ERM Saves the Day for the CEA v2
Abstract. The California Earthquake Authority (CEA) became operational December 1, 1996. It was created in response to an insurance crisis precipitated by the 1994 Northridge Earthquake. Its enabling statute required that carriers representing at least 70 percent of the homeowners join. Different considerations influenced each insurer’s decision and the paper describes one insurer’s approached. Based on a conventional silo-based analysis the insurer initially decided against joining but subsequently revised its decision and joined as a result of a more holistic, enterprise-wide view. The carrier’s revised decision was critical to the CEA achieving 70 percent market share and becoming operational. The study analyzes the pros and cons of CEA participation using general risk management and actuarial principles. It draws several lessons relevant today for insurer organization and effective management and in the face of on-going disruption.
JEL Codes: G22, G24, H84, K23, C65
Keywords: Enterprise Risk Management, catastrophe insurance, reinsurance, market organization, dynamic financial analysis, California, earthquake
Introduction
How did property casualty insurance companies decide whether or not to join the California Earthquake Authority (CEA) in 1996? It was a complicated decision, drawing together long-standing insurance issues around solvency, risk quantification, adverse selection, underwriting, regulation, affordability and availability with emerging ones such as the use of catastrophe models, securitization, risk based capital, and holistic enterprise risk management. The design and creation of the CEA itself is a political case study with law makers, regulators, insurers and the public balancing responsibility for a large and hard to quantify risk, coverage availability, financial strength, and, overwhelmingly, issues of trust. The quality solution they found has a clear message, perhaps more relevant today than ever before, of the need to combine legal and contractual safeguards with appropriate incentives, but also with a willingness of all parties to compromise and work towards the common good.
The paper details the triggering Northridge event and explains why it caused such disruption in the California homeowners market. It then presents an economic model an an insurer could use to decide whether or not to join. Trade journals reported November 25, 1996 that the CEA did not have enough industry support to become operational. They also reported Berkshire Hathaway had swooped in and committed to write a substantial upper layer of CEA protection originally envisioned as a cat bond.
At that time I worked in the personal lines product management department at CNA, a large multi-line insurance company. CNA had originally decided not to join the CEA. I was asked by the company CEO to review that decision in the light of subsequent information, particularly the Berkshire announcement. As a result of taking an enterprise-wide view of CEA membership, rather than just considering it as a personal lines problem, and of understanding the economics of CEA reinsurance the company decided it should, in fact, join, subject to certain conditions. This re-evaluation provides a wonderful example of making an important, material and economically beneficial decision using the precepts of the (then yet to be christened) enterprise risk management, ERM. The decision was important to both the CEA, which was able to announce on November 26 that all its statutory conditions for existence had been met and to start operations on December 1, 1996, and to CNA, which radically improved its risk/return profile for California earthquake exposure.
Why should you be interested in a decision made in 1996? I believe there are several relevant lessons from the CEA process for insurers today.
- The new technological innovation in 1996 was cat modeling. Today insurers are struggling with how best to integrate telematics, IoT, driverless cars, drones and big data into their processes. The lesson: economics triumphs. Model users were motivated by lower prices (for insurance or reinsurance) to invest in the data and systems needed to run cat models effectively.
- The new financial innovation was securitization. Today securitization dominates catastrophe reinsurance with over USD100 billion of alternative capital deployed. The industry continues to investigate how it can be used for other risks, such as extreme casualty events. The lesson: economics triumphs but it takes persistence. Cat bonds provide a better solution for tail risk than a traditional corporate structure but they threatened entrenched interests. Pioneer sponsors had to work for many years before their idea took hold.
- The new 1996 environmental reality was the occurrence of frequent solvency-threatening, multi-billion dollar events. Since then catastrophe risk has continued to increase along with the global economy and exacerbated by demographic and climate change. Non-property vectors also threaten mega-risks. The industry continues to struggle with how best to quantify extreme risk, what level to bear, and how to share it equitably amongst insureds and investors. The emerging risk component of ERM must be robust and fully integrated it into day-to-day operations.
- Then risk based capital and DFA were new. Today ERM and own risk solvency assessments (ORSA) are mainstream and an important part of regulator and rating agency evaluations. Some companies still struggle with passing the “use test” and justifying their ERM investment. A lesson of the CEA analysis is the need for a disciplined and consistent use of an enterprise-wide view in all decision making. Really big decisions may be rare events but the ERM framework must be ready when they need to be made.
- Public private partnerships work: the industry rose to the challenges of supporting the CEA, particularly the reinsurance industry. It is important to be seen as part of the solution, not the problem, when opportunity arises.
- Earthquake is still under-insured, along with flood. An objective, external observer would find it mystifying that US insurers do not include quake and flood in a standard homeowners policy, [1]. The CEA provided a single-state solution for quake. Can it be extended?
- Coming to the right decision involved overcoming organization difficulties. A frank assessment of internal organization needs to be part of ERM.
Lastly, the story is told from the industry’s viewpoint, not the legislator’s or state executive’s or regulator’s or consumer’s. The insurance industry is a critical part of the modern economy, relied upon every day by billions of people around the world to delivery economic security and help people, companies and governments re-build after catastrophes. But we are not good at telling our own story nor explaining the benefits we deliver to society nor detailing the basis for our concerns. This case study presents the industry at its best, helping to solve an important and material problem. It is something of which all industry participants can be justly proud.
There are several important topics that are not discussed. Most are already well covered elsewhere. Coverage and pricing issues for the minipolicy became a big part of the CEA debate once the program was running. What is an actuarially fair rate? How should territories be set and should there be subsidies between them? How should models be used? How should affordability be addressed? Do rates adequately communicate risk to the public? Why is the earthquake take-up rate so low in California? Should earthquake insurance be a requirement for a mortgage like fire and flood insurance? What is the appropriate role of the CEA in promoting loss mitigation? What is the role of the state in promulgating building codes? These are all important questions but they are not relevant to our story.
The rest of the paper runs as follows. Section 1 sets the scene in 1994, describes the Northridge event and explains why it had such a profound impact on the industry. Section 2 explains some key aspects of the CEA solution. Section 3 gives background on CNA. Section 4 describes an economic model, based on underlying CEA economics, that can be used to decide whether or not to join the CEA. The model is silo-based and only considers the problem from personal lines’ perspective. Section 5 recaps press reports from Fall 1996 as the CEA struggled to meet its statutory requirements to become operational. Section 6 describes a revised analysis used by CNA, based on holistic enterprise-wide principles, to decide it should participate in the CEA. Section 7 draws some conclusions.
Disclaimer
The paper’s quantitative models are all based on public information. CURVES!
Acknowledgments
I would like to thank: XX.
Northridge and Its Impact
Prior to 1992 the industry had only experienced one USD 1 billion insured loss catastrophe event: Hurricane Hugo in 1989. Between August 1992 and January 1994, less than 18 months later, that changed profoundly. First Andrew, which PCS estimated as a USD 15.5 billion insured loss event1. State Farm Fire and Casualty, founded in 1935, lost all the money it had ever made in property and was rescued by a USD 3 billion capital injection from its parent. Prudential Property and Casualty (PruPAC) lost more than its starting surplus and was also saved by a parental rescue.
