(Bloomberg) -- The federal government, seeking to protect itself from the growing cost of natural disasters, is borrowing a technique from the private sector and buying reinsurance.
The Federal Emergency Management Agency, which started purchasing reinsurance last year for the National Flood Insurance Program, is now exploring the expansion of the program, spokesman Michael Hart said by email Tuesday.
Reinsurance is coverage bought by insurers -- or, in this case, FEMA -- as protection against unexpectedly high claims.
As the federal government’s exposure to extreme weather and associated natural disasters has grown, so has the reinsurance industry’s role in helping cover that risk. In 2014, Freddie Mac and Fannie Mae began buying reinsurance to protect against a drop in the value of their mortgage loans, including losses caused by natural disasters.
FEMA worked through Guy Carpenter & Co. LLC, a subsidiary of Marsh & McLennan Cos., to buy $1 billion worth of reinsurance in 2017 from 25 carriers for the flood insurance program. This year, the agency bought $1.46 billion of reinsurance for the program.
In April, the agency announced its intention to buy a so-called catastrophe bond, which works like reinsurance, with the investor getting a return unless disaster costs to the government exceed a certain threshold. FEMA didn’t say how much the bond would pay out.
Separately, Republican Representative Dennis Ross of Florida, the vice chairman of the House Financial Services Committee’s Subcommittee on Housing and Insurance, has introduced a bill that would direct FEMA to look at buying reinsurance or similar products for part of its overall disaster costs -- not just flooding.
Ross said that change would protect taxpayers from a sudden spike in costs, and also better protect the public from disasters by increasing the government’s incentive to reduce risk -- for example, by restricting development in vulnerable areas, or imposing stricter building standards.
“Private capital is going to impose good risk-management procedures,” Ross said in an interview. “Those are market forces that help dictate safe communities, safe environments, better cities.”
The Reinsurance Association of America, a trade group for the industry, has backed Ross’s proposal, telling him in a letter May 31 that “disaster victims, businesses, and communities could greatly benefit from a reinsurance risk transfer program.”
Disaster and insurance experts said that reinsurance would probably work at sheltering taxpayers from unexpected costs. But they said it’s far from clear that reinsurers would exert enough influence on the government to enact policies that reduce Americans’ exposure to risk -- policies that tend to be unpopular, which is why they haven’t been adopted yet.
Reinsurers have significant influence over the decisions made by primary insurers, whose business models depend on reinsurers agreeing to buy their risk, according to Peter Kochenburger, a professor and deputy director of the Insurance Law Center at the University of Connecticut School of Law. But he said that same dynamic doesn’t hold for the government.
The federal government “can use reinsurance to reduce its risk, but it doesn’t need reinsurance in the way that many insurers do,” Kochenburger said. If reinsurers insist on unpopular changes to where or how people build, FEMA or Congress can say no.
Another problem is that FEMA doesn’t have direct control over building codes or development decisions. Paula Jarzabkowski, a management professor at Cass Business School in London, said reinsurance programs can spur policy changes, but it’s easier when the agencies facing higher premiums also have the authority to make those changes.
“There needs to be a concerted effort to join the parts of government,” Jarzabkowski said.
Jeffrey Czajkowski, managing director for the Wharton Risk Management and Decision Processes Center, said the rising costs of disaster, rather than pressure from reinsurers, is what’s most likely to spur more aggressive federal policy on climate resilience.
“If we have 2017 every year, we’re not going to make $70 billion available to the State of Texas every single year,” Czajkowski said. “We just can’t keep doing that.”
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