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2016 Outlook for Property-Casualty

For U.S. property-casualty insurers, 2016 will be a year of continuing disruptive change. Digital technologies, such as social media, analytics and telematics, will continue to transform the market landscape, recalibrating customer expectations and opening new ways to reach and acquire clients. The rise of the “sharing economy,” under which assets like cars and homes can be shared, is requiring carriers to rethink traditional insurance models. Combined with an outlook for slower economic growth, increased M&A and greater regulatory uncertainty, the stage is set for innovative firms to capitalize on an industry in flux. Insurers that stay ahead of these shifts should reap substantial benefits, while laggards risk falling behind, or even out of the race.

Competitive pressures in the insurance industry have been building as cost-effective solutions in digital communication, distribution and infrastructure become widely available. Digital technology is eroding the advantages of scale enjoyed by established insurers and empowering smaller players to compete for market share through more flexible pricing models and new distribution channels. The recent launch of Google Compare, which enables customers to comparison shop for insurance, is the start of a larger wave of “InsuranceTech” activity in 2016.

At the same time, customer expectations and behaviors are evolving at a rapid pace, often faster than traditional mechanisms can react. Driven by their interactions in other digitally enabled industries, such as retail and banking, property-casualty customers are increasingly demanding a more sophisticated and personalized experience – including digital distribution, anytime access, premiums accurately reflecting usage and individual risk and higher levels of product customization and advice. Policyholders are also seeking coverage of broader risks, such as cybersecurity risk and under-protected property exposure.

Significant change to insurance ecosystem

Almost eight years after the global financial crisis, most major economies are still operating at well below potential. Although the U.S. is doing better than many countries, forecast growth of less than 2.5% for 2016 is unlikely to boost employment or wage growth significantly. With little sign that inflation is picking up, the Fed is intent on keeping interest rates near their current lows for the foreseeable future. Meanwhile, concern around the slowdown in China and other key emerging markets will continue to dampen U.S. growth prospects.

Despite sluggish economic conditions, property-casualty insurers should do well next year because of the favorable underwriting performance of the commercial lines sector and rising personal lines premiums. Softness in reinsurance pricing may increase opportunities for companies to cede capacity into the reinsurance and alternative capital markets, as well as achieve more stable reinsurance protection through broader terms and conditions. The industry will enter 2016 with a strengthened balance sheet and a strong base of invested assets from several years of solid reserve development and benign catastrophe experience.

But that is where the good news ends. In 2016, return on investment for firms is likely to continue to slip from its 2014 peak because of a combination of capital accumulation, competitive pricing, weakening investment returns and rising loss costs. Losses and expenses are growing faster than revenue, forcing companies to actively seek new solutions. In personal automobile and workers’ compensation, rising frequency and severity are beginning to erode loss ratio performance.

Competition is putting downward pressure on pricing, particularly in the commercial property and liability lines. This is compounded by slowing growth in commercial exposures because of economic weakness.

Regulatory headwinds ahead

In 2016, property-casualty insurers will face heightened political and regulatory uncertainty. An open presidential election for both parties, along with congressional and state elections, creates the potential for radical change with taxation and regulatory repercussions. Meanwhile, the Fed is preparing new capital standards for significant insurance companies, and HUD and the Federal Insurance Office may intensify investigations into the affordability and accessibility of personal lines insurance to customers from different backgrounds. The IAIS is also pursuing international capital standards through field testing, and the results may come into clearer focus in 2016.

The NAIC and states may separately advance their expectations of best practices in risk management, governance and solvency as current programs enter their second year of full rollout. All jurisdictions will likely push for better information, reporting and compliance in such areas as accounting, solvency, fair practices, transparency, governance and marketplace equity.

Impact of external forces on the US property-casualty market in 2016 (0 = Very low impact, 10 = Very high impact)
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Coping with transformative change: priorities for 2016

In such a fluid, fast-changing environment, insurance firms need to build a road map for strategic transformation aligned to new customer imperatives. Refining legacy products and approaches is not enough – what is required is a fresh, outside-in approach that starts with the customer and carries through to digital trends and market shifts, both inside and outside the insurance industry.

1. Position Your Organization for Digital Leadership

Preparing for further digital disruption


As digital service models become more common in other industries, the property-casualty sector will need to align to the rising expectations of consumer and commercial customers. Digital technologies, such as mobility, social media and telematics, will continue to disrupt all parts of the property-casualty insurance value chain – from client acquisition to claims and servicing. Although the industry is ripe for digital transformation, many traditional insurers still display a low level of digital maturity, struggling to develop digital strategies that enhance the customer experience, extract efficiencies and drive future growth.

Priorities for 2016

Lay the groundwork for digital transformation. To meet changing expectations, insurers need to digitize interactions with customers, employees and suppliers. Building new distribution channels and working closely with existing distribution partners to enhance the customer experience is a strategic imperative.

Build a back-office to support the digital frontline. In 2016, carriers must continue to invest in back-office systems to enable digital enterprise platforms. These should be designed to allow
for future expansion, omni-channel distribution and an improved customer experience, while minimizing customer service costs and protecting against escalating cyber risks.

Start new market initiatives now. As back-office systems are being readied, leading insurers should not wait for full integration, but push forward with next-generation portals, redefining customer experience, data access, queries and navigation. With the rise of real-time risk monitoring, there is a knowledge shift taking place between customers and insurers. Insurers need to tap into client and industry data sources to take full advantage of this new risk-information flow.

2. Prepare for the next wave of M&A activity

M&A will accelerate in 2016

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Uncertain economic and regulatory conditions have caused insurers to cut costs and expand product and geographic diversification. Under growing pricing pressure and competition from non-traditional sources, in 2015 insurers turned to transformative mergers to achieve these goals. This surge in M&A activity is
expected to continue in 2016, as acquirers seek to build scale and access US markets.

Priorities for 2016

Establish a well-defined process for post-merger integration. Mega consolidations require immense integration of systems and data. Companies involved in M&A should assemble the necessary building blocks to create single technology platforms, self-service customer portals and omni-channel distribution systems. Replacing duplicative technology, outdated service centers and first-generation mobile-enabled distribution will remove cost redundancies and inefficient processes. Successful mergers could create lower-cost infrastructures, which will enable these combined entities to invest in data sources and analytical tools that improve pricing, risk analysis and claims management.