Andrew began an industry-wide re-evaluation of catastrophe loss potential and changed the industry’s approach to homeowners insurance. State Farm, for example, had already begun to manage exposure in California prior to Northridge2. It also moved catastrophe modeling to the top of the agenda. Data that had been impossible to obtain suddenly became available as reinsurance price differentials made data gathering an economic necessity.
The Northridge earthquake was a 6.7 moment magnitude event that occurred on January 17, 1994 at about 4:30 am in the densely populated San Fernando Valley region of Los Angeles. The tremblor killed 57 people and caused more than 8000 injuries, see [2] for these and related facts. It is estimated to have caused economic losses in excess of USD 40 billion and a PCS insured loss of USD12.5 billion when it occurred. Prior to Northridge, the most devastating California earthquake was the 1989 Loma Prieta, with current insured losses just under USD 1 billion. Nearly 50 percent of the economic losses and over 70 percent of insured losses from Northridge were residential. Insurance covered just under half the residential economic loss, consistent with estimated earthquake insurance take-up rates in the mid-40 percent range.
Losses from Northridge cost the industry more than the total California earthquake premium written since 1972. The industry was, however, able to pay all claims and no insurer became insolvent because of the losses, though several companies were downgraded and Twentieth Century required a capital infusion to remain solvent.
Northridge was an infamously difficult loss to estimate. Petak says that while the earthquake was relatively small in terms of seismic intensity its economic losses were extreme, and they exceeded all previous predictions. Contemporary estimates illustrate the difficulties. In its first report (January 24, 1994) the National Underwriter headline proclaimed Calif. Quake Insured Loss Could Hit USD 1.9 Billion. Pete Wilson said the cost would approach USD 30 billion. EQE International “estimated total quake damage at USD 15.1 billion and insured loss of between USD 1.5 and 1.9 billion.” Individual company reports were also far from the mark. State Farm’s first report was USD 280 million (NU 2/7); ultimately it paid USD 3.2 billion (Best Reports). Twentieth Century: USD 160 million (NU 2/14); ultimately it paid USD 1 billion (op. cite)
RMS Report [3] revealed that “the exposure data that had served as the basis for risk calculations was of poor quality with locational information often incomplete, or miscoded.” It drew attention to under-insurance problems, which is especially problematic for policies with a deductible expressed as a percentage of policy limits.
Even before Hurricane Andrew homeowners was a stressed line of business. Between 1976 to 1979 it ran an average combined ratio of 95.3 percent, while the industry as a whole averaged 99.4 percent. In the 1980s homeowners combined ratio increased to 104.8 percent, including 113.9 percent in Hugo’s 1989. From 1990 to 1995 it averaged 122.3 percent.
California homeowners was the largest homeowners market in the US accounting for 11 percent of premium. It was over 25 percent larger than #2 Texas. It was obviously immune to wind losses: a huge attraction in 1994. Its five year combined ratio 1986-90 was 102.0 percent, which looked very favorable compared to countrywide results. However in 1991 and again in 1993 loss ratios were adversely impacted by major brush fires. In addition there were major losses from the 1992 Los Angeles riots. By 1994 the five year average combined ratio had increased to an alarming 130.0 percent. Nonetheless, since homeowners does not include earthquake and “it never rains in Southern California”, carriers remained confident they could quantify and price homeowners. In retrospect their confidence was well-founded. 1996-2000 all produced an underwriting profit and by 2000 the five year average combined ratio was 91.0 percent.
In summary: California was a large and important homeowners state, regarded as potentially profitable, and with a lower catastrophe risk. Insurers were highly motivated to write in the state.
The industry reaction to the uncertainty caused by Northridge was fast and broad.
Already by June 6, 1994 NU reported Calif. Homeowners Market Shrinking Fast, Agents Say with some companies refusing to sell new policies and others cutting back. IIABC said two thirds of its members reported restrictions, including termination of agents and a ban on new policies. Problem companies are a “Who’s who of P-C insurers”. Allstate said business was up 40 percent since the quake. State Farm was limiting business, but says this was part of a program started before January 17.
Complicating the quake-related uncertainty, on October 3, 1994 NU reports Garamendi Says State Farm Redlines. And November 28, 1994 that Garamendi Orders $1.25B In [Proposition 103] Rebates
It also reports Quake Risk Scares Off Calif. HO Mkt. CSAA no longer accepting new applications. Its proportion of homeowners policies with quake has increased from 8 percent in 1983 to 30 percent now and to over 40 percent in Bay Area. “We’ve hung in there long after many insurers withdrew from the market, but it would be unfair to our existing policyholders to allow our catastrophe exposure to expand any further,” a company representative said.
As these articles show the reaction was primarily on homeowners insurance availability. Homeowners insurance is a critical part of the modern economy because it is required in order to obtain a mortgage. By contrast, and perhaps surprisingly, earthquake insurance is not required for a mortgage, although flood insurance is required for properties located in flood plains. How did earthquake losses spill over to homeowners coverage?
California insurance code has a unique mandatory offer law that requires homeowners insurers to offer their policyholders an earthquake policy every two years, created in 1984 by Cal. Ins. Code §10081. The policy must provide certain minimum coverages. The mandatory offer exposes insurers to two undesirable effects. First, they have no control other their exposure. Penetration of earthquake insurance typically spikes after an event owning to heightened insured awareness. Second, insurers can be adversely selected against, with only high-risk (location or type of structure) insureds accepting the offer.
The mandatory offer was introduced as a quid pro quo for the abrogation of concurrent causation as applied to earthquake in Cal. Ins. Code §10088. Insurers had seen earthquake exclusions successfully challenged in litigation and were very concerned about the possibility of implied coverage, especially following a major event.
At the height of the crisis in summer 1996 the Department of Insurance reported that 95 percent of the homeowners writers in California had either stopped writing or had severely restricted the writing of new homeowners insurers (ARL1997). In addition many insurers were actively non-renewing existing homeowners customers.
Homeowners vote: elected representatives could not tolerate a frozen homeowners insurance market. Through a series of initiatives and bills they set about solving the problem.
The CEA Solution
This section summarizes the design of the CEA and figures the economics of its minipolicy. For additional background on the CEA see [4], which provides a detailed, insider’s description of its history and operation, and [5], which discusses the design and operation of the CEA.
Legislators and regulators were unwilling to drop the mandatory offer and it soon became clear that a new entity would be required. There were already three mechanisms in use to address insurance availability issues in California and they all involved state run or sponsored entities: the California FAIR plan, the California Insurance Guaranty Fund (CIGA) and the State Compensation Insurance Fund (SCIF). The first two are pass-through pools. SCIF writes insurance policies and competes in the open market was the best model.
Law makers, regulators, insurers and the public all agreed on the urgent need to re-open the homeowners market. Beyond that common point they operated under different constraints.
Regulators and law makers and the State of California needed a solution that
- maintained the mandatory offer,
- made no call on the public purse, and
- was not seen as “bailing out” the insurance industry.
They felt repealing the mandatory offer could end residential earthquake availability in the state, which was deemed unacceptable.
