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                             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 –
                                                                                 deferred.
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.
14 2002/2
■ 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-
                                                                                                                                        $ Millions
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
benefits:
                                                                                             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
                                                          Company
                                                           Sale of




                                                                                             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.

                                                                                                                                             EMPHASIS 15
                                                                                         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
                              Unadjusted
                                                                                         shape to pay cat losses in the future, and that
                              Adjusted
                                                                                         future earnings will be better when big catas-
                              Expected Loss Ratio
                                                                                         trophes occur.
               5.0                                  5.0
                                                                                         ■  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
 Loss Ratios




                                                                                         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
                .6                                   .6
                                                                                         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-
                                    occurrences.
                                                                                         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

16 2002/2
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?
them.
                                                     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-
                                                     phes occur.
■ 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
                                                     this article.



                                                                                                             EMPHASIS 17

								
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