How To Manage Long‐term Financial Self‐sufficiency of a National Catastrophe Insurance Fund? The Feasibility of Three Bailout Programmes

• Date: 01 October 2017
• DOI: http://doi.org/10.1111/eufm.12111
• Published date: 01 October 2017

How To Manage Long-term Financial

Self-sufficiency of a National

Catastrophe Insurance Fund? The

Feasibility of Three Bailout

Programmes

Jo-Yu Wang and Wen-Lin Wu

Department of International Trade, College of Business, Feng Chia University, Taichung 40724,

Taiwan

E-mail: jywang@fcu.edu.tw; wlwu@fcu.edu.tw

Yang-Che Wu and Ming Jing Yang

Department of Finance, College of Finance, Feng Chia University, Taichung 40724, Taiwan

E-mail: wuyangche@fcu.edu.tw; mjyang@fcu.edu.tw

Abstract

This paper shows the feasibility that a national catastrophe insurance fund (NCIF)

may achieve financial self-sufficiency via three bailout programmes, including pre-

funding, loan-financing and equity-financing, to support the insurers during the

bad years. Under such programmes, different accounting procedures for the

insurers and NCIF are developed to simulate their 30-year cash flows based on the

best-fitting loss model calibrated by the global insured loss data. The numerical

analysis results indicate that the proposed programmes can balance the financial

revenue and expenditure of NCIF in the long term, and this conclusion implies the

authority can develop similar schemes as NCIF to smooth the peak risk of natural

catastrophes.

Keywords: national catastrophe insurance fund, pre-funding bailout programme,

loan-financing bailout programme, equity-financing bailout programme

JEL classification: C15, G32, G11

The authors are grateful to the Editor (John Doukas), two anonymous referees, and

participants of the European Financial Management Association (EFMA) 2016 Annual

Meeting (Basel, Switzerland) for their helpful comments and valuable suggestions.

[Correction added on 17 January 2017, after first online publication: the phrase ‘natural

catastrophe insurance fund’has been corrected to ‘national catastrophe insurance fund’in

the Abstract, the keywords and the Conclusion section.]

European Financial Management, Vol. 23, No. 5, 2017, 951–974

doi: 10.1111/eufm.12111

© 2016 John Wiley & Sons, Ltd.

1. Introduction

Natural catastrophes (NatCats) have become more frequent over the past three decades,

and they have caused a number of losses. A country needs an insurance mechanism to

respond to the economic consequences of NatCats. Kunreuther (1996) suggested a

disaster-management insurance programme to minimise losses from infrastructure

damage. It was also suggested that a new form of reinsurance coverage against

catastrophic losses from natural disasters should be created to protect insurers against

potential insolvency. Froot (2001) examined the clinical data in the US and proposed

eight explanations for why the prices of reinsurance are so high while the demand for

reinsurance is so low. Dacorogna et al. (2013) indicated that, according to the US version

of Generally Accepted Accounting Principles (GAAP) and new IFRS, insurers are

forbidden to carry equalisation reserves over to future business if no loss has occurred.

This restriction might weaken insurers’capability to respond to NatCats.

Most governments have allocated substantial resources for the improvement of

preventing and forecasting NatCats. A catastrophe insurance fund offers a different

trade-off between risk and return than the insurance products offered in the private

market, and it can increase efficiency in the private market (Boulatov and Dieckmann,

2013). Cummins (1988) also suggested that guaranty funds with flat premiums create

adverse incentives in insurance markets. Therefore, it would be more prudent to establish

a national catastrophe insurance fund (NCIF)

1

(or a scheme with similar functions) to

manage the large claims or losses caused by NatCats. For example, Boulatov and

Dieckmann (2013) illustrated that the involvement of disaster insurance funds and the

well-designed insurance in the NatCat market could increase the demand in the private

market. In the real world, there are many similar funds, including the National Flood

Insurance Program and the Hawaii Hurricane Relief Fund in the US; the Natural Disaster

Fund in New Zealand; the National Catastrophe Insurance Fund in Thailand; PT.

Asuransi MAIPARK in Indonesia; and the Earthquake Insurance Pool in the Philippines.

Generally, these funds have some advantages. For example, they protect policyholders

by ensuring the affordability and availability of the insurers. Furthermore, a majority of

the funds are set and operated by the government, so they will not fail even if they have

extreme losses. In this circumstance, the government needs to budget some reserves to be

used in future claims. Governments certainly cannot always cover the loss claims after

each disaster. Intuitionally, if a government must constantly pay for reconstruction in the

aftermath of every large NatCat, the country’sfiscal position could be weakened (Keen

et al., 2003). Generally, NCIFs and similar schemes offer some advantages in

minimising NatCat risk. NatCat risk can be diversified to insureds, insurers and

reinsurers because NCIFs would offer insurers different types of bailouts to cover large

claims. The insurers could be allowed to pay back in instalments or newly issued equity.

Thus, NCIF could be viewed as a mechanism to encourage the insurance industry to

regain normal operations after a NatCat. An NCIF ensures capacity to insurance

companies at a reasonable price in different manners.

From the perspective of NatCat risk, the actual claim size easily exceeds the expected

size by a significant margin recently in large-NatCat years, and the annual premium is

1

In this study, the national catastrophe insurance fund (NCIF) is established as a non-profit

organisation.

© 2016 John Wiley & Sons, Ltd.

952 Jo-Yu Wang et al.