All parties were concerned that any new entity be credible, solvent and sustainable. It needed to be financially robust enough that it was unlikely to fail in the short term. No one wanted to be faced with the same problem again in the near future.
Some insurers lobbied that whereas (wind-free) California homeowners risks were well understood, earthquake risk was too high and too poorly understood. Their concerns varied by company but they looked
- to manage earthquake exposure as effectively as any other catastrophic exposures,
- to obtain a cap on their earthquake exposure, including any liabilities to new or existing state entities, and
- to control against the State ``raiding the purse’’ of a new entity if it were successful: if the new entity were successful insurers were concerned that its assets not be used general state purposes.
Everyone was concerned about the “over the top” (OTT) exposure of liabilities in excess of assets: if the new entity failed who paid? Deep pocketed insurers were wary of being forced to pay. The state was sensitive that if it were responsible for OTT losses it would strain public finances at a bad time and be seen as bailing out insurers. Because of the uncertainties introduced by Northridge, as well as a general post-Andrew caution, no one felt confident about estimates of the OTT exposure. Ultimate responsibility for “the big one” was a particularly sensitive problem.
The mandatory offer specifies the coverages insurers must offer residential property policyholders. In 1995 the Legislature scaled back the mandatory coverages by creating the so-called minipolicy. The minipolicy is described in Cal. Ins. Code §10089. It included a substantial 15 percent of TIV deductible, limited coverage to the dwelling and excluded outbuildings, capped contents coverage at USD 5,000 and additional living expenses at USD 1,500. The minipolicy design incorporated lessons from Northridge. The level of damages to appurtenant structures (Coverage B) such as swimming pools, detached patios and garages was far in excess of assumptions. In part this was caused by their comprising a much higher proportion of property value than had been assumed, [3].
Companies that elected not to participate in the CEA were allowed to file their own mini-policies, which most did.
The CEA design combined a robust financial structure, Federal tax free status and an explicit right to pro rate claims above its financial resources. It is privately financed and publicly managed entity, governed by a Board consisting of the Governor, the Treasurer and the Commissioner. Its creation allowed law makers to maintain the mandatory offer, albeit subject to the lower minipolicy provisions.
The proposed structure gave the CEA the ability to pay claims up to USD 10.5 billion if all insurers participated. This represents substantial protection compared to re-estimated minipolicy losses of USD 4 billion for Northridge (REF). The 100 percent financial tower is shown in . All except Layer 4 is pre-funded, a deliberate design choice to avoid the possibility of substantial debts early on at the expense of slower capital build-up.
| Layer | Abbreviation | Description | Cover at 100 Pct |
|---|---|---|---|
| Over the Top | OTT | Pro Rate Claims | unlimited xs 10.5 |
| Layer 5 | 2IAL | Second Industry Assessment Layer | 2.0 xs 8.5 |
| Layer 4 | Re2 | Securitized Cat Bond | 1.5 xs 7.0 |
| Layer 3 | Debt | Policyholder assessment | 1.0 xs. 6.0 |
| Layer 2 | Re1 | First Reinsurance Layer | 2.0 xs 4.0 |
| Layer 1 | 1IAL | First Industry Assessment Layer | 3.0 xs 1.0 |
| Working capital | Capital | New Member Capital Contributions | 1.0 xs 0 |
| Total | 10.5 xs 0 |
Participant capital contributions are based on residential earthquake premiums at January 1, 1994. [5] describes the capital contribution as an “exit tax”. Liability for the industry assessment layers (IAL) is based on actual writings of member companies in the CEA. The IALs had various phase outs, with the first IAL eroding as retained capital accumulated.
The first reinsurance layer was a two year, USD 2 billion aggregate protection. Cal. Ins. Code §10089.14 required the CEA obtain reinsurance contracts in an amount of at least 200 percent of the total initial cash contributions from participating insurers.
The policyholder assessment layer is provided by debt issuance or a letter of credit repayable by policyholders assessments.
Layer 4, the second reinsurance layer, was proposed to be a catastrophe bond, securitized transaction. The bond would have been by far the largest cat bond issued and would have been a huge boost to the emerging cat bond market. However, as events transpired at the eleventh hour, it was placed as traditional reinsurance with Berkshire Hathaway.
The CEA is exempt from state premium tax. Amounts of premium tax otherwise due, amounting to 2.35 percent of gross premium, are included in rates and booked as a capital contribution by the state to the CEA.
Cal. Ins. Code §10089.35(a) gives the CEA an explicit right to pro rate claims it if determines it has insufficient funds to pay 100 cents on the dollar. The Commissioner does not have the right to place the CEA into conservatorship and it is not subject to normal bankruptcy proceedings. As a result neither the state nor the insurance industry is responsible for losses in excess of claims paying capacity. The state’s liability is explicitly disavowed in Cal. Ins. Code §10089.35(a): the state has no liability and no “obligation whatsoever” for payments in excess of funds available. Removing this exposure was a very important design consideration for both regulators and insurers.
As [5] points out it is nearly impossible to conceive of a private market having the contractual ability to pro rate claims, especially on the basis of a market loss. [6], [7] discuss some interesting alternative methods to apportion resources in default. (PICK ONE)
Insurers were also concerned with indirect exposure to earthquake loss. One exposure was via CIGA assessments to pay earthquake claims of insolvent carriers. To address concerns about CIGA assessments Cal. Ins. Code §10089.34 states that CEA policyholders shall not be assess for, nor shall they be eligible for benefits from, CIGA. Paragraph b(2) makes clear that participating insurers have no obligation to pay CIGA assessments arising from basic residential earthquake insurance policies written by non-participants. To the extent there were CIGA assessments driven by non-earthquake claims a participating insurer would still be liable. This is a more likely scenario. For example the vast majority of 20th Century’s business was personal auto.
In summary, the CEA legislation, Sec. 10089.14, specified three conditions for the CEA to become operational:
- The Internal Revenue Service determines the authority is exempt from federal income tax,
- Insurers whose residential earthquake insurance market share is more than 70 percent as of January 1, 1994 commit to participate and agree to make an initial capital contribution (up to USD 1 billion)
- The authority secured reinsurance limits of at least 200 percent of the total capital contributions of participating insurers (up to USD 2 billion).
Marshall describes these as “three extraordinary conditions”. He then states that “When all three benchmarks were duly met, the insurance commissioner formally authorized CEA to commence operations”. His “duly met” hides much analysis, debate and angst at insurers over whether or not they should participate. The rest of the paper describes one such analysis.
CNA Situation
In 1996 the top 10 property casualty groups included 6 multi-line, commercial dominated companies: AIG (2nd largest), CNA (4th), Travelers (6th), Liberty Mutual (8th), The Hartford (9th) and Zurich (10th). Today only Liberty Mutual (3rd) and Travelers (6th) remain in the top 10, and Liberty Mutual now writes more than 50 percent of its business in personal lines. There are only two commercial dominated carriers in 2018’s top 10: Chubb and Travelers.
