The New York Insurance Department has formally proposed a new regulation which would require authorized property/casualty insurers to establish reserve funds for the payment of losses that occur in New York which arise out of natural catastrophes.
  
The bold regulatory initiative is currently being evaluated by many sectors of the industry to determine what, if any, significant impact the regulation may have on company operations. Interestingly, the regulation has been proposed without an accompanying press announcement by the department explaining the reasons why this measure is being taken at this time.
   
The issue of establishing a CAT reserve, in some form, has been discussed and debated for many years now. The debate always seems to heat up in the wake of one natural disaster or another and then dies down. It has been several years since a major hurricane (Katrina) has hit the United States and we are not currently in the aftermath of some other kind of natural disaster. 
 
So why has the Department picked this time to propose this regulation? Could it be that I have become so accustomed to the flurry of governmental activity in the wake of any disaster that I am intrigued when government takes action well in advance of a problem? 
 
Key provisions
The proposed regulation will be number 189 or, in modern codification terms, 11 NYCRR Part 111. It is intended to apply to "Every authorized property/ casualty insurer issuing a policy of insurance or contract of reinsurance covering losses resulting from a natural catastrophe to property located in this State, and receiving New York subject premiums…" Each such company would be required to set up a CAT reserve to be used for payment of claims for "qualifying losses", which are defined as losses resulting from loss to property in this State attributable to a "catastrophe" in this State. Catastrophe is defined as: a natural event designated as a catastrophe by the Property Claims Service, a division of the Insurance Services Office, Inc., and: (1) which causes $250 million or more in industry-wide direct insured losses in the United States and results in a qualifying loss to property located in this State; or (2) which causes $25 million or more in direct insured losses results in a qualifying loss to property located in this State, and results in a 10% reduction in the insurer's surplus to policyholders in any calendar year. (See Section 111.2(a))   
A natural event shall mean an occurrence that is not man-made, including but not limited to wind, hail, hurricane, earthquake, winter storms (including snow, ice, freezing rain), tsunami, or flood. (Section 111.2(h)) So to qualify as a loss to be paid from the reserve, there must be a natural event, designated as a catastrophe by ISO, causing $250 million or more in industry-wide direct insured losses in the US and is a qualifying loss to property in New York or which causes $25 million or more in direct losses, is a qualifying loss in New York and results in a 10% reduction in the insurer's surplus to policyholders in any calendar year. This key definition may still need a little work to make it clearer. 
 
The amount of the reserve will be equal to the property/casualty insurer's aggregate catastrophe load, included in the New York subject premiums, for the calendar year, net of any federal, state and local income tax incurred on the reserve. (Section 111.3(a) and (c)) There is no obligation to fund the reserve with respect to assumed reinsurance premiums on excess of loss reinsurance contracts.  
 
The reserve fund shall have a 30- year rolling term, meaning that at the end of the 30th year, the first year's annual contribution including investment income, to the extent not used to fund qualifying losses, shall be taken into income and the 30th year's annual contribution, including investment income, shall be added to the reserve. (Section 111.4))   

Further, when an insurer incurs a qualifying loss on property within this State, it may convert the reserve, or a portion thereof, to an event specific catastrophe loss reserve, giving notice of the same to the Superintendent. (Section 111.5) The Superintendent may authorize release of funds from the reserve, 1) to mitigate potential impairment of the insurer; (2) when the insurer no longer has such exposures; (3) in accordance with a reciprocal agreement with another state entered into by the Superintendent; and (4) where the release of such funds would be in the best interests of the policyholders of this State. (Section 111.5(d))
  
Discussion
In the Regulatory Impact Statement (RIS), a document required by the State Administrative Procedure Act (SAPA), the Department reasons that the new rule simply requires insurers to reserve the amount they now charge policyholders for catastrophe protection (including investment income), net of any reinsurance purchased to mitigate the impact of a catastrophe. Thus, without establishing a reserve, this "catastrophe load" is reported as pure profit by the insurer if the catastrophe does not occur in the policy year and goes to the insurer's capital. The Department states that it merely seeks to require the companies to "set aside" the money they collect from policyholders for catastrophe risk instead of using that money for other purposes. This regulation would also enhance transparency as the consumer could track the location of the portion of premium paid for catastrophe risk. The Department also reasoned that it chose a 30-year rolling term for the fund because any less of a term would potentially lead the fund to be insufficient for its intended purpose.   
The Department conducted outreach to the National Association of Insurance Commissioners (NAIC), the Casualty Actuarial Society, insurers, consumer groups and other interested parties. Of particular interest was the fact that the Department "considered" the current NAIC proposal, which creates a voluntary CAT reserve fund and a "cap" which requires an insurer to draw down the reserve when the cap is reached. The NAIC proposal is dependent upon the Congress creating a tax deduction for the reserve, which the Department believes, will not happen anytime soon. In any case, the Department is seeking a national application of this regulation at the NAIC, and the regulation provides for reciprocity with any other state which has a CAT funding provision.   

