Commenter Warns Against Bright-Line Test in Reinsurance Regs

As a consequence, only 11% of all houses in California are insured against earthquakes. In Florida, insurance against hurricane damage is very expensive, eating up a significant portion of household budgets.

Insurance companies can reduce the cost of the insurance by purchasing protection from property catastrophe reinsurers. The cheaper the reinsurance protection, the less the insurance company needs to charge the home or business owner. The price of reinsurance protection has reduced significantly in the last few years, mainly due to the significant influx of new capital. Much of this new capital is provided by pension funds, sovereign funds and other intuitional investors seeking to diversify their investment portfolios with an alternative asset class, catastrophe risk, which is has the highly attractive attribute of being uncorrelated with financial markets.

These investors are willing to assume the remote risk of a large financial loss as the result of an Act of God in return for a fair risk premium. Tax avoidance is not a consideration. Often these investors have a lower cost of capital than traditional reinsurers so can offer protection at a lower cost than traditional reinsurance company. This lower cost of reinsurance ultimately translates into a lower cost of insurance to the home or business owner.

Most of the recent influx of capital responsible for decreasing the price of reinsurance has not been invested in traditional reinsurance companies but in alternative reinsurance vehicles, sometimes structured as funds, other times as special purpose vehicles.

Alternative reinsurance is a blossoming industry that provides a positive benefit to US home and business owners. Its growth should be encouraged, not hindered.

Now to the point. These alternative reinsurance vehicles often have very low premium to capital ratios (the risk of loss, although potential severe, are remote so the premium paid is commensurately low (often less than 5% of the collateral or capital). These vehicles often have no reserves (under US accounting principles you cannot reserve for an event that has not happened, so if no catastrophe has occurred reserves will be zero). It would be a very unfortunate unintended consequence if the new PFIC rules included any bright line test based on premium to capital or reserves to capital as that would penalize an industry that provided a benefit to the US home or business owner.

The correct test for these types of vehicles would be to look at how much notional risk they assume as a percentage of capital. If there is the chance, however remote, of the vehicle losing a significant amount of its capital from any one natural catastrophe, it is a risk bearing entity and should be exempt from the new PFIC rules.