In 1996 CNA was the fourth largest property casualty writer in the US based on direct written premium. It was a multi-line insurer, including personal, commercial and specialty lines business and a professional reinsurer. Its 1994 merger with Continental Insurance3 was motivated in part by a desire to boost personal lines. Following the Jack Welsh strategy CNA looked to be a top 3 player in lines where it competed, and so growth was essential. CNA had a 1.4 percent residential earthquake market share in 1994, which by 1996 was about 1 percent (SOURCE). It had a substantial loss from Northridge, caused in part by the inclusion of earthquake coverage on contents for some of its premier homeowners policies. Its countrywide homeowners loss ratio in 1994 was 110.7 percent compared to 98.5 percent in 1992 and 70.9 percent in 1993.
List many large companies in the early 1990s CNA included a professional reinsurer, CNA Re. Over the next decade all of these were shut down or sold off, as multi-lines came under attack from more focused competitors, often based in tax advantaged jurisdictions.
Essentially risk-neutral.
SBUs. NEV analysis.
Not a buyer and seller of reinsurance.
Silo-Based Analysis and Economic Model
Against this backdrop, how did companies analyze whether or not to participate in the CEA? We begin by giving some qualitative advantages and disadvantages to participation. Then we present a quantitative financial model.
Throughout PI is a participating insurer and NPI a non-participating insurer.
The principle advantage of CEA participation for some insurers was to provide a definite cap on their exposure to earthquake losses. Insurers were particularly sensitive to their total exposure for obvious solvency reasons, but also because of their recent experiences in Andrew and Northridge suggested peak exposures were very difficult to estimate reliably.
The value of a cap on varies by type of company. A typical multi-line insurer had several potential sources of earthquake exposure:
- Many carriers voluntarily wrote commercial lines earthquake.
- All property writers had exposure through fire policies. California is a Standard Fire Policy state and insurers have to cover fire following earthquake even if the policyholder has no earthquake coverage.
- Similarly, it is impossible for workers compensation writers to exclude injuries at work caused by earthquake.
- Some wrote third party reinsurance assumed and these would generally participate in the earthquake market.
- Indirect losses from the FAIR plan and CIGA assessments. Although FAIR plan assessments can and CIGA assessments must be recouped in rates insurers were exposed to timing risk, between paying an assessment and re-couping it in premium. They were also subject to Proposition 103 prior approval laws, which created significant uncertainty about whether assessments could be fully reflected in rates. A surcharge required a filing that could lower profitability: if rates were very profitable they would have to be lowered to add the assessment, making the insurer worse off.
As a result an exposure cap was more valuable to predominantly personal lines companies than multi-line companies because it addressed a larger proportion of their total earthquake exposure. For CNA the cap was not a material benefit.
A second advantage of participation was to eliminate risks associated with developing, maintaining and filing a voluntary residential earthquake policy form. Insurers were allowed to file their own mini-policies, and many did so. But their filings exposed them to Prop 103 prior approval scrutiny, as well as potentially unwanted public scrutiny of fairness, soundness and affordability. CNA had a large and robust department dedicated to creating and filing rates, and was small enough its filings did not attract undue attention. Again, this was not a material benefit for them.
Third, participation meant insurers did not need to purchase their own reinsurance for residential earthquake losses. Placing reinsurance is an expensive and time consuming process. It exposes the buyer to reinsurance market price swings, which can be extreme. Like CIGA and FAIR plan assessments, the net cost of reinsurance can in theory be passed along in filed rates. But California prior approval regulation made companies wary they would be able to do this quickly and completely. CNA NO RE.
Fourth, participation meant insurers no longer need be concerned with the impact of the mandatory offer, which made it hard to manage exposures and opened them to adverse selection. Participation for a personal lines writer was essentially equivalent to exiting earthquake altogether, allowing them to focus on their core homeowners and auto businesses.
Overall, the qualitative advantages point to the CEA being very attractive to large personal lines writers, and Allstate and State Farm were both vocal advocates. On the other hand, large multiline carriers such as CNA, with a commercial lines focus, had much less to gain.
To join the CEA insurers had to pay an assessment to fund its working capital. The assessment was computed as USD 1 billion times the participants January 1, 1994 residential earthquake market share. A company with a 1 percent market share would pay an assessment of USD 10 million. DUP BEST HERE?
In addition participants were exposed to two Industry Assessment Layers, for USD 3 billion excess CEA capital and USD 2 billion at the top of the capital structure. Their assessments were proportional to their share of CEA premiums.
Next we build a simple financial model of California residential earthquake. The model will use an accounting view, similar to the approach taken at the time. The model estimates the underwriting results of the minipolicy as written by the CEA and adjusts them to show how they would appear to NPIs. First we determine point estimates, and then introduce a frequency severity loss model to determine expected losses in different layers of the CEA claims paying tower.
The model shows the minipolicy was profitable for a multiline insurer like CNA. It makes no sense to pay an assessment for the right not to write profitable business, particularly for companies with experience writing and pricing earthquake. This is what CNA Personal Lines determined in the summer of 1996.
In order to understand CEA minipolicy economics we work backwards from a knowledge of how their rates were set. We estimate the key expense components and end up with a breakdown of the overall CEA combined ratio into underwriting expenses, gross losses and cost of reinsurance. The analysis is based on public filings.
Ins. Code §10089.40(a) requires CEA rates to be ``actuarially sound’’. Marshall (p. 110-111) describes that this to mean premium must cover expected losses, the net cost of reinsurance and CEA expenses. Normally an insurer would require a cost of capital for its shareholders, but the CEA does not have any shareholders and it chose not to load rates with an explicit underwriting profit provision. It did, however, assume an implicit margin because rates did not include an offset for investment income. Thus it wrote to a 100 percent combined ratio but an to operating ratio below 100 percent by the amount of investment income.
It could be argued that the IALs should include a cost of capital adjustment because they expose (costly) participant capital. Indeed in 05-6848 (p.131) the Personal Insurance Federation of California raises exactly this point saying PIs have “real exposures to loss and many buy reinsurance for their exposure.” They also point out that if the PIs did not provide the capital then the CEA would have to buy protection “in the open market” and would incur a cost of capital charge. They calculate the industry’s expected annual assessment is USD 33 million (compare to current estimates). However, the cost of the IALs is offset by the OTT cost participants avoid and so no additional loading is included in the rates.
In order not to be distracted by timing issues, earning commissions etc., we will take a policy year view.
Based on this interpretation actuarially sound rates implies that premium satisfies \[\begin{equation}\label{eq:pricing} P= \frac{L + R^*}{1-e} =\frac{(L-L^*) + R}{1-e} \end{equation}\] where
- \(P\) is total CEA premium,
- \(L\) is expected loss payments limited by CEA claims paying ability of USD 10.5 billion,
- \(R^*\) is the net cost of reinsurance, that is reinsurance premiums less expected reinsurance recoveries,
- \(R\) is reinsurance premium and \(L^*\) is ceded losses, and
- \(e\) is the expense ratio excluding reinsurance, so \(P(1-e)\) gives premium net of expenses.
By definition \(R=L^*+R^*\) and net losses are \(L-L^*\) giving the second equation. The cost of reinsurance to the CEA is not the same as profit to the reinsurers because of internal reinsurer expenses. The CEA included reinsurance brokerage as a separate expense.
can be re-written to give the underwriting combined ratio \(u\) by dividing by \(P\) \[\begin{equation}\label{eq:pricing-u} u = 1 - e - l - r^*. \end{equation}\] where \(l = L/P\), etc. Because of the ratemaking formula \(u=0\).
