
advantage would come when insurers are closer 24 Net Profit 26 26 N/A
to adequate cat rates. Today, no one charges 25 Surplus Addition 66 26 40
extra for having to pay federal income taxes 26 Reduction in Cat Surplus 500 0 500
when cat losses do not occur. Most insurers 27 Net Surplus Addition -434 26 -460
have not fully reflected expected losses in their 28 Ending Surplus 1,056 916 140
charged rates, nor the full cost of reinsurance
17 29 Total Gain From Cat Account 140
and the added risk margins needed on the
30 Federal Tax on Cat Account 49
retained portion of cat risk. When they do,
31 Tax Penalty 14
insurers will have to further reflect today’s
adverse tax impact in the premiums. 32 Net Result 993 916 77
■ Better Performance Measurement. Sepa-
rating out the cat premiums may be a burden Without removing the cat premiums, home-
for some carriers. However, with tax benefits, owners direct loss ratios in states with cat
insurers that have significant hurricane expo- exposure are not very useful for measuring
sure would likely make the programming performance. (See Exhibit 2, page 16.) The
changes in their accounting systems. But even lucky years without cats appear overly good.
without tax benefits, other benefits flow from The years with cats are usually considered
separately recording the hurricane premium — unlucky and not representative.
mainly in performance measurement for the
residual coverages heretofore intertwined with Using net premiums after cat reinsurance may
cat coverage premiums. solve part of the problem, but the retained risk
still has a lot of volatility. Furthermore, the
Some of these monitoring devices are possible process remains unwieldy because of the need
without formally splitting the premium, by for precise allocations of reinsurance by state
internal allocation methods, but it is easier if and agency source.
the premiums are recorded separately.
If GAAP statements followed suit, stock ana-
Exhibit 2 lysts would need to adjust their evaluations of
p/c companies. One way is to calculate the
Loss Ratios Are Too Volatile With Cat Premiums Included
equivalent income from the former system.
Another is to realize that the carrier is in better
shape to pay cat losses in the future, and that
future earnings will be better when big catas-
Expected Loss Ratio
■ Defining Catastrophe Perils That Qualify.
4.0 4.0 The logical candidates are hurricane and earth-
1.0 1.0 quake. Because earthquake is already a separate
line of business, it is easier to keep track of
.8 .8 retained earthquake premiums net of reinsur-
ance, expenses and losses. The latter quantity
then becomes the long-term cat account segre-
.4 .4 gated within surplus.
.2 .2 Although hurricane is more difficult to split
State 1: Low Cat Risk State 2: High Cat Risk out, the Florida legislature has already mandat-
4% of Premium for Hurricane 40% of Premium for Hurricane ed that primary carriers identify the hurricane
premium charge to residential insureds. The
tax deferral, via this 401(k)-type fund, would
motivate insurers to separately track these
If cat premiums (and losses) are removed from premiums.
the basic management reports, traditional
Segregating the hurricane component from the
performance measures for homeowners insur-
rest of homeowners premium also accommo-
ance are appropriate.
dates a more appropriate class plan, totally
Contingent commissions are more accurate different from fire protection and policy
without the cat premiums for homeowners form distinctions needed for the other part
insurance and more comparable to auto insur- of homeowners coverage.
ance standards. This avoids overpaying profit
Any insurer that chose not to separate the hur-
commissions due to the randomness of cat
ricane portion of its homeowners or commer-
cial property premiums would be ineligible for
In addition to those lines of business that this new tax treatment. But the insurer would
would have tax benefits from splitting out the be no worse off than it is under the current tax
cat premiums, a carrier might select other lines law.
of business where it would want to split out
Other catastrophe perils might also qualify for
even more of the premium than the above pro-
this tax and performance monitoring treatment
posal contemplates, for performance monitor-
(e.g., tornado, hail or even terrorism risk). Any
ing purposes. This, however, involves a
catastrophe peril with a return period greater
trade-off between programming resources
than 20 years, in theory, should be considered.
and the need for precision.