Gain greater access to insurance buyers through M&A. Consolidation in the insurance broker and independent agent markets has tipped the balance of power toward distribution. In response, insurers in 2016 will look to gain direct customer access by purchasing specialty distribution and continue the trend of underwriters acquiring managing general agencies with exclusive books of business to increase premiums in less price-sensitive lines. Access to captive distribution should help tilt the scales back toward underwriters.

Take steps to protect against tougher competition. Insurers that refrain from the M&A frenzy will require a strategy to compete more effectively against larger, better capitalized companies. Recruiting human capital will become paramount, as will accessing distribution that provides high-retention, profitable business.

M&A activity in 2016 will make insurers vulnerable to takeovers, particularly those with the potential to provide an acquirer with greater product diversification, wider market access, stronger analytics and increased cost efficiencies.

3. Create a culture of continuous innovation

The innovation imperative

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The rise in usage-based insurance, digital distribution channels and other disruptors is shaking up the industry. Widespread data availability and advanced analytical techniques are enabling new market entrants to absorb risk that was once the exclusive territory of insurers. Larger and more efficient capital providers entering the industry are siphoning off premium that ordinarily flowed to insurers. To stay relevant, traditional insurers need to shed their conservative orientation and cultivate a culture of innovation.

Priorities for 2016

Explore new technologies and start-up models. Competition is heating up as an array of new Fintech companies offer services that were once the exclusive domain of traditional insurers. To cope, insurers will need to adopt, acquire or even fund new technologies and experimental models that may even compete with their existing businesses. Recently introduced property-casualty insurance products, such as insurance for cyber risk, ridesharing and drone exposures, suggest that insurers can rise to the innovation challenge.

Be prepared to cannibalize parts of your business, before competitors do. The property-casualty insurance industry has not been known as a change leader. A growing asset base is a vital sign of stability for clients, but, as a business grows, more processes are added, creating bureaucratic layers that stymie innovation. To offset these institutionalized barriers to change, insurers will need to develop a culture of innovation that allows for internal competition.

4. Shift from a product to a service orientation

Staying relevant in a fluid marketplace

Changing customer needs are making many of today’s insurance services less relevant. With a few notable exceptions, the traditional product suite has been relatively static and has not kept pace with evolving risks. Personal lines insurers are seeing reduced demand for their services because of advanced safety technology, the growth of the sharing economy and changing demographics and customer behaviors. Likewise, commercial lines insurers are coming to grips with new industries, emerging risks and a client base with significant access to their own risk data. Access to better data and analytics empowers customers to retain more risk, and much of the risk at the other end of the spectrum has been taken by capital market alternatives, leaving traditional carriers scrambling for the leftovers.

Priorities for 2016

Think outside-in, not inside-out. To adapt to this fast-evolving marketplace and differentiate themselves from competitors, insurers must enhance their service capabilities while developing products better able to serve new customer needs and behaviors. By providing services that build on the customer experience and changing expectations, insurers can foster stronger, more holistic relationships with clients and ultimately improve policy retention and generate higher margins.

Take a value-added, advisory approach. Customers are increasingly looking to their insurance partners for risk advice, not just insurance products. To enhance their brand and improve performance, insurers must be ready to provide customer-centric services to satisfy these expectations. Insurers will need to analyze their clients’ exposures and develop risk-mitigation strategies and insurance coverage tailored to their needs. The rise of real-time risk data in both personal and commercial lines provides an opportunity for innovative insurers to address uncovered or mispriced risks.

5. Build a next-generation distribution platform

The rise of omni-channel distribution

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Independent and captive agents have dominated the property-casualty insurance industry for decades. Even today, many insurance buyers rely on a trusted adviser to assist them with personal and business insurance purchases. But the days of a single distribution channel are over for many insurers. Consumers are demanding omni-channel access to insurance products. Insurance buyers want the same flexibility to learn, compare, purchase and report a claim as they have become accustomed to in other industries.

Priorities for 2016

Come to grips with pricing transparency. Creating an effective omni-channel platform is critical, as it allows insurers to promote their customer service capabilities, product differences and claims-response times more widely. But the rise of aggregator and non-traditional comparison models has also made it easier for buyers to shop for the best rates. In a digitally enabled environment of price transparency, there will be further pressure in 2016 for insurers to streamline costly and duplicative infrastructure.

Consider acquiring captive distribution. As insurance products become more commoditized, insurers may want to acquire captive distribution to add customers and boost business. By acquiring managing general agents (MGAs), insurers can gain access to experienced underwriters able to secure and retain profitable business, along with the systems and tools for underwriting and processing that business. Insurers will need to integrate these systems into core underwriting platforms to avoid duplicating costs.

Rethink compensation plans for distributors. Private equity-financed broker consolidation, going on for nearly a decade, will continue to shift bargaining power in favor of distributors. Agent and broker control of profitable businesses has allowed some large distributors to negotiate greater compensation. This power shift is happening at a time when rate softening has become the norm. As a result, insurers in 2016 should consider changing the industry’s level-commission compensation standards in favor of greater up-front payments that reward access to new profitable customers.

6. Drive performance through analytics

The new role of analytics

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Disparities in frequency and severity trends among several large personal auto insurers highlights the importance of data and analytics in driving underwriting results. Harnessing large volumes of data from real-time sources can help insurers develop new products and refine pricing strategies. When combined with a robust operating strategy, advanced analytics can significantly increase underwriting profitability and provide a valuable market differentiator.

Priorities for 2016

Apply proven analytics to the homeowners market. In 2016, personal lines insurers will increasingly apply analytical capabilities developed in the personal auto sector to the homeowners market. Greater adoption of technological innovation in the home creates an opportunity for both real-time risk assessment and pricing strategies, similar to the trend unfolding in the personal auto market. As insurers move back into the homeowner market, they will be better equipped to understand and price risks.

Use analytics to manage commercial market risks. As risks rise, small business owners are seeking broader insurance coverage and a simpler sales process. Insurers with the analytical capabilities to manage evolving risks and the technological know-how to create an automated sales experience will be better equipped to meet fast-changing customer needs. The experience in using analytics in the small commercial market will provide insurers with a blueprint for gaining efficiencies in the larger commercial market.

