Natural Disasters and Tax Deductible Reserves

1. Natural Disastersand Tax Deductible Reserves Kevin McCarty Florida Department of Insurance CAS Ratemaking Seminar March 11 & 12, 1999

2. $21 Billion Hurricane Northeast Region $66 Billion Earthquake San Francisco $101 Billion Earthquake New Madrid Region $71 Billion Earthquake Los Angeles $17 Billion Hurricane Southeast Region $22 Billion Hurricane Houston-Galveston $76 Billion Hurricane Florida Region Sources: U.S. Geological Survey, Uniform Building Codes, Council of State Governments 1/500 Year Insured Losses Estimated by Risk Management Solutions, ISO

3. Rules Current Tax, Accounting Rules • GAAP and Insurance Statutory Accounting • Reserves for future catastrophes not allowed • Internal Revenue Code: • Event must have occurred to be deductible

4. Drawbacks to Current Tax and Accounting • Do Not Allow Insurers To Establish Reserves for Future Catastrophes • Current Tax Law: • Transfers Policyholder Risk Capital to Government • Increases Cost of Insurance • Can Reduce Availability, Especially in Rate Constrained States • Current Accounting Rules: • Transfer Cat Premiums to Surplus Prematurely • Mask Need for Capital Retention

5. How Other Major Industrial Countries Deal With The Issue • Most major industrialized countries allow or require insurers to establish reserves for future catastrophic exposures. • Each country has its own rules for setting up and drawing down such reserves, but all have reserves that are tax deductible.

6. Reserve Requirements • Tax-Deductible • Statutory Liability • Cover Mega-Cats • Mandatory NAIC Tax-Deductible Cat Reserve Key Characteristics • Tax Deductibility a Precondition • Required Statutory Liability • Cover U.S. Exposures • Apply to Catastrophe-Prone Lines • Offset Qualified Losses from Specified “Named” Perils • Focus on High Impact Events

7. Purposes of Tax-Deductible Catastrophe Reserve • Retain Cat Premiums to Cover Long-Term Exposures • Better Provision Insurers to Deal With Mega-Cats • Assure Consumers, Regulators That Cat Portion of Rates will be Available for Intended Purpose • Prevent Premature Allocation of Policyholder Risk Capital: • To Federal Government Through Taxes • To Surplus for Distribution to Owners or to Cover Other Risks • Augment (Not Displace) Other Funding Sources

8. _____ Perils______ Wind Earthquake/Fire Following Tsunami Fire Flood Hail Snow, Ice, Freezing Volcanic Eruption NAIC Tax-Deductible Cat Reserve Covered Lines & Perils • ____Covered Lines_____ • Fire • Allied Lines • Earthquake • Homeowners M/P • Farmowners M/P • Commercial M/P • Private Passenger Auto P/D • Commercial Auto P/D

9. NAIC Tax-Deductible Cat Reserve Eligible Insurers • Any Entity Required to File a NAIC Property Casualty Annual Statement Blank • Exceptions: • Insurers Taxed on Investment Income (Premium less than $1.2 M) • Insurers Not Subject to Federal Taxation (Premium less than $350K) • Unless Commissioner Requires

10. ( ) Ratio of Premiums Less Ceded Excess to Premiums Insurer Direct Plus Assumed Less Ceded Premium By-State, By-Line Cat Exposure Factors Insurer Annual Reserve Addition X = X NAIC Cat Reserve Annual Additions • Grow Industry Reserve Gradually • $2B Per Year Based on 1996 Premium Levels • Allocate to Insurers Based on Relative Catastrophe Exposure and Premiums • Subject to: • Cap (20 X Current Year’s Accumulation) • Rolloff, if Not Used After 40 Years

11. Based on Insured Losses from 1967-1996 for Covered Lines Which Exceeded PCS Cat Losses Allied PPAuto Etc. Fire AL … .0179 .1761 .0093 ... AK .0145 .0099 .0044 .0693 ... AR .0163 .0020 ... .0122 .0056 .0114 AZ ... ... ... ... Etc. NAIC Cat Reserve Exposure Factors

12. NAIC Cat Reserve Qualifying Losses • Losses • Loss Adjustment Expenses • Assessments, surcharges and other liabilities attributable to a qualifying catastrophe • Net of reinsurance, subrogation/salvage

13. >$10B Industry Cat; Insurer’s Losses Exceed 20% Insurer Cap Insurer’s Annual Cat Losses Exceed 15% Insurer Surplus Insurer’s Annual Cat Losses Exceed 40% Insurer Cap or or Yes Release Reserve to Extent of Net Excess Losses Release Also Required If: Addition Not Used After 40 Yrs. Reserve Exceeds Insurer Cap Regulator Requires to Forestall Insolvency Yes Yes NAIC Cat Reserve Drawdown Criteria Catastrophe Declared by PCS Results From Named Peril

14. NAIC Cat ReservesBenefits and Costs • Benefits: • More Explicit Recognition of Cat Exposures • More Accountability (Less “Transparency” of Risk) • More Dedicated Capital to Cover Cat Risks (Pre-Event) • More Industry Stability, Fewer Insolvencies/Assessments • More U.S. Based Reinsurance • More Availability of Catastrophe Insurance • Less State, Federal Disaster Assistance for Insurable Losses • More Local Economic Stability, Growth • Costs: • Less Tax Revenue From Insurers

15. Considerations in Evaluation • Federal Budget Scoring • “Dynamic” Benefits: • Insurers’ Risk Bearing Capacity/Desire • Insurance Industry Solvency after Mega-Catastrophe • Availability, Affordability of Catastrophe Insurance • Consumer Insurance Choices • Reinsurance, Capital Markets • Local, State, National Economies • Federal, State Disaster Assistance • NAIC Survey, Analysis

16. Tax-Deductible Cat Reserves Tough Questions • Is Tax Deduction Achievable/Advisable? • Public Policy Imperatives vs. Budget Impact • Will NAIC Keep Tax Deduction as Precondition for Accounting Change? • Will It Improve • Industry Solvency? • Catastrophe Insurance Markets? • How Will It Be Coordinated With • State, Federal-based Initiatives? • Reinsurance, Capital Markets? • Other Initiatives?

17. Tax-Deductible Cat Reserves NAIC Development Timeline • Evaluate and Comment March ‘99 • Make Appropriate Revisions July ‘99 • Conditional NAIC Adoption Fall ‘99 • Federal Tax Consideration 1999 • Final NAIC Adoption After Tax Deduction