From a practical standpoint, the size of the
Overcoming Obstacles. Aside from the annual premium relative to the total composite
need to obtain congressional action, this new premium is a major factor in determining
system would require insurers to address: whether it is worth pursuing.
■ Depressed Reported Income. Taxes today ■ Inadequate Charged Premiums. In some
are paid immediately when no catastrophes states, the regulatory process has not yet
occur, and income from cat lines after tax is allowed insurers to charge adequate premiums.
included in total income statements. Under the The proposed system relies on charged premi-
proposal, income is deferred for tax purposes, ums rather than on a set of factors by state.
much as salary is deferred in a personal 401(k) The desired factors might not be acceptable to
account. the IRS if they imply rates materially different
from the currently approved ones. To gain the
full benefit, insurers would have to wait until ■ What is the parameter risk of current mod-
the regulators permit adequate rates. There- els? Are yet-to-be-developed, more sophisticat-
fore, achieving the full benefit would be a ed models likely to differ from the current
gradual process. models now on the market?
■ Allocating Catastrophe Reinsurance Pre- ■ How short of the indicated rate level are cur-
miums. Reinsurers would cooperate by split- rent approved catastrophe rates?
ting their final quotes by earthquake, hurricane
and all other catastrophe perils. Splitting ■ Is there enough risk margin in the layers
homeowners premium for catastrophe perils above and below the reinsured layers? Have the
other than hurricane is not needed because risk margins for each of the reinsured layers
their return periods are much shorter and there been quantified so that the needed margin can
is less need for separate surplus treatment for be estimated in the retained layers?
A concentration-of-risk measure, relating the
■ Meeting IRS Objections. The main objec- gross catastrophe 100-year PML to total
tion is the potential loss of current tax revenue. homeowners premium, may be surprising when
The response is that the current treatment is done by state. This measure may show that
inequitable to insurers and reinsurers, which some states have almost as much risk for an
priced the product to consumers assuming that insurer as does Florida, due to concentrations
federal tax would not siphon large portions of of exposure. If some insurers had done this
the premium in catastrophe-free years, with no analysis by agency sources of business in Flori-
return of those taxes after the carryback provi- da before Hurricane Andrew, a huge loss of
sions run out. surplus might have been averted.
Prior attempts to create cat reserves ran afoul Another measure, often used by reinsurers, is a
of the need for simplicity and raised concerns payback ratio, which compares the 100-year
about new international reserving principles PML to income generated by the business,
regarding loss occurrences. The above subject to catastrophe in a series of normal
approach overcomes these concerns by relying non-catastrophe years. This can be done both
on actually charged premiums, not allocation gross and net of reinsurance or retrocessions.
methods, and by earmarking the funds as part Management may desire a payback ratio, such
of surplus, not treating them as liabilities or that the PML is recovered in less than ten years
incurred losses. in markets with high catastrophe risk.
Measuring Catastrophe Performance. The Time Has Come. Some say there is no
While separating out the cat premiums makes good time to seek tax changes that favor busi-
it easier to measure residual business perfor- ness. Yet the current system of taxing cat busi-
mance, the split of cat premiums highlights the ness as profitable before long-term catastrophes
need to have performance standards for the occur is not only unfair and outmoded, but
catastrophe business other than loss ratios. also counterproductive to maintaining a thriv-
ing private insurance market for this risk. With-
Some important cat performance measures out that market, government would have to
follow: expend much greater resources when catastro-
■ What is the amount of surplus at risk, as
deduced from various scenarios in the annual The alternative suggested here would facilitate
(or more frequent) probable maximum loss the accumulation of surplus to pay for those
(PML) studies, using catastrophe simulation catastrophes. If the funds were used for other
models? For example, is there a 10% net expo- purposes, insurers would pay the federal tax at
sure from a 100-year event, a 20% exposure that time, with a 10% penalty, just as individu-
from a 250-year event or a 50% exposure from als saving for a rainy day in a 401(k) account
a 500-year event? would do. E
■ What is the cost of increasing reinsurance to D. Brooks Clark, a consultant in the Hartford
stay within those bounds? office of Tillinghast – Towers Perrin, contributed to