In yesterday’s note, a great deal of time was spent discussing the loss reserves that an insurance or reinsurance company is required to record on its books. The one thing that these reserves have in common is that the losses for which these reserves are booked have occurred. This approach works for most of the business that a company may write. The premiums charged anticipate that the losses, if any, will occur during the term of the policy.

There is a portion of the premium in most property lines of business that is charged for catastrophe protection, “catastrophe premium”. Catastrophes by definition are unusual events and may occur only once every 10, 50, 250 or more years. The models that are used to help price the catastrophe premium factor these and more frequencies of occurrence into their results. Don’t worry, this will not be a discussion of catastrophe modelling. While catastrophe pricing takes a long view of these events, US accounting and tax rules do not. If there isn’t a catastrophe during the reporting period, the catastrophe premium is considered to be profit.

The New York Insurance Department has issued Proposed Regulation 189, http://www.ins.state.ny.us/r_prop/pdf/rp189txt.pdf that addresses at least part of this concern. This proposed regulation requires insurance companies writing NY natural catastrophe exposed business to create a mandatory contingent reserve which will be used to pay catastrophe losses. I am not going to discuss the pros and cons of this particular proposal. I do want to say that this is a step in the right direction. We need more states to step up and changes in the tax code to recognize that, when a catastrophe does not occur during a particular year, the catastrophe premium is not pure profit.