7. Develop and attract the right talent to lead change

Coping with a widening talent gap

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Existing insurance teams often are not prepared for today’s fast-changing digital marketplace. But filling the talent gap can be challenging, because the insurance industry is not often the first choice of new graduates from top colleges and universities. With finance, technology and consulting attracting most of the promising students, a talent chasm is forming in the property-casualty industry. Insurers must recruit and retain next-generation innovators and leaders – while retooling existing teams with new skills.

Priorities for 2016

Develop new roles to facilitate change. As insurers embrace innovation and adopt more advanced digital platforms, they will need to establish new business roles to drive these initiatives. For instance, the stronger focus on analytics is increasing the demand for data scientists – able to apply predictive analytics and other sophisticated quantitative tools to support underwriting and claims- handling processes.

Create an environment that rewards innovation. A culture of innovation will help attract Millennials and entrepreneurial talent with fresh perspectives. Bringing in new ideas and skills will be essential for insurers pursuing technological innovation in an industry not known for change. To acquire and retain this new crop of talent, insurers will need to set up systems to reward innovation and risk-taking in alignment with new strategic imperatives.

Expand risk advisory capabilities. Customers are increasingly interested in working with true risk advisers and finding insurance solutions that match their lifestyles. Traditional product approaches directed at individual risks are falling out of favor as customers seek more holistic solutions. In 2016, insurance teams will need to develop expertise in health, wealth and risk advisory, so that they can bundle products and provide value-added services to customers.

8. Make risk management a C-suite priority

Coping with complexity

Economic, financial and political uncertainty, combined with linked global markets and disruptive technological change, has created a more complex and volatile landscape for insurance firms – heightening the need for best-in-class risk management. Faced with a challenging environment and driven by regulatory demands, insurers have made risk management a C-suite and board-level priority, with risk managers being held accountable for improved financial performance and value creation.

Priorities for 2016

Keep on top of changing regulations. Emerging regulatory regimes include calls for greater uniformity at the state, federal and global levels, but the ultimate form of these requirements is far from settled. As always, insurers will need to stay on top of shifting regulatory frameworks, communicate the industry impacts and respond to changes as they emerge.

Watch for emerging risks, such as cyber-attacks. With access to growing volumes of sensitive data, both large and small insurers are seeking greater cyber risk protection. Corporate boards are becoming increasingly aware of the damage a cyber-attack can cause, including potential liability at the board level and the destruction of reputation and brand. Risk managers must stay ahead of the ever-increasing sophistication of hackers.

Remember, protection is only as strong as the weakest link in the chain. Even if an insurer is well insulated from cyber-attacks, its outside vendors may be vulnerable. Vendors that have access to an insurance company’s systems, such as its underwriting platform, can inadvertently provide hackers with a conduit to valuable company data. Risk managers must be careful with data released to third party vendors for any reason, especially when that data is subsequently returned to the company.

This article was written by David Hollander, Thomas Cranley, Gail McGiffin and Jay Votta. To access the full white paper, click here.

Reducing Losses From Extreme Events

The number of presidential disaster declarations in the U.S. has dramatically increased over the past 50 years. Figure 1 depicts the total number of presidential disaster declarations and those that were triggered by flooding events (inland flood and storm surge from hurricanes). This pattern highlights the need to encourage those at risk to invest in loss reduction measures prior to a disaster rather than waiting until after the event occurs. Insurance coupled with other risk management programs can play an important role, as it is designed to spread and reduce risk. Each policyholder pays a relatively small premium to an insurer, which can then cover the large losses suffered by a few. Ideally, those who invest in loss prevention measures are rewarded by having the price of their coverage reduced to reflect their lower expected claims payments.


Insurance against low-probability, high-consequence (LP-HC) events presents a special challenge for individuals at risk, insurers and regulators, for good reason. Decision-makers have limited experience with these events, and even experts are likely to conclude that there is considerable uncertainty as to the probability of these events occurring and their resulting consequences. As a result, insurance decisions often differ from those recommended by normative models of choice.

Consider the following examples:

Example 1: Most homeowners in flood-prone areas do not voluntarily purchase flood insurance—even when it is highly subsidized—until after they suffer flood damage. If they then do not experience losses in the next few years, they are likely to cancel their policy. Demand for earthquake insurance in California increased significantly after the Northridge earthquake of 1994— the last severe quake in the state; today relatively few homeowners have coverage.

Example 2: Prior to the terrorist attacks of Sept. 1, 2001, actuaries and underwriters did not price the risk associated with terrorism, nor did they exclude this coverage from their standard commercial policies. Their failure to examine the potential losses from a terrorist attack was surprising given the truck bomb that al Qaeda detonated below the North Tower of the World Trade Center in 1993, the 1995 Oklahoma City bombing and other terrorist-related events throughout the world. Following 9/11, most insurance companies refused to offer coverage against terrorism, considering it to be an uninsurable risk.

Example 3: State insurance regulators sometimes have restricted insurers from setting premiums that reflect risk, in part to address equity and fairness issues for those in need of homeowners’ insurance. For example, following Hurricane Andrew in 1992, the Florida insurance commission did not allow insurers to charge risk-based rates and restricted them from canceling existing homeowners’ policies. After the severe hurricanes of 2004 and 2005 in Florida, the state-funded company Citizens Property Insurance Corp., which had been the insurer of last resort, offered premiums in high-risk areas at subsidized rates, thus undercutting the private market. Today, Citizens is the largest provider of residential wind coverage in Florida.

The three examples indicate that insurance today is not effectively meeting two of its most important objectives:

  • providing information to those residing in hazard-prone areas as to the nature of the risks they face;
  • giving incentives to those at risk to undertake loss reduction measures prior to a disaster.

The insurance industry played both of these roles very effectively when the factory mutual companies were founded in the 19th century, as detailed in Box 1. This paper proposes a strategy for insurance to take steps to return to its roots. The examples and empirical data presented here are taken primarily from experience in the U.S.; however, the concepts have relevance to any country that uses insurance to protect its residents and businesses against potentially large losses.

The next three sections explore the rationale for the actions taken by each of the interested parties illustrated in the above three examples by focusing on their decision processes prior to and after a disaster. I then propose two guiding principles for insurance and outline a long-term strategy with roles for the private and public sectors if these principles are implemented. Reforming the National Flood Insurance Program (NFIP) to encourage mitigation for reducing future losses while providing financial protection to those at risk is a target of opportunity that should be seriously considered. The concluding section suggests directions for future studies and research so that insurance can play a central role in reducing losses from extreme events.



