PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

304 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESbeneficial to understand the expected average severity of naturalcatastrophes, catastrophe models are unable to help identifythe future timing of these events. As a result, the future earningsstream of an insurer with significant insurance exposure tonatural catastrophes is much more difficult to predict.Due to the immediate and extremely adverse impact catastrophesmay have on the balance sheets of property/casualty insurersand reinsurers, there has been a recent NAIC proposalto establish a tax-deferred prefunded catastrophe reserve. Theintent of this proposal is to establish a simple mechanism bywhich insurers and reinsurers can prudently manage risk createdby exposure to natural catastrophes. This mechanism is intendedto reduce the uncertainty related to the future earnings stream ofinsurers with significant exposure to natural catastrophes. The focusof the current proposal is on exposure of property insurancecoverages to natural mega-catastrophes (e.g., Hurricane Andrewin 1992) that are expected to occur in the future.As currently proposed, this “reserve” can be more appropriatelyviewed as segregated surplus. For the purpose of solvencyregulation, the pre-funded nature of this reserve is also expectedto come with restrictions on how it may be taken down overtime.This reserve and its funding mechanism will lead to additionalconsiderations related to the determination of starting capitaland future earnings for the purpose of a valuation. If thecatastrophe reserve is immediately funded out of existing capitaland as a liability, the entity’s starting capital for the purposeof valuation will be reduced. If, however, the reserve is consideredto be segregated surplus, the value of the company will notchange. An alternative pre-funding approach is to contribute apercentage of premiums to the catastrophe reserve fund. Thiswould have no impact on starting capital, but would affect futureearnings. The direction of the change, however, is uncertain.