In all the calculations we assume that total premium for the CEA is USD 1.2 billion at 100 percent industry participation and denote it by \(P\). The premium estimate is based on CAL Update document. It is broadly consistent with the CEA maintaining earthquake penetration at its 1996 levels, in the mid-30 percent range.
A detailed analysis of the CEA’s 1999 rate filing4 gives the following accounting summary of the CEA’s minipolicy.
| Item | Symbol | Ratio |
|---|---|---|
| Loss Ratio | \(l\) | 49.0 |
| Net Cost of Reinsurance | \(r^*\) | 30.5 |
| Expense Ratio | \(e\) | 20.5 |
| Combined Ratio | \(e+l+r^*\) | 100.0 |
| Underwriting Result | \(u = 1-e-l-r^*\) | 0.0 |
At this point observe that all decisions are scale invariant in the sense that premium, expenses and the loss distribution are homogeneous variables that scale in proportional to market share, [8], [Tsanakas2016b?]. Therefore going forward we work on the level of the total market and consider results scaled by \(P\). All ratios should be multiplied by residential earthquake premium to convert to dollar amounts for a particular company.
Having established the baseline underwriting result for the CEA we next look at how it needs to be adjusted to show the underwriting results for an insurer like CNA writing its own minipolicy. The loss ratio, expense ratio and cost of reinsurance all need adjusting. We start with reinsurance.
CNA did not purchase any catastrophe reinsurance (Best Report QUOTE) and According to A. M. Bests Reports (1995, 1997 editions), “CNA chose not to purchase catastrophe reinsurance upon its June 1, 1993 renewal and has not purchased such protection since. The group views the capacity of catastrophe reinsurance available from financially sound companies as low and prices high, thus making it impractical for the group to purchase such coverage.” It re-entered the market in 1996. Therefore \(r'=0\): this difference is the source of the apparent minipolicy profitability.
Next consider expenses. The average NPI expense ratio can be estimated using the earthquake line in the Insurance Expense Exhibit (IEE). Average direct acquisition expenses for earthquake (commercial and residential, all states) are 18 to 21 percent and general expenses are 6 to 8 percent, with a total of 24 to 28 percent. California residential property was a distressed market and an earthquake policy could piggy-back off a homeowners policy and so it is reasonable to assume total expenses at the lower end of the range. Assume an NPI has \(e'=0.24\) implying a 3.5 point expense disadvantage compared to the CEA, . These estimates suggest the CEA was expense-efficient compared to commercial carriers.
Finally consider the loss ratio component, computed as expected loss divided by premium. Because the market is competitive, minipolicy premium must be based on the same rate level as the CEA. An NPI could charge a lower rate and try to cherry pick (a strategy adopted by some specialist writers) but it could not reasonably charge a higher average rate. To be adequate in the aggregate it needs to match the CEA’s rates. Expected losses need to be adjusted from CEA assumptions to reflect different levels of capitalization, i.e. the absence of right to pro rate claims. To compute this impact requires an earthquake loss model.
In 1996 the aggregate loss model was created using output from the EQECat catastrophe model. Since the late 1980s catastrophe computer simulation models have become the preferred approach to estimating losses. Catastrophe models are described in [9] and [10]. For each simulated event cat model output includes the annual rate of occurrence and the insured loss. The sum of individual event rates gives the total annual frequency for modeled earthquakes. Dividing the event rate by the total rate produces a severity curve, i.e. a conditional occurrence probability distribution. Aggregate losses are then computed assuming a compound Poisson process for each individual event. See [bowersEtAl?] Chapter 10 or [Klugman2004?] for standard facts about compound Poisson distributions.
The original EQECat distribution was based on an assumed distribution of policyholders. It was not put into the public domain as far as I know. In order to proxy the results we show results from three newer evaluations of California earthquake residential losses, each scaled to match the the original CEA loss cost of gross loss cost of USD 588.5 million , which we call models A, B and C (AIR, IF, RMS). None is perfect since the original data and models no longer exists. But their variety illustrates the realities companies grappled with in 1996: there were (and still are) a variety of models producing different results. Part of management’s task is to select between them.
shows aggregate losses from the three models on a linear scale laid against the claims paying structure.
Given a random variable \(X\) representing unlimited aggregate earthquake losses we can compute expected losses to different layers as follows. Let \(F\) and \(S\) be the distribution and survival function \(X\). A layer of width \(y\) in excess of an attachment \(a\) pays \(L=\min(\max(X-a, 0), y)\) when ground-up losses are \(X\). The expected value of \(L\) is given by \[\begin{equation} \label{eq:layer-cost} \mathsf{E}[L] = \int_a^{a+y} S(x)\, dx. \end{equation}\] This expression follows by integration by parts, see [11]. By applying this formula with diffferent values of \(a\) and \(y\), given by table XXXX, we can compute expected losses for the CEA claims paying tower and estimate the value of OTT losses. shows the results. It assumes the OTT layer covers claims up to USD 100 billion, which would proxy CNA’s level of claims paying ability at 100 percent5.
shows expected loss dollars by layer, computed using , as well as their ratio to premium. Total insured losses are calibrated to USD 589.5 million, giving a 49 percent loss ratio for all models. As is clear from the different models have different implications for losses by layer, even though they all agree up to USD 10.5 billion. The biggest differences are at the bottom of the program, in the Capital layer, with expected losses between 14.1 percent and 23.2 percent, and the OTT layer, between 5.4 percent and 30.7 percent. CEA’s 1999 rate filing quantifies the OTT benefit as only 1 percent of unlimited (modeled) losses6.
shows CNA’s estimated profitability for the minipolicy ranges from an underwriting profit of 21.6 percent (combined ratio of 88.4 percent) to a small loss of 3.5 percent, assuming a 24 percent expense ratio.
Since the minipolicy is profitable under RMS and IF, and since participation involves a certain cost, it is clear that faced with this choice and insurer would not participate. But what about model AIR? To know for sure we need to estimate the cost of the IALs. These are shown : between 18.3 and 21.6 percent of premium, or, at a 1 percent market share, between USD 2.2 and 2.6 million per year. These costs are far in excess of the 3.5 percent loss from participating under AIR.
The metrics are expressed per dollar of premium, in terms of \(u_i\), the underwriting ratio for an NPI writing a minipolicy directly, \(v_i\), the expected annual cost of the two industry assessment layers, and \(b=1/1.2=0.83\) the cost to buy-into the CEA per dollar of premium.
The basic decision rule is to use expected net present value at a risk adjusted discount rate. Denote the insurer’s cost of capital by \(r\) and recall the present value of an annuity of 1 paid at the end of the year is just \(1/r\). Also it will be convenient to let \(b = B/P = 1/1.2 = 0.83\) denote the initial assessment per dollar of residential earthquake premium.
We now have all the components needed to decide whether a given insurer should participate.
For a PI the cash flows are:
- On electing to participate pay a one-time capital assessment equal to USD 1 billion times its 1994 earthquake market share.