Intuitive and deliberative thinking

A large body of cognitive psychology and behavioral decision research over the past 30 years has revealed that individuals and organizations often make decisions under conditions of risk and uncertainty by combining intuitive thinking with deliberative thinking. In his thought-provoking book Thinking, Fast and Slow, Nobel laureate Daniel Kahneman has characterized the differences between these two modes of thinking. Intuitive thinking (System 1) operates automatically and quickly with little or no effort and no voluntary control. It is often guided by emotional reactions and simple rules of thumb that have been acquired by personal experience. Deliberative thinking (System 2) allocates attention to intentional mental activities where individuals undertake trade-offs and recognize relevant interdependencies and the need for coordination.

Choices are normally made by combining these two modes of thinking and generally result in good decisions when individuals have considerable experience as a basis for their actions. With respect to LP-HC events, however, there is a tendency to either ignore a potential disaster or overreact to a recent one, so that decisions may not reflect expert risk assessments. For example, after a disaster, individuals are likely to want to purchase insurance even at high prices, while insurers often consider restricting coverage or even withdraw from the market. In these situations, both parties focus on the losses from a worst-case scenario without adequately reflecting on the likelihood of this event occurring in the future.

Impact of intuitive thinking on consumer behavior

Empirical studies have revealed that many individuals engage in intuitive thinking and focus on short-run goals when dealing with unfamiliar LP-HC risks. More specifically, individuals often exhibit systematic biases such as the availability heuristic, where the judged likelihood of an event depends on its salience and memorability. There is thus a tendency to ignore rare risks until after a catastrophe occurs. This is a principal reason why it is common for individuals at risk to purchase insurance only after a disaster.

Purchase of flood insurance

A study of the risk perception of homeowners in New York City revealed that they underestimate the likelihood of water damage from hurricanes. This may explain why only 20% of those who suffered damage from Hurricane Sandy had purchased flood insurance before the storm occurred.

An in-depth analysis of the entire portfolio of the NFIP in the U.S. revealed that the median tenure of flood insurance was between two and four years, while the average length of time in a residence was seven years. For example, of the 841,000 new policies bought in 2001, only 73% were still in force one year later. After two years, only 49% were in force, and eight years later only 20%. Similar patterns were found for each of the other years in which a flood insurance policy was first purchased.

One reason that individuals cancel their policies is that they view insurance as an investment rather than a protective activity. Many purchase coverage after experiencing a loss from a disaster but feel they wasted their premiums if they have not made a claim over the next few years. They perceive the likelihood of a disaster as so low that they do not pay attention to its potential consequences and conclude they do not need insurance. A normative model of choice, such as expected utility theory, implies that risk-averse consumers should value insurance, as it protects them against large losses relative to their wealth. Individuals should celebrate not having suffered a loss over a period rather than canceling their policy because they have not made a claim. A challenge facing insurers is how to convince their policyholders that the best return on an insurance policy is no return at all.

Purchase of earthquake insurance

Another example that reveals how the availability bias affects the choice process is the decision of California homeowners on whether to purchase earthquake insurance. Surveys of owner-occupied homes in California counties affected by the 1989 Loma Prieta earthquake showed a significant increase in the purchase of coverage. Just prior to the disaster, only 22% of the homes had earthquake insurance. Four years later, 37% had purchased earthquake insurance—a 64% increase.

Similarly, the Northridge earthquake of 1994 led to a significant demand for earthquake insurance. For example, more than two-thirds of the homeowners surveyed in Cupertino county had purchased earthquake insurance in 1995. There have been no severe earthquakes in California since Northridge, and only 10% of those in seismic areas of the state have earthquake insurance today. If a severe quake hits San Francisco in the near future, the damage could be as high as $200 billion, and it is likely that most homeowners suffering damage will be financially unprotected.

Impact of intuitive thinking on insurer behavior

Two factors play an important role in insurers’ behavior with respect to pricing and coverage decisions: the role of experience and the role of ambiguous risk. We examine each of these features in turn.

Role of experience on supply of insurance

When insurers have experienced significant losses from a particular extreme event, there is a tendency for them to focus on worst-case scenarios without adequately considering their likelihood. In some instances, because of extreme losses from hurricanes, floods, earthquakes and terrorist attacks, insurers determined that they could not continue to market coverage in the U.S. without involvement by the public sector. In these situations, either the state or federal government stepped in to fill the void.

Hurricane wind-related losses

Following catastrophic wind losses from hurricanes in Florida, insurers felt they had to significantly raise their homeowners’ premiums. Rather than using catastrophe models to justify rate increases, insurers pointed to their large losses following Hurricane Andrew in 1992 as a basis for demanding higher premiums, without considering the likelihood of another disaster of this magnitude. The insurers were denied these rate increases and reduced their supply of new homeowners’ policies.

By the beginning of 2004, most insurers viewed their Florida rates as being close to adequate except in the highest-risk areas. However, after four major hurricanes battered Florida in 2004 and two more in 2005, many insurers again began to file for major premium increases, and many of them were denied, or approved at lower increases by the regulators. In 2007, the Florida Office of Insurance Regulation (FLOIR) took a position against any further rate increases of homeowners’ insurers and denied requests by all insurers. In December 2008, State Farm asked for a 67% increase in premiums that was denied by the FLOIR, leading the insurer to announce that it would no longer offer homeowners’ coverage in Florida. Five years later (March 2014), State Farm announced that it would again begin offering homeowners and renters insurance in the state on a limited basis.

Flood insurance

Following the severe Mississippi floods of 1927 and continuing through the 1960s, there was a widespread belief among private insurance companies that the flood peril was uninsurable by the private sector for several reasons: Adverse selection would be a problem because only particular areas are subject to the risk; risk-based premiums would be so high that no one would be willing to pay them; and flood losses could be so catastrophic as to cause insolvencies or have a significant impact on surplus. This lack of coverage by the private sector triggered significant federal disaster relief to victims of Hurricane Betsy in 1965 and led to the creation of the NFIP in 1968.

