Recent catastrophic events such as the Northridge earthquake and Hurricane Andrew each cost the insurance industry in excess of $10 billion. While most insured losses were paid, each event did cause some insolvencies. These events illustrate the potential stress facing insurance markets. Andrew, which cost the insurance industry about $15.5 billion, would have been much more severe had its path veered slightly to hit Miami. Moreover, scenarios constructed by the insurance industry suggest the feasibility of a $76 billion hurricane in Florida, a $21 billion Northeast hurricane, a $72 billion California earthquake and a $101 billion New Madrid earthquake. At first glance, it might appear that the insurance industry could pay for such mega catastrophes. The U.S. property liability insurance industry's surplus, essentially the value of its equity, is a little under $200 billion. The surplus is potentially available to pay for losses which exceed the reserves (established for their payment from premiums). However, the reality would be different; depending on the distribution of damage and the spread of coverage, many insurers would become insolvent, Technically, this problem should be solved by the state operated insolvency guarantees which re-allocate defaulted liabilities amongst solvent insurers. But these only operate within small limits and even this burden would stretch the already strained resources of surviving insurers. Thus, the prospect of a mega catastrophe brings the real threat of widespread insurance failures and unpaid insurance claims. Moreover, surviving insurers would be so depleted of surplus, and thus over-levered, they would have to reduce the future sale of all types of property liability insurance causing severe availability problems.
These scenarios have led both state and federal governments to contemplate legislative solutions involving the government as a reinsurer and directly enlisting capital markets as providers of catastrophe capital. Both Florida and California have such proposals and the Natural Disaster Protection Act was introduced in Congress in 1993 with similar provisions. Moreover, the vulnerability of insurance markets had led to financial market innovations such as the catastrophe futures and options now traded on the CBOT. New instruments have appeared such as "Act of God Bonds" in which borrowers contract for some degree of debt forgiveness in the event of a predefined catastrophe. Also, in the absence of adequate reinsurance, insurers have sometimes swapped their catastrophe exposures.
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