- Assume a liability for the two contingent IALs, triggered in the event of CEA losses above its capital (USD 1 billion at 100 percent) and at the top of the program (above USD 8.5 billion). The PIs exact liability is based on their CEA market share. The annual expected amounts are \(v_A, v_E\) on an accounting and risk adjusted basis. They are independent of characteristics of the insurer.
In return the CEA writes residential earthquake policies directly for any PI policyholder who does not reject the mandatory offer.
In general amounts due under the two IALs are subject to the participant’s catastrophe reinsurance. This could drive a perceived cost to the PI closer to the economic view than the accounting view.
A PI benefits from not being liable for earthquake related CIGA assessment liabilities. We ignore CIGA assessments as a second order effect.
We treat \(v\) as fixed over time even though it changes each year as the CEA builds capital, the IALs are eroded, reinsurance pricing changes, and minipolicy rate adequacy changes. In reality the CEA’s capital built up quite slowly. By year end 2000 surplus had increased to USD 948 million compared to contributed capital of USD 700 million. Reinsurance and minipolicy pricing moved in tandem, acting as hedges. Our simplified model is adequate for illustrative purposes, particularly because in most cases the decision is clear.
Therefore the expected net present value of cash flows for a PI are \(b + v_i / r\), \(i=A,E\) and regarding the assessments as a perpetuity.
For an NPI the cash flows are:
- Collect premium and pay losses and expenses, and possibly reinsurance costs, on the minipolicy, modeled as \(u_A, u_E\) in and as a function of \(e',s', r', Q\) the insurers expenses, safety level, cost of reinsurance (accounting view) or risk adjusted pricing measure \(Q\) (economic view).
A non-participant insurer must make an earthquake insurance offer to all residential property policyholders every two years and write earthquake policies directly for insureds who do not reject the offer. It can manage its earthquake exposure through internal risk management processes, including reinsurance, but it has limited control over take-up rates and premium volume. It is liable for large earthquake losses up to its total capital and surplus: as always, all capital stands behind all policies.
An NPI is liable for CIGA assessments to pay covered claims of insolvent insurers but as for PIs we ignore the impact of potential CIGA assessments.
The insurer should participate in the CEA if the expected net present value of doing so is greater income than writing the minipolicy directly, that is \[\begin{align}\label{eq:participate} \text{\bf participate} &\Longleftrightarrow \text{EPV(NPI cash flows)} \le \text{EPV(PI cash flows)} \\ &\Longleftrightarrow u_i / r \le -b + -v_i/r \ge u_i/r \\ &\Longleftrightarrow u_i \le -br - v_i \ge u_i < 0 \label{eq:participate3} \end{align}\] where \(i=A,E\) for the accounting or economic views. The PI cash flows are expenses, hence the signs. Since \(-br-v_i<0\) it follows that if \(u_i \ge 0\), i.e. if the insurer believes it can write the minipolicy profitably, then it will never participate no matter its cost of capital \(r\) nor its assessment of \(v_i\). It also follows that in most situations the incremental cost of the initial capital contribution, \(-br\), will not be material.
shows the results of performing these calculations across the three models for a reasonable selection of parameters. All panels assume the insurer’s expenses for earthquake are 24 percent.
For all views the decision metric, comparing \(u\) to \(-br-v\) depends on \(r\), the cost of capital. The exhibit shows results for \(r=0.05, 0.15, 0.25\) bracketing a reasonable range.
The value of \(u\) does not depend on the cost of capital and so is shown only once for each block. The value of \(v\), which is the expected value of the two IALs does not vary by cost of capital or the insurer’s safety level because it is just determined by CEA performance. It is shown only once for each block.
The decision compares \(u\) to \(-br-v\), . Here \(-br-v\) obviously varies the the cost of capital \(r\) but not with the insurer’s safety level. Finally the decision is NPI (do not participate) if \(u>-br-v\) and PI (participate) otherwise. For example in the first table looking at the first row \(u=0.271>0\) which always drives NPI. In the seventh row for A safety level \(u=-0.295\) is a worse result that \(-br-v=0.258\) at \(r=0.05\) resulting in PI; but at \(r=0.15\), \(-br-v=0.341\) resulting in NPI.
Look first at the accounting \(P\) view. There is unanimity not to join, as expected.
The graphs show the results scenario by scenario for a participant vs. a non-participant. Scenarios have been sorted from smallest to largest loss and are identified with their percentile on the \(x\)-axis. The right hand column plots the same data as the left hand column but with a different scale to reveal the detail. The \(x\)-axis scaling uses the distortion calibrated by the first reinsurance layer to better reveal details in the worse outcomes. The blue lines show the result for an NPI from writing the minipolicy, assuming a 1 percent market share. These show the insurer will make money between 80 and 90 percent of the time, when there are no events or only small events. Then the NPI stands to pay considerable losses. The orange is zero until CEA losses exceed its capital, when the first IAL activates. Losses increase through the first layer. Then there is a period where the debt and reinsurance layers respond and the PI pays no more. Finally, the second IAL begins to respond. In all cases the most the PI pays is its market share times USD 5 billion. The compare line is the difference, with positive values indicating participation is better.
Insurers who opted not to participate are revealing a risk preference for the green line, which has a positive expected value, . The green line is typical of the risk-return profile assumed by insurers: a large chance of little or no claims on an individual policy but a small chance of a large loss.
CNA had filed its own minipolicy. Since CNA had no earthquake catastrophe reinsurance costs, based on it expected at least a nearly a 20 percent underwriting margin, after allowing for higher expenses, especially if it ignored its higher safely level. Relative to the homeowners book, with a five year average pure loss ratio of 84.1 percent this appeared very profitable.
A Call from Quakenbush
The CEA was frequently in the trade press during the Fall of 1996. This section presents extracts from Business Insurance (BI), the National Underwriter (NU) and other sources to give a flavor of how events unfolded. It focuses on press treatment of the CEA’s reinsurance program.
September 27, 1996: Governor Wilson signed the CEA package of bills
October 14 “CEA Law Prompts Allstate To Write Again In Calif.” (NU). A representative stated the creation of CEA “which we supported all along” will allow us to reduce our cat exposure “to the $1 billion range”. Allstate had stopped renewing policies shortly after Northridge.
Insurers representing 95 percent of the market in California stopped selling earthquake protection to new customers after the Northridge earthquake, according to the insurance department.
October 28 “CEA Gears Up For Kickoff on Dec. 1” (NU). Commissioner Quakenbush attended the annual Baden Baden reinsurance meeting. He “wanted to assure that reinsurance commitments were sill in place, given the fact the startup of the CEA was delayed for months” by the legislature. There is broad reinsurance market support for the CEA, with Continental European reinsurers committing USD 600 million, Lloyd’s USD 200 million the remainder of the London market USD 100 million, Bermuda USD 575.5 million and US/Canadian reinsurers USD 400 million, for a total of USD 1.875 billion. At least three companies, AXA Re, Swiss Re and Munich Re, authorized USD 100 million lines.