The NFIP subsidized premiums to maintain property values on structures in flood-prone areas; new construction was charged premiums reflecting risk. Even though premiums on existing property were highly subsidized, relatively few homeowners purchased coverage, leading the U.S. Congress to pass the Flood Disaster Protection Act (FDPA) of 1973. This bill required all properties receiving federally backed mortgages to purchase flood insurance. The NFIP has grown extensively in the past 40 years; as of January 2015, it had sold more than 5.2 million policies in 22,000 communities and provided almost $1.3 trillion in coverage. Insurance tends to be concentrated in coastal states, with Florida and Texas alone composing nearly 40% of the entire program (in number of policies, premiums and coverage). After making claims payments from Hurricane Katrina in 2005, the NFIP found itself $18 billion in debt, so that its borrowing authority had to be increased from $1.5 billion to $20.78 billion. To date, the program has borrowed nearly $27 billion from the U.S. Treasury to meet its claims obligations in the aftermath of the 2004, 2005, 2008 and 2012 hurricane seasons.

In July 2012 (three months before Hurricane Sandy), Congress passed and the president signed the Biggert–Waters Flood Insurance Reform Act of 2012 (BW12), which applied the tools of risk management to the increasingly frequent threat of flooding. Among its many provisions, the legislation required that the NFIP produce updated floodplain maps, strengthen local building code enforcement, remove insurance subsidies for certain properties and move toward charging premiums that reflect flood risk.

Soon after becoming law, BW12 faced significant challenges from some homeowners who had reason to complain that the new flood maps overestimated their risk. These residents and other homeowners in flood-prone areas felt that their proposed premium increases were unjustified and that they could not afford the increased premiums that they would face. In March 2014, Congress passed the Homeowner Flood Insurance Affordability Act (HFIAA14), which required the Federal Emergency Management Agency (FEMA) that operates the NFIP to draft an affordability framework based on the recommendations of a National Academy of Sciences’ study that addresses the affordability of flood insurance premiums.

Earthquake insurance

Until the San Fernando earthquake of 1971, few homeowners and businesses in California had purchased earthquake insurance even though coverage had been available since 1916. In 1985, the California legislature passed a law requiring insurers writing homeowners’ policies on one- to four-family units to offer earthquake insurance to these residents. The owners did not have to buy this coverage; the insurers only had to offer it. At that time and still today, banks and financial institutions do not require earthquake insurance as a condition for a mortgage.

The Northridge earthquake of January 1994 caused insured losses of $20.6 billion, primarily to commercial structures. In the three years following Northridge, demand for earthquake insurance by homeowners increased 19% in 1994, 20% in 1995 and 27% in 1996, leading private insurance companies in California to re-evaluate their seismic risk exposures. Insurers concluded that they would not sell any more policies on residential property, as they were concerned about the impact of another catastrophic earthquake on their balance sheets. The California Insurance Department surveyed insurers and found that as many as 90% of them had either stopped or had placed restrictions on the selling of new homeowners’ policies. This led to the formation of a state-run earthquake insurance company—the California Earthquake Authority (CEA)—in 1996.

Terrorism insurance

Following the terrorist attacks of 9/11, most insurers discontinued offering terrorism coverage given the refusal of global reinsurers to provide them with protection against severe losses from another attack. The few that did provide insurance charged extremely high premiums to protect themselves against a serious loss. Prior to 9/11, Chicago’s O’Hare Airport had $750 million of terrorism insurance coverage at an annual premium of $125,000. After the terrorist attacks, insurers offered the airport only $150 million of coverage at an annual premium of $6.9 million. This new premium, if actuarially fair, implies the annual likelihood of a terrorist attack on O’Hare Airport to be approximately 1 in 22 ($6.9 million/$150 million), an extremely high probability. The airport was forced to purchase this policy because it could not operate without coverage.

Concern about high premiums and limited supply of coverage led Congress to pass the Terrorism Risk Insurance Act (TRIA) at the end of 2002 that provided a federal backstop up to $100 billion for private insurance claims related to terrorism. The act was extended in 2005 for two years, in 2007 for seven years and in January 2015 for another six years, with some modification of its provisions each time the legislation was renewed.

In return for federal protection against large losses, TRIA requires that all U.S. primary insurance companies offer coverage against terrorism risk on the same terms and conditions as other perils provided by their commercial insurance policies. Firms are not required to purchase this coverage unless mandated by state law, which is normally the case for workers’ compensation insurance. TRIA also established a risk-sharing mechanism between the insurance industry, the federal government and all commercial policyholders in the U.S. for covering insured losses from future terrorist attacks.

Role of ambiguity

After 9/11, insurers determined that they could not offer terrorism insurance because the uncertainties surrounding the likelihood and consequences of another terrorist attack were so significant that the risk was uninsurable by the private sector alone. Because terrorists are likely to design their strategy as a function of their own resources and their knowledge of the vulnerability of the entity they want to attack, the nature of the risk is continuously evolving. This dynamic uncertainty makes the likelihood of future terrorist events extremely difficult to estimate.

Empirical evidence based on surveys of underwriters reveals that insurers will set higher premiums when faced with ambiguous probabilities and uncertain losses than for a well-specified risk. Underwriters of primary insurance companies and reinsurance firms were surveyed about the prices they would charge to insure a factory against property damage from a severe earthquake when probabilities and losses were well specified and when the probabilities and losses were ambiguous. The premiums the underwriters charged for the ambiguous case were 1.43–1.77 times higher than if underwriters priced a precise risk.

A recent web-based experiment provided actuaries and underwriters in insurance companies with scenarios in which they seek advice and request probability forecasts from different groups of experts and then must determine what price to charge for coverage for flood damage and wind damage from hurricanes. The average premiums that insurers would charge was approximately 30% higher for coverage against either of these risks if the probability of damage was ambiguous rather than well-specified and if the experts were conflicted over their estimates. The data reveal that they would likely charge more in the case of conflict ambiguity (i.e., experts disagree on point estimates) than imprecise ambiguity (i.e., experts agree on a range of probability, recognizing that they cannot estimate the probability of the event precisely).

Impact of intuitive thinking on regulator behavior

Rate regulation and restriction on coverage has had more impact on property insurance than on any other line of coverage, particularly in states that are subject to potentially catastrophic losses from natural disasters.

Homeowners’ insurance in Florida

Following Hurricane Andrew in August 1992, Florida regulators imposed a moratorium on the cancellation and nonrenewal of homeowners’ insurance policies during the coming hurricane season for insurers that wanted to continue to do any business in Florida. In November 1993, the state legislature enacted a bill that these insurers could not cancel more than 10% of their homeowners’ policies in any county in Florida in one year and not cancel more than 5% of their property owners’ policies statewide for each of the next three years. During the 1996 legislative session, this phase-out provision was extended until June 1, 1999.

