The California Earthquake Authority, which has been lobbying Congress to establish a federal backstop to its debt financing, is proving once again that it can do plenty fine on its own. The quasi-public agency just completed its third catastrophe bond placement in the past year, bringing its total cat bond coverage to $600 million.
This latest installment of CEA’s cat bond program, known as Embarcadero Re Ltd., will offer $300 million of reinsurance coverage to the authority (double the amount originally planned for the offering) that kicks in when losses exceed $6.233 billion. All told, when combined with the $150 million offerings completed in August 2011 and February 2012, the $600 million in cat bond coverage now accounts for about 20 percent of the CEA’s total reinsurance program.
The securities, which will pay a 5 percent coupon to investors, pushed the face value of insurance-linked securities listed on the Bermuda Stock Exchange over $5 billion, according to the Royal Gazette. The bonds, which were rated BB+ Standard & Poor’s, will mature as of Aug. 7, 2015.
This continues what has already been a record year for cat bond issuance, demonstrating enormous investor interest in taking on natural disaster risk. Other state insurance entities like Florida Citizens Property Insurance Corp. and Louisiana’s Citizens Property Insurance Corp. both have also looked to take advantage of the current appetite for cat bonds. The risk management blog Artemis.bm pondered whether the CEA will stick with their current mix of reinsurance options, or whether it might ultimately decide to transfer even more risk to the cat bond market.
Of course, the CEA also utilizes collateralized reinsurers for some of their coverag,e meaning that capital market investors actually contribute more than 20% of their risk transfer program. Could this be a sign of where the reinsurance market is going and the amount of influence the capital markets and investor backed coverage will have in the future?
Ultimately, what we find most interesting about these developments is that they underscore there is ample private sector interest in taking on earthquake risk. This puts the lie to the CEA’s own argument that there is a pressing public policy need for the federal government to step in and offer loan guarantees to the authority (or, theoretically, to other state earthquake insurance vehicles, should other states decide to create them.)
We at R Street are opposed to government-run insurance programs in general, but as it is currently structured, the CEA offers a nearly perfect model of a state-run insurer, if one absolutely had to be created. It prices risk upfront, it charges actuarially indicated rates, it transfers a substantial portion of its risk to the private reinsurance market and it has nearly $10 billion of claims-paying capacity, almost enough to cover a 1-in-500 year event. Comparing that to Florida Citizens and the Florida Hurricane Catastrophe Fund, which both rely heavily on post-event funding and would struggle to cover a 1-in-100 year event, and it’s hard to understand why anyone would want to make the former more like the latter.
It is true that the CEA faces a problem of low penetration. Only about 12% of at-risk Californians actually purchase the earthquake cover. The primary explanation for this is that, while Fannie Mae and Freddie Mac require insurance for fire, flood and windstorm perils on all conforming mortgages, the government-sponsored entities do not have a similar requirement for earthquake coverage. Without a requirement to purchase the coverage, most homeowners in California and other earthquake-prone states do not, although there is evidence that many of them do invest in mitigation, such as seismic retrofitting.
The risk of massive mortgage losses on homes destroyed by earthquakes is one that should certainly be in the discussions as Congress moves forward over the next few years on GSE reform. But as a new R Street paper we are set to present today shows, the projections made by sponsors of legislation to create a federal earthquake backstop that it would either significantly reduce premium rates or significantly increase take-up are massively exaggerated.
Instead, the primary thing such a bill would accomplish is to displace a private market that, it seems evidently clear, is working just fine.