November 4: “California Quake Authority Suffers Growing Pains” (NU). Despite split votes on the three person board over rates and the CEO search, Commissioner Quakenbush says “[CEA] is on track and heading for a Dec. 1 kickoff”. He characterized the votes as “stylistic differences”. Thus far, carriers representing 48 percent of the market have signed on. The largest company that has not yet joined is Farmers, but they are expected to sign up by Nov. 8.
November 4: “Bermuda Writes $700M For Calif. Quake Facility” (NU). After a successful marketing trip Quakenbush reports Bermuda has the potential to become “the center of catastrophic reinsurance in the world if it chooses to move in that direction”. All eight property cat markets signed-on, with Ren Re the first to quote. He continued, “The fact that Bermuda came on so quickly motivated the rest of the markets to come on board.” The CEA USD 2 billion was program over-subscribed after the marketing trip. Quakenbush and his team are now “turning their efforts to raising the USD 1.5 billion of coverage which the CEA’s architects plan to tap from the U.S. capital markets”.
November 11: “CEA Creation Fueling Reentry of Large Insurers” (NU). Several large insurers have announced plans to reenter the homeowners market. Allstate and State Farm confirmed they will lift their moratoriums. Allstate “began selling policies last week” after a 24 month moratorium. “We did not want to have a moratorium, but because of everybody else leaving the market, we couldn’t be the only game in town” said a senior director at Allstate. Prior to Northridge State Farm had begun to cut exposure because of Andrew and other property losses. Farmers, which has had a moratorium since June 1994, is “developing [a] managed reentry.”
November 18: “California Earthquake Bonds Slated For Sale In Early ’97” (NU). Morgan Stanley, Bear Stearns and Goldman Sachs are set to bring a USD 2 billion offering to market early next year.
There has been softening in the reinsurance market, with “premium levels down 20-30 percent for the year”. In contrast CEA pricing as “remained firm” and as a result “companies are dedicating higher limits than they were last February to the CEA”. The CEA program is expected to be over-subscribed. REFERENCE THIS!
November 25: “Berkshire Hathaway to reinsure CEA” (BI) The CEA arranged up to $1.5 billion in reinsurance from Warren Buffett’s Berkshire Hathaway Inc., abandoning original plans to finance excess layers through capital markets. Reinsurance was less expensive, cumbersome to arrange and more plentiful than expected, said aides to California Insurance Commissioner Chuck Quackenbush. The cover will earn USD 590 million in premium for paying losses USD 1.5 billion excess USD 7 billion during a 4 year period starting April 1, 1997.
November 25: “California Quake Authority Scraps Bond Proposal” (NU) “State authorities, struggling to put together the final pieces of the CEA, have scrapped a proposed bond issue in favor of a more traditional reinsurance arrangement.”
“While state officials along with key insurers publicly remain optimistic the CEA will become a reality, private doubts are being raised as to how soon.”
“At least two self-imposed dead-lines by the CEA’s staff and advisory board to announce the finalization of the program’s financial underpinnings—the participation of insurers representing at least 70 percent of the market—have been missed.””
There are “conflicting reports” of who has signed. “Companies representing 60-65 percent are committed to the CEA, although in most cases contracts have not been signed”, officials say.
Greg Butler, the CEO of CEA, said the 70 percent market share threshold is likely to reached either via the inclusion of the FAIR Plan (with 240,000 policies and USD 14 billion of insured value, more than two-thirds of it in Los Angeles county) or by permitting 20th Century Industries to re-enter the market7.
The week before Thanksgiving 1996 the CEA was struggling to meet its statutory 70 percent participation hurdle, as the press clippings make clear. Sometime during that week Commissioner Quakenbush called Dennis Chookaszian, CEO of CNA, and asked if he was sure CNA did not want to join. As a result, a request came down through several layers of management to me.
Enterprise Analysis
laid out CNA’s analysis of the CEA. It was performed by Personal Lines8 from a Personal Lines perspective. It was a straightforward analysis given agreement on the profitability of the minipolicy.
Given CNA’s 1994 earthquake market share of 1.4 percent and 1996 approximately 1 percent share, participating in the CEA involved a payment of USD 14 million and assumption of contingent liabilities to the two IALs of approximately USD 2.5 million per year on an expected basis in order for the right not to write its own profitable minipolicy. REFS
Details of the CEA’s reinsurance had been reported in the press since the original review, particularly the surprise move by Warren Buffett and Berkshire Hathaway to write the second layer. Hearsay in the markets at the time (backed up by subsequent published articles, LANE/Sedgwick) suggested the reinsurance layers were very well priced. CNA’s businesses included an active and growing assumed reinsurance operation, CNA Re. Alerted to the potential profitability of the reinsurance layers I called CNA Re management to find out how much capacity they committed to the first reinsurance layer. Lacking a reinsurance business perspective, I was surprised to learn the answer: very little. They acknowledged the CEA layer was well priced but had already used all their ``California quake aggregate’’ (i.e. allocated capacity) writing existing clients. And for them the relevant pricing benchmark was not a minipolicy, it was other California catastrophe business written at broadly comparable rates to the CEA’s treaty. Unlike the Bermuda markets mentioned in NU October 28, CNA Re had been unwilling to “warehouse” capacity for the CEA. It is understandable CNA Re did not to want to cut back or non-renew existing customers to hold capacity for an organization that may never write business. Since the CEA did not become operational until December 1 the capacity needed to be warehoused for almost a full year, bearing in mind the prevalence of January 1 renewals. Deference to incumbents is important in reinsurance where reinsurers make long-term commitments to their customers, staying on programs over multiple years. Nonetheless, it was surprising to me that CNA Re was unable to participate more.
[12] reports that Berkshire’s stock market valuation jumped by almost USD 300 million in excess of the board market change on the day the deal was announced (November 18). The total premium was USD 423 million at placed percentages.
The magnitude of the profit differential between the minipolicy, roughly an 80 percent combined with no reinsurance cost, and the reinsurance, less than a 20 percent loss ratio and a 30 percent combined ratio, seemed like an opportunity. Because of the CEA’s approach to actuarially fair rates, their pricing only included market risk loads for the reinsurance layers, but their pricing drove market rates for the whole tower. Therefore NPIs faced diluted pricing. Writing the reinsurance allowed to capture all of the CEA’s risk margin without assuming any business with no risk load.
CNA thus faced a classic ERM problem. A business unit silo-by-silo analysis said
- Personal Lines should not participate in the CEA because doing so amounted to paying money to be barred from writing profitable business and
- Reinsurance could not participate on the CEA reinsurance owing to commitments to existing clients and its need to manage within its risk budget and agreed aggregate limits.