Early in 2007, Florida enacted legislation that sought to increase regulatory control over rates and roll them back based on new legislation that expanded the reinsurance coverage provided by the Florida Hurricane Catastrophe Fund (FHCF). Insurers were required to reduce their rates to reflect this expansion of coverage, which was priced below private reinsurance market rates. This requirement applies to every licensed insurer even if an insurer does not purchase reinsurance from the FHCF.

Citizens Property Insurance Corp., Florida’s state-funded company, was formed in 2002 and has experienced a significant increase in market share of the residential property market in recent years. Consumers are allowed to purchase a policy from Citizens if a comparable policy would cost 15% more in the private market. The most serious defect of such a system is that it encourages individuals to locate in high-hazard areas, thus putting more property at risk than would occur under a market system. This is the principal reason not to introduce such a system in the first place. Since 2005, there have been no hurricanes causing severe damage in Florida. But should there be a serious disaster that depletes Citizens’ reserves, the additional claims are likely to be paid from assessments (taxes) charged to all homeowners in Florida.

Earthquake insurance in California

As pointed out earlier, when insurers refused to continue to offer earthquake insurance in California, the state formed the CEA. The CEA set the premiums in many parts of the state at higher levels than insurers had charged prior to the Northridge earthquake of 1994. At the same time, the minimum deductible for policies offered through the CEA was raised from 10% to 15% of the insured value of the property. There was no consideration by the state insurers as to how this change would affect the demand for coverage.

This increased price/reduced coverage combination was not especially attractive to homeowners in the state. A 15% deductible based on the amount of coverage in place is actually quite high relative to damages that typically occur. Most homes in California are wood-frame structures that would likely suffer relatively small losses in a severe earthquake. For example, if a house was insured at $200,000, a 15% deductible implies that the damage from the earthquake would have to exceed $30,000 before the homeowner could collect a penny from the insurer. Given that only 10% of homeowners in California have quake insurance today, if a major earthquake were to occur in California next year so that many homes were partially damaged, the uninsured losses could be very high. It is surprising that there has been little interest by private insurers in offering earthquake coverage at competing or lower rates to those offered by the CEA, even though there is no regulation preventing them from doing so.


The following two guiding principles should enable insurance to play a more significant role in the management and financing of catastrophic risks.

Principle 1—Premiums should reflect risk

Insurance premiums should be based on risk to provide individuals with accurate signals as to the nature of the hazards they face and to encourage them to engage in cost-effective mitigation measures to reduce their vulnerability. Risk-based premiums should also reflect the cost of capital that insurers need to integrate into their pricing to ensure an adequate return to their investors.

Catastrophe models have been developed and improved over the past 25 years to more accurately assess the likelihood and damages resulting from disasters of different magnitudes and intensities. Today, insurers and reinsurers use the estimates from these models to determine risk-based premiums and how much coverage to offer in hazard-prone areas.

If Principle 1 is applied to risks where premiums are currently subsidized, some residents will be faced with large price increases. This concern leads to the second guiding principle.

Principle 2—Dealing with equity and affordability issues

Any special treatment given to low-income individuals currently residing in hazard-prone areas should come from general public funding and not through insurance premium subsidies. Funding could be obtained from several different sources such as general taxpayer revenue or state government or by taxing insurance policyholders depending on the response to the question, “Who should pay?” It is important to note that Principle 2 applies only to those individuals who currently reside in hazard-prone areas. Those who decide to locate in these regions in the future would be charged premiums that reflect the risk.

Developing long-term strategies for dealing with extreme events

Given the nature of intuitive thinking for LP-HC events, this section proposes strategies for applying the two guiding principles so that insurance in combination with other policy tools can reduce future losses from extreme events. The proposed risk management strategy involves:

  • Choice architecture to frame the problem so that the risks are transparent and key interested parties recognize the importance of purchasing and maintaining insurance while also undertaking protective measures to reduce their losses from the next disaster.
  • Public–private partnerships to assist those who cannot afford to invest in protective measures and to provide financial protection against catastrophic losses for risks that are considered uninsurable by the private sector alone.
  • Multi-year insurance to provide premium stability to policyholders and lower marketing costs to insurers and to reduce cancellation of coverage by those at risk.

Choice architecture

The term choice architecture, coined by Thaler and Sunstein, indicates that people’s decisions often depend in part on how different options are framed and presented. Framing in the context of LP-HC events typically refers to the way in which likelihoods and outcomes are characterized. One can also influence decisions by varying the reference point or by changing the order in which alternatives or their attributes are presented, or by setting one option as the no-choice default option.

Framing the risk

People are better able to evaluate low-probability risks when these are presented via a familiar concrete context. For example, individuals might not understand what a one-in-a-million risk means but can more accurately interpret this figure when it is compared to the annual chance of dying in an automobile accident (1-in-6,000) or lightning striking your home on your birthday (less than one in a billion).

Probability is more likely to be a consideration if it is presented using a longer time frame. People are more willing to wear seat belts if they are told they have a 1-in-3 chance of an accident over a 50-year lifetime of driving, rather than a 1-in-100,000 chance of an accident on each trip they take. Similarly, a homeowner or manager considering earthquake protection over the 25-year life of a home or factory is far more likely to take the risk seriously if told that the chance of at least one severe earthquake occurring during this time is greater than 1-in-5, rather than 1-in-100 in any given year.

Studies have shown that even just multiplying the single-year risk so the numerator is larger— presenting it as 10-in-1,000 or 100-in-10,000 instead of 1-in-100—makes it more likely that people will pay attention to the event. Studies have also found that comparisons of risks— rather than just specifying the probability of a loss or an insurance premium—are much more effective in helping decision-makers assess the need for purchasing insurance.

Another way to frame the risk so that individuals pay attention is to construct a worst-case scenario. Residents in hazard-prone areas who learn about the financial consequences of being uninsured if they were to suffer severe damage from a flood or earthquake would have an incentive to purchase insurance coverage and may refrain from canceling their insurance if they have not made a claim for a few years. One could then provide them with information on the likelihood of the event occurring over the next 25 years rather than just next year.

Insurers could also construct worst-case scenarios and then estimate the likelihood of the event’s occurrence when pricing their insurance policies. They could then determine a premium that reflects their best estimate of their expected loss while at the same time factoring in the uncertainty surrounding the risk.