The Department also considered a "single state CAT reserve fund" of the type that is currently pending in the legislature (S. 4188), but decided against such a measure as it would not encourage sound underwriting practices since companies could merely draw upon the statewide fund to pay their CAT losses.  
 
It appears that not everyone in the industry is content with the Department's issuance of this regulation or its reasons therefor.  
 
It appears that the major criticism of the regulation is that it requires the establishment of such a reserve which would be subject to state and federal income taxes. This tax issue has hung like a shroud over the entire CAT fund debate for years. There have been many discussions with federal officials over the years about changing the tax law to provide a deduction for CAT reserves similar to the deduction the companies may currently take for its loss reserves. No company can find it desirable to set aside premium monies in a reserve while having to pay tax on those monies at the same time. While the Department states that it supports a change in the tax law it clearly does not wish to wait for Congress to act, stating in the RIS, "it is imperative that New York create a source of funds that will be available to pay claims in the event a catastrophe occurs in New York State." For whatever reason, the Department has determined that now is the time for CAT reserving.  
 
The Department is hoping that if New York makes the first move to mandate CAT reserving, the feds would be better incentivized to act on a tax change. The RIS contains the following statement, "[T]he best way for the entire industry to achieve that change is to take responsible action first, which will give it the credibility to ask the federal government for a new tax treatment of catastrophe reserves, with the added support of insurance regulators." Superintendent Dinallo has stated many times in the past that when an issue is stuck at the national level, New York may just act unilaterally in an effort to force the issue. The strategy here may be similar to the Department's unilateral strategy on reinsurance collateralization.   
Small insurers are also concerned that the regulation does not take into account their needs. They may need additional protection in the form of reinsurance from loss events that do not meet the definition of "catastrophe" contained in the regulation, thus increasing their costs. Reinsurers are concerned that since the rule applies to assumed quota share or proportional contracts, it may be difficult for reinsurers to obtain necessary information from ceding insurers so that the reinsurers are able to calculate the CAT reserve amount. Since the Department has amended the regulation to provided that the contribution to the CAT reserve is the aggregate CAT load that is part of the policyholder's premium, net any excess of loss reinsurance ceded, the Department has argued that this concern is has been resolved. I'm not sure that the reinsurers would agree with this position. 
 
Insurers have also expressed concern that because many risks are written on a multi-state basis, with many properties in different states being insured, that they would have to "walloff" the property risk based on its location in a particular state, making those monies unavailable to pay losses on any other state's property. The Department states that insurers will just have to rate each state's property individually.   

The elephant in the room of this proposed regulation is what the Department refers to as the "opportunity cost" of retaining catastrophe premiums for payment of future losses, rather than using those premiums for other purposes. The insurers have complained about this to the Department by arguing that with the CAT premiums being placed in a dedicated reserve, premium rates may have to increase to enable insurers to raise more capital to earn the target rate of return underlying their current rate structure. If rates are not allowed to increase, the argument goes; insurers may be forced to reduce CAT exposures to limit the need for additional capital. The Department has strongly signaled that it will not tolerate the use of this proposed regulation as an excuse for carriers to raise rates. The Department writes, "The catastrophe reserve required by this rule merely builds upon the catastrophe load already charged by insurers to policyholders, and therefore should not increase an insured's rates. In the rate making process, the catastrophe load is not considered profit; it is a specific charge associated with the payment of a specific type of loss." (See RIS, paragraph 8.) I'm not sure that the Department's response to this concern adequately addresses the simple economic fact that if premium previously used as capital is transferred to a reserve, the insurer must take some kind of action to compensate for the resulting lost "opportunity".  
 
Conclusion
It is expected that the Department will receive a large volume of official commentary to this proposal in the days ahead. The CAT reserving issue has been a vexing one for the industry and its regulators for many years now. I commend the Department for taking some action to decisively move the issue forward. However, without federal action on tax relief and in the absence of a more consistent and broad-based state regulatory initiative, the New York proposal presents significant problems for the industry. While New York is accustomed to being a national regulatory leader, this regulation simply creates another 49 and 1 issue for those companies seeking to comply with the law and do business here.  
 