Looked at holistically, the solution was clear. If CNA Personal Lines participated in the CEA it would lower Personal Lines’ and CNA’s earthquake exposure. The 100 percent exposure would be replaced with a liability for just the two industry assessment layers meaning the net exposure is lowered by the impact of the remaining elements of the CEA’s capital layer: the capital, debt, and reinsurance layers, as well as the OTT cap, which was quite material for CNA, . As a result, CNA could increase its exposure, by writing reinsurance, and leave CNA’s risk, as a whole, in the same position. Or almost the same position: it would also have to pay USD 14 million to join.
is a summary of the accounting and risk adjusted expected values, with the latter calibrated as before, to CEA pricing \(Q\) and to a 40 percent reduction, \(Q-0.4\). Insured losses are computed based on a safety level of 83.3, i.e. USD 100 billion claims paying capacity. The first three rows of each block show the 100 percent expected losses, IALs and reinsured losses (DOUBLE CHECK AGAINST TABLES AT END). The PI and NPI results reflect a 1 percent market share and 8.6 percent participation on the two reinsurance layers, based on actual cessions in 2000, . The table shows a large accounting gain from the reinsurance. There is a much smaller gain under \(Q\) because it is calibrated to the first layer pricing. Thus there is only a gain from the second layer, which had slightly preferable pricing. Under \(Q-0.4\) both layers look attractive and the gain is larger.
shows actual cash flows under the NPI, PI and PI with reinsurance scenarios. Adding reinsurance means participating is preferred through the 90th to 95th percentile, depending on the cat model output. There is then a zone when the reinsurance will incur losses and the position is worse. For very large losses the OTT benefit dominates.
shows the CEA’s reinsurers at year end 2000. (The CEA was not an insurance company and did not initially file statutory statements. The 2000 statement is the oldest I have been able to obtain. Other NAIC reporting companies did not list their assumptions from the CEA in their Schedule F reports.) It shows that CNA, lead company Continental Casualty Company, was the second largest reinsurer of the CEA after National Indemnity (Berkshire Hathaway). Thus CNA was able to obtain significant participations across the CEA’s reinsurance programs. It is impossible to tell from these exhibits how CNA’s participations were split between the first and second reinsurance layers.
| Reinsurer | Assumed Premium | Pct Total |
|---|---|---|
| National Indemnity | 93,361 | 38.9% |
| Continental Casualty Company | 20,735 | 8.6% |
| Lehman Re, Ltd. | 16,721 | 7.0% |
| Swiss Re | 16,141 | 6.7% |
| Lloyds | 14,362 | 6.0% |
| AXA Re | 11,341 | 4.7% |
| Partner Re | 8,721 | 3.6% |
| Tempest Re | 5,742 | 2.4% |
| Munich Re | 5,476 | 2.3% |
| XL Global Re | 5,444 | 2.3% |
| Zurich Re | 5,426 | 2.3% |
| National Union Fire Ins. Co. | 5,342 | 2.2% |
| Numerous smaller shares | ||
| Grand Total | 239,758 | 100.0% |
Was any other carrier positioned to execute the same strategy as CNA? It required a reasonably large book of residential earthquake insurance and an active reinsurance assumed operation. Residential earthquake is hard to isolate from statutory filings but will be correlated with homeowners premium. Based on multiline carriers with assumed reinsurance operations and 1996 California homeowners premium Chubb, Fireman’s Fund, Hartford, Zurich, Kemper and TIG appear potential candidates. The first companies two specialized in high value homeowners business which was not a good fit with the low-limits minipolicy. The last two were caught up in the industry’s general transition from a multiline model to a specialist model: Kemper Re was bought by GE Re in 1998 and TIG was in the process of being sold by Xerox. Hartford is left as a potential candidate. Its statutory filings show it was more focused on assuming casualty business than property. Zurich lacked the homeowners premium in 1996. They bought the Farmers attorney in fact in 1998 but the accounting for reciprocals would still not have given them the same opportunity as CNA. We conclude that CNA was in a unique position in the industry being able to execute the participate-and-reinsure strategy.
Meeting on the Monday?
Conclusions
November 26: CEA Certified. The State of California Insurance Commissioner certified that all statutory conditions necessary for the CEA to become operational had been met, and the CEA began writing earthquake policies on December 1, 1996.
Thursday November 28: Thanksgiving
December 1: CEA accepted its first insurance risks (Marshall p. 91).
December 2: “California Starts Marketing Earthquake Facility Cover” (NU) “California’s first-in-the-nation earthquake insurance program, culminating two years of negotiations, won final approval last after week to begin marketing policies after reaching—just barely—the threshold of insures’ participation required by law.””
Early expectations were that the CEA would attract 85 to 90 percent participation. It became operational with 71.6% of the market [including 1.5 percent from the California FAIR plan].
Commissioner Quakenbush said the no-fills policy, with a 15 percent deducible will have rates averaging about USD 3.55 per USD 1,000 of insured value.
The CEA solved the homeowners availability problem in California, with the large writers quickly re-opening for business. The importance of the CEA in this process is clear from the comments of Allstate, Farmers and State Farm (ref Sec 6).
The CEA had a beneficial effect on commercial lines too, with contemporary reports of higher capacity availability and rates down 15 to 20 percent (Dec 23/30, BI “CEA success may create beneficial aftershocks in commercial lines”).
Today the CEA stands as a financial success. It has been rated A- by A. M. Best Co. since 2002 and has remained privately financed, receiving no money from the state.
ERM Lesssons
Managing Large Organizations
EPS vs. EVA approaches.
ERM is difficult to put into action
- Hard to get info cross silos
- Who makes the decision? What is their motivation?
- Other parts of company may not react as you expect for various reasons
- Cos often not good at opportunistic bets (short term, high risk, non recurring, outsize for material benefit = what Warren did)
- Analyze everything, not just your part! Cf impact of assets (pension assets in stocks)
- Take the enterprise view!
- ERM should prepare you to make these decisions; not ctees and reports but an awareness and openness to broad thinking
- Even today cos not making good decisions e.g….
This paper has described how CNA, with 1.4 percent market share, decided to join the CEA and made clear they were in a unique position. What about the other 68.6 percent? That is a story with interesting implications about the structure of the PC industry and the nature of corporate risk tolerances that I will return to in a subsequent paper.
References
References
Footnotes
Unless otherwise stated loss amounts are in current terms, rather than constant. Because (1) the paper ages and two old estimates are useless, (2) comparison with contemporary premium are more relevant, and (3) adjusting for inflation is notoriously difficult.↩︎
See National Underwriter, June 6, 1994 and November 11, 1996.↩︎
Continental Insurance Company is distinct from CNA’s lead company, Continental Casualty Company.↩︎
The original rate filing, made in 1996 and California DOI code #96-8834 is no longer available because it is past the document destruction retention period. The 1999 filing #99-377 is available from the WARFF website. The detailed analysis is available from the author on request.↩︎
The CEA covered claims up to \(8.75=10.5 / 1.2\) times its premium. For CNA (Continental Casualty Company) claims paying capital (USD 4.6 billion) was about \(255\) times earthquake premium (USD 18.1 million). However the capital covers earthquake from all sources, including commercial lines and workers compensation, not just residential. In the exhibits total losses are computed using USD 100 billion claims paying capacity. That represents \(83.3=100/1.2\) times premium, and a reasonable middle ground.↩︎
See Exhibit 20 page 2 in CEA filing 99-159. The insurance department insisted the CEA lower the filed loss cost to reflect their ability to pro rate claims. the CEA’s original filing did not make this adjustment (S.A. personal communication).↩︎
In the end The FAIR Plan participated; Twentieth Century did not.↩︎
At the time I was as a pricing actuary in the product management department of CNA Personal Lines. I performed the first analysis leading to the “do not participate” decision.↩︎