Default options

Field and controlled experiments in behavioral economics reveal that consumers are more likely to stick with the default option rather than going to the trouble of opting out in favor of some alternative. Many examples of this behavior are detailed in Thaler and Sunstein’s important book, Nudge. To date, this framing technique has been applied to situations where the outcome is either known with certainty, or when the chosen option (such as a recommended 401(k) plan), has a higher expected return than the other options. It is not clear whether people who failed to purchase coverage would reverse course if having insurance against an extreme event was the default option, given the intuitive thinking that individuals employ for these types of risks. More empirical research is needed to more fully understand the role that default options can play with respect to encouraging insurance protection for LP-HC events.

Public–private partnerships

Individuals at risk may be reluctant to invest in cost-effective loss reduction measures when these involve a high, upfront cash outlay. Given budgetary constraints and individuals’ focus on short time horizons, it is difficult to convince them that the expected discounted benefits of the investment over the expected life of the property exceeds the immediate upfront cost. Decision-makers’ resistance is likely to be compounded if they perceive the risk to be below their threshold level of concern. Residents in hazard-prone areas may also be concerned that, if they move in the next few years, the property value of their home will not reflect the expected benefits from investing in loss reduction measures because the new owner will not be concerned about the risk of a disaster.

Mitigation grants and loans

FEMA created the Flood Mitigation Assistance (FMA) program in 1994 to reduce flood insurance claims. FMA is funded by premiums received by the NFIP to support loss reduction measures, such as elevation or relocation of property, flood-proofing commercial structures or demolition and rebuilding of property that has received significant damage from a severe flood.

In July 2014, Connecticut initiated its Shore Up CT program designed to help residential or business property owners elevate buildings or retrofit properties with additional flood protection, or assist with wind-proofing structures on property that is prone to coastal flooding. This state program, the first in the U.S., enables homeowners to obtain a 15-year loan ranging from $10,000 to $300,000 at an annual interest rate of 2 3⁄4%.

More generally, long-term loans to homes and businesses for mitigation would encourage individuals to invest in cost-effective risk-reduction measures. Consider a property owner who could pay $25,000 to elevate his coastal property from three feet below Base Flood Elevation (BFE) to one foot above BFE to reduce storm surge damage from hurricanes. If flood insurance is risk-based, then the annual premium would decrease by $3,480 (from $4,000 to $520). A 15-year loan for $25,000 at an annual interest rate of 2 3⁄4% would result in annual payments of $2,040 so that the savings to the homeowner each year would be $1,440 (that is, $3,480−$2,040).

Means-tested vouchers

One way to maintain risk-based premiums while at the same time addressing issues of affordability is to offer means-tested vouchers that cover part of the cost of insurance. Several existing programs could serve as models for developing such a voucher system: the Food Stamp Program, the Low Income Home Energy Assistance Program (LIHEAP) and Universal Service Fund (USF). The amount of the voucher would be based on current income and determined by a specific set of criteria as outlined in the National Research Council’s report on the affordability of flood insurance. If the property owners were offered a multi-year loan to invest in mitigation measure(s), the voucher could cover not only a portion of the resulting risk-based insurance premium, but also the annual loan cost to make the package affordable. As a condition for the voucher, the property owner could be required to invest in mitigation.

An empirical study of homeowners in Ocean county, NJ, reveals that the amount of the voucher is likely to be reduced significantly from what it would have been had the structure not been mitigated, as shown in Figure 2 for property in a high-hazard flood area (the V Zone) and a lower-hazard area (the A Zone).


Catastrophe coverage

Insurers’ withdrawal from certain markets because of lack of reinsurance capacity and other risk transfer instruments (e.g. catastrophe bonds) led to the establishment of government-backed programs such as the CEA, NFIP and TRIA.

If insurers were permitted to charge risk-based premiums, they would very likely want to market coverage against earthquakes and floods as long as they were protected against catastrophic losses. State reinsurance facilities could play an important role in this regard if premiums were risk-based using data provided by catastrophe models. One such facility exists today—the FHCF. It was established in 1993 following Hurricane Andrew to supplement private reinsurance and reimburse all insurers for a portion of their losses from catastrophic hurricanes.

TRIA provides protection to insurers against catastrophic losses from future terrorist attacks. American taxpayers will not be responsible for any payments until the total commercial losses from a terrorist attack exceed $60 billion. In other words, insurers will cover the entire losses from future terrorist attacks that are not catastrophic.

Lewis and Murdock proposed that the federal government auction a limited number of catastrophe reinsurance contracts annually to private insurers to provide them with more capacity to handle truly extreme events. The design of such contracts would have to be specified, and a more detailed analysis would have to be undertaken to determine the potential impact of such an auction mechanism on the relevant stakeholders.

Well-enforced regulations and standards

Given the reluctance of individuals to voluntarily purchase insurance against losses, one should consider requiring catastrophic coverage for all individuals who face risk. Social welfare is likely to be improved under the assumption that individuals would have wanted insurance protection had they perceived the risk correctly, not exhibited systematic biases and used simplified decision rules that characterize intuitive thinking. If the public sector were providing protection against catastrophic losses from these extreme events, they could pass regulations requiring insurance coverage for individuals at risk.

Risk-based insurance premiums could be coupled with building codes so that those residing in hazard-prone areas adopt cost-effective loss-reduction measures. Following Hurricane Andrew in 1992, Florida re-evaluated its building code standards, and coastal areas of the state began to enforce high-wind design provisions for residential housing. As depicted in Figure 3, homes that met the wind-resistant standards enforced in 1996 had a claim frequency that was 60% less than that for homes that were built prior to that year. The average reduction in claims from Hurricane Charley (2004) to each damaged home in Charlotte County built according to the newer code was approximately $20,000.

Homeowners who adopt cost-effective mitigation measures could receive a seal of approval from a certified inspector that the structure meets or exceeds building code standards. A seal of approval could increase the property value of the home by informing potential buyers that damage from future disasters is likely to be reduced because the mitigation measure is in place. Evidence from a July 1994 telephone survey of 1,241 residents in six hurricane-prone areas on the Atlantic and Gulf Coasts provides supporting evidence for some type of seal of approval. More than 90% of the respondents felt that local home builders should be required to adhere to building codes, and 85% considered it very important that local building departments conduct inspections of new residential construction.