New York has fired the shot that may be the beginning of serious progress in this area. Will the Federal government and the rest of the States hear the shot and take action?
  
Allstate Chief Steps into It
If one reads the usual playbook of government relations for insurers regarding the interface of an industry official with federal or state regulatory officials, one will find that the correct procedure in the event that unpleasant or difficult positions need to be taken publicly, let your trade association do the dirty work for you. In this way, individual companies do not make themselves the issue and the focus of the governmental community. Recently, however, Allstate CEO Tom Wilson threw away the playbook by personally drafting a New York Times op-ed piece entitled "Regulate me, please" in which he makes the case for the elimination of state insurance regulation and replacing it with federal regulation.  
 
If there ever was an exception that proved the rule, it is this one. Mr. Wilson, in a little over 400 words, managed to ignite a firestorm of debate in the trade press over the validity and accuracy of his assertions, while causing his company to be the recipient of a dreaded section 308 inquiry from the New York State Insurance Department concerning assertions he made in the article. That is quite a lot of action caused by one opinion piece. 
 
Mr. Wilson stated that many components of the financial markets are to blame for the recent collapse, the insurance industry, regulators, banks and credit rating agencies. Ultimately, he argued that Congress should "eliminate the hodgepodge of state regulatory systems by establishing a federal regulator for national insurance companies." He further argued that the individual states "lack the expertise to properly oversee rapid innovation or systemic risks." However, in the course of making his point, he also wrote that Allstate played "a small role in unregulated insurance markets" and noted that insurance companies like Allstate that wrote credit default swaps "were happy not to be regulated." 
 
It was the last two assertions that drew the New York Department's attention. On the same day that the Op-ed piece appeared in the Times, the Department's Deputy Superintendent and General Counsel, Robert Easton fired off a letter to Mr. Wilson, pursuant to Section 308 of the Insurance Law requiring that Allstate provide to the Department, "under penalty of perjury… specific details about any credit default swap transaction into which any New York licensed Allstate entity entered, as you say, in the ‘unregulated insurance markets'. Then, perhaps giving insight into how angry the Department was at Mr. Wilson's assertions, the Department issued a press release announcing that the letter had been sent. In that release, Superintendent Dinallo is quoted as saying, 
 
I am also concerned that the Allstate opinion article makes a number of broad statements that could risk unnecessarily undermining consumer confidence in the insurance industry as a whole. It states that the insurance companies wrote credit default swaps and were not regulated and their solvency was not protected. Wilson's column does not name those companies, leaving consumers to wonder which companies. It says A.I.G. sold credit default swaps as an insurer, suggesting any insurer could do the same, which is not true. It says Allstate itself was involved in unregulated insurance, without defining what that means. The column says insurance contributed to themarket failure, but is not clear if it means only credit default swaps or insurance generally. Consumers should know that insurance companies are weathering this crisis better than the rest of financial services and that state regulators are focused on ensuring insurers are solvent and can pay claims. I welcome a principled debate about federal regulation of insurance, but the last thing an insurance executive should be doing now is undercutting consumer confidence.
  
To make matters even worse for the big carrier, Mr. Dinallo's remarks were supported publicly by Illinois Insurance Director Michael McRaith.
  
Allstate responded through its vicepresident and general counsel, Mary J. McGinn who wrote in an affidavit that all derivative transactions by companies in the Allstate group were done under a Derivative Use Plan (DUP) approved by the company board and the New York Insurance Department for Allstate's New York companies. 
 
The substance of the issue has been dealt with ad nauseum both in this column and throughout the trade press. Whether or not you agree with Mr. Wilson's assertion that federal regulation of insurance could have prevented the AIG meltdown, the story here is the very vocal and controversial statements by the CEO of one of the largest insurers in the United States. In addition, the very public "calling out" of a company CEO by the Superintendent of Insurance is unprecedented to my knowledge. I must wonder what Mr. Wilson was thinking when he put together this Op-ed and what were his goals? Did he intend to draw out the Superintendent the way he did? Were there additional sources of frustration experienced by Mr. Wilson that led him to this controversial move? 

It is unknown at this time whether the Department will pursue the matter further. Whatever ultimately happens on this issue you can bet the next Insurance company CEO will think long and hard before putting pen to paper on an Op-ed piece.