Multi-year insurance

As a complement to property improvement loans, insurers could consider designing multi-year insurance (MYI) contracts of three to five years. The insurance policy would be tied to the structure rather than the property owner and carry an annual premium reflecting risk that would remain stable over the length of the contract. Property owners who cancel their insurance policy early would incur a penalty cost in the same way that those who refinance a mortgage have to pay a cancellation cost to the bank issuing the mortgage. With an MYI contract, insurers would have an incentive to inspect the property over time to make sure that building codes are enforced, something they would be less likely to do with annual contracts.

To compare the expected benefits of annual vs multi-year contracts, Jaffee et al. developed a two-period model where premiums reflect risk in a competitive market setting. They show that an MYI policy reduces the marketing costs for insurers over one-period policies and also eliminates the search costs to policyholders should their insurer decide to cancel their coverage at the end of period 1. Should the policyholder learn that the cost of a one-period policy is sufficiently low to justify paying a cancellation cost, it is always optimal for the insurer to sell an MYI policy and for a consumer to purchase it. The insurer will set the cancellation cost at a level that enables it to break even on those policies that the insured decides to let lapse before the maturity date.

Several factors have contributed to the non-marketability of MYI for protecting homeowners’ properties against losses from fire, theft and large-scale natural disasters. Under the current state-regulated arrangements in which many insurance commissioners have limited insurers’ ability to charge risk-based premiums in hazard-prone areas, no insurance company would even entertain the possibility of marketing a homeowner’s policy that was longer than one year. Insurers would be concerned about the regulator clamping down on them now or in the future regarding what price they could charge. Uncertainty regarding costs of capital and changes in risk over time may also deter insurers from providing MYI.

For the private sector to want to market coverage if the above issues are addressed, there needs to be a sufficient demand to cover the fixed and administrative costs of developing and marketing the product. To empirically test the demand for MYI, a web- based experiment was undertaken with adults in the U.S.; most were older than 30 years, so they were likely to have experience purchasing insurance. The individuals participating in the experiment were offered a choice between one-year and two-year contracts against losses from hurricane-related damage. A large majority of the responders preferred the two-year contract over the one-year contract, even when it was priced at a higher level than the actuarially fair price. Introducing a two-year insurance policy into the menu of contracts also increased the aggregate demand for disaster insurance.

Modifying the National Flood Insurance Program

The NFIP provides a target of opportunity to implement a long-term strategy for reducing risk that could eventually be extended to other extreme events. The two guiding principles for insurance would be used in redesigning the rate structure for the program:

  • Premiums would reflect risk based on updated flood maps so that private insurers would have an incentive to market coverage.
  • Means-tested vouchers would be provided by the public sector to those who undertook cost-effective mitigation measures. This would address the affordability issue. Homeowners who invested in loss-reduction measures would be given a premium discount to reflect the reduction in expected losses from floods. Long-term loans for mitigation would encourage investments in cost-effective mitigation measures. Well-enforced building codes and seals of approval would provide an additional rationale for undertaking these loss-reduction measures.
  • An MYI policy tied to the property would deter policyholders from canceling their policies if they did not suffer losses for several years.
  • Reinsurance and risk-transfer instruments marketed by the private sector could cover a significant portion of the catastrophic losses from future floods. Some type of federal reinsurance would provide insurers with protection against extreme losses.

The social welfare benefits of this proposed program would be significant: less damage to property, lower costs to insurers for protecting against catastrophic losses, more secure mortgages and lower costs to the government for disaster assistance.

Directions for future studies and research

In theory, insurance rewards individuals who undertake loss reduction measures by lowering their premiums. For insurance to play this role, premiums have to reflect risk; otherwise, insurers will have no financial incentive to offer coverage or will not want to reduce premiums when those at risk undertake protective measures. Charging risk-based premiums raises questions of affordability for those low-income residents in hazard-prone areas who are currently paying subsidized prices for coverage or have elected to be uninsured because of budget constraints or misperceptions of the risk. In addition, insurers may elect not to offer coverage if they are concerned about the impact that catastrophic losses will have on their balance sheet as evidenced by their decisions not to offer flood, earthquake or terrorism insurance in the U.S. without some type of back-up from the state or federal government. To determine the price of risk-based premiums, there is a need for more accurate data. In the U.S., FEMA is now updating its flood-risk maps as recommended by a Government Accountability Office (GAO) study and by recent federal legislation on the NFIP.

The impact of changing climate patterns on future damage from flooding because of potential sea-level rise and more intense hurricanes also needs to be taken into account. There is evidence that federal agencies and other bodies have underestimated the risks of damage from extreme weather events because of climate change. Hurricane Sandy has stimulated studies on ways that communities can be more prepared for future disaster damage as well as highlighting the need for a suite of policy tools including insurance to address the climate change problem.

Studies are also needed as to ways that other policy tools, such as well-enforced building codes to encourage good construction practices, can complement insurance. Enforcing building codes for all residences in Florida could reduce by nearly half the risk-based prices of insurance under climate change projections with respect to hurricane damage in 2020 and 2040. In this regard, Chile serves an example for the U.S. to emulate. The country passed a law that requires the original construction company to compensate those who suffer any structural damage from earthquakes and other disasters if the building codes were not followed. Furthermore, the original owner of a building is held responsible for damage to the structure for a decade, and a court can sentence the owner to prison. Well-enforced building codes in Chile account for the relatively low death toll from the powerful earthquake (8.8 on moment magnitude scale) that rocked the country on Feb. 27, 2010.

The challenge facing the U.S. today is how to capitalize on the concerns raised by hurricanes Katrina and Sandy and discussions on the renewal of the NFIP in 2017. The case for making communities more resilient to natural disasters by investing in loss reduction measures is critical today given economic development in hazard-prone areas. For risk-based insurance to be part of such a strategy, there is a need for support from key interested parties. These include the real estate agents, developers, banks and financial institutions, residents in hazard-prone areas and public sector organizations at the local, state and federal levels.

The principle of risk-based premiums coupled with concerns regarding affordability and catastrophic losses apply to all countries that use insurance as a policy tool for dealing with risk. Studies on the role that the private and public sectors play with respect to risk sharing of these losses reveal significant differences between countries. Other countries face similar problems and would do well to consider how to develop long-term strategies that have a chance of being implemented because they address short-term concerns.