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MASSIVE REINSURANCE PROGRAM IN PLACE

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SAN FRANCISCO-The largest reinsurance placement in history is about to bring a proposed California earthquake insurance facility a step closer to reality.

A consortium of intermediaries is close to wrapping up a nearly $2 billion reinsurance program for the California Earthquake Authority, a $10.5 billion state-sponsored entity that would take over most homeowners earthquake exposures in the state.

Defying early doubts, the CEA by last week had already attracted more than $1.5 billion in capacity, including commitments of $100 million or more from several reinsurers (see chart).

The successful placement will fulfill one of three conditions set by the state Legislature for the targeted April 1 start-up of the CEA. The facility's other conditions are securing participation of insurers representing at least 75% of the state's residential earthquake market, and gaining tax-exempt status from the Internal Revenue Service.

Observers expect the participation requirement will easily be met. California Insurance Department officials were still waiting last week for a ruling from the IRS, without which "the whole thing falls apart," a department spokesman said.

"We continue to have what I would term very positive conversations with them," said Greg Butler, deputy insurance commissioner. "They have been very responsive, if you can say that about a government agency.

"I'm very confident that it's going to happen," Mr. Butler said.

Reinsurance brokers, meanwhile, expressed satisfaction and some surprise with the success of the placement of unprecedented scale.

"I thought that it was achievable but that there was a good chance it wouldn't happen," said John C. Graham, a San Francisco-based executive vp with E.W. Blanch Co., the lead intermediary on the program.

"Frankly, I didn't know capacity of that kind existed when we started this process."

"The reinsurance market has reacted very favorably to the fact that they would have all of their California personal lines earthquake exposure in one entity and would know exactly what their exposure was," added Willis T. King Jr., chairman of Willcox Inc. Reinsurance Intermediaries in New York, another member of the broker group.

Reinsurers often have said they would put up substantial lines for exposures they could quantify, Mr. King noted. "They're really proving it in this situation."

Much of the capacity being committed to the CEA, moreover, is "new" capacity that will not drain reinsurance support for commercial earthquake and other catastrophe risks, brokers and reinsurers say.

"It's capacity that's been put into the business and capacity that's been created by (cat reinsurers') retained earnings over the last two to three years," Mr. King said.

While some participants-including Insurance Department officials themselves-express mixed feelings about government involvement in solving the earthquake coverage problem, they also acknowledge the CEA as a model of cooperation among policyholders, government and the private sector.

"The toughest day in my (career) with (Insurance Commissioner) Chuck Quackenbush was when I went in and told him it would have to be a state agency," Mr. Butler said of the CEA's development.

But "this is something that embodies the best of everything," he said.

The CEA has its genesis in a market crisis that followed a devastating string of losses from the $960 million Loma Prieta earthquake in 1989 to the $12.5 billion 1994 Northridge quake. Prompted in part by such losses, more homeowners bought quake coverage: 34.5% at year-end 1994 compared with 10% in 1985, according to CEA documents.

At the same time, insurers-required by law to offer the coverage with homeowners policies but facing uncapped liabilities-have been increasingly unwilling to write new and renewal business. Over 90% of the market is now closed to new business and insurers have said they would non-renew more than 1 million policies unless the problem is addressed, CEA documents say.

The Insurance Department and state Legislature responded with two bills signed into law last October: one created a new earthquake "mini-policy" that significantly reduced existing earthquake coverages and the other measure authorized creation of the CEA.

The mini-policy, a key to attracting support for the CEA, includes a deductible of 15% of the limit for structures, a $5,000 limit on contents and a variety of other sublimits and exclusions. The policy covers earthquake "shake" damage only and excludes other perils.

Had the policy been widely used at the time of the Northridge quake, insured residential losses would have been cut to $4.3 billion from $8.2 billion, the CEA estimates.

As proposed, the CEA would issue policies through participating insurers, and existing policies would be converted to CEA coverage at renewal. The facility is structured to provide a maximum aggregate limit of $10.5 billion in several layers funded by property insurers, reinsurers, the state government, policyholders themselves and possibly the capital markets.

The $10.5 billion would consist of:

An initial $1 billion layer built with non-refundable capital contributions from participating insurers based on their market share. An insurer with a 10% market share, for example, would have to contribute $100 million.

A layer consisting of the CEA's retained earnings. Assuming no losses, the CEA estimates its retained earnings will grow from $147 million at the end of this year to $5.2 billion by the year 2004.

A $3 billion layer funded by assessments of participating insurers based on market share. The total amount of this layer will be reduced yearly as the retained earnings layer grows, and will be cut to zero after 10 years, the CEA projects.

The $2 billion reinsurance layer.

A $1 billion layer funded by a state general revenue bond issue. Principal and interest payments would be covered by a surcharge to CEA policyholders of up to 20% of their annual premium.

A layer of at least $1.5 billion funded with the sale of an investment product. The California department is still discussing the form this product will take with Morgan Stanley & Co. and other advisers, and a decision should be made this week, Mr. Butler said.

A second industry assessment layer of $2 billion, again based on insurers' market share. This layer will also be reduced yearly after the initial capital and retained earnings layers surpass $6 billion, and could be eliminated by the year 2006, the CEA projects.

The total aggregate limit offered by the CEA will depend on the degree of insurer participation: The $10.5 billion limit would require participation by all the state's earthquake insurers. At the minimum required 75% participation level, the total limit would be $7.86 billion and the amount of each layer would be proportionally reduced. The reinsurance layer, for example, would be $1.5 billion at 75% participation.

The Insurance Department has received verbal commitments from about 84% of the market, according to Blanch's Mr. Graham, who said actual participation will be in the 75% to 82.5% range.

Many smaller insurers-those with $50 million or $60 million in surplus, for example-won't participate because they can't afford the required CEA capital contribution, he said.

Before the CEA could get a green light from the Legislature to start operating, though, it had to put its reinsurance program in place.

Apart from its sheer size, the placement was unusual because reinsurers were being asked to commit to a facility that might never get off the ground if other conditions weren't met, brokers note.

Knowing that global capacity would be needed, the California department assembled a team of brokers and divided the market geographically: Blanch acted as coordinating intermediary while Willcox took Bermuda, most of Europe and the Far East; Sedgwick Re took the United States and Canada; G.J. Sullivan Co. of Los Angeles approached direct writing reinsurers; and London broker Ballantyne, McKean & Sullivan took Lloyd's of London and the United Kingdom market.

The CEA decided early on to market the program as a single $2 billion quota share layer in which reinsurers would all get the same price and terms, Mr. Graham said. Breaking the program into layers, he explained, would have risked infighting among reinsurers.

The reinsurance layer will also respond on an aggregate basis, meaning that as losses exhaust the underlying limits, the reinsurers move closer to having to respond on a first-dollar basis to the next loss.

On Dec. 6, the brokers, accompanied by Mr. Quackenbush, embarked on a road show to sell the program to reinsurers, finishing the tour Dec. 16 in Zurich, Mr. Graham said.

In the process, a select number of targeted lead reinsurers were asked for quotations and other terms. By Dec. 29, the leads had come back with quotes ranging from $470 million to $600 million for the two-year term of the deal. On Jan. 4, the CEA approved a two-year premium of $575 million, equating to a 14.4% annual rate on line for the reinsurers, Mr. Graham reported.

Within two weeks, a syndicate of lead reinsurers and several following markets had committed a total of more than $1.5 billion to the program (see chart, page 1).

Several following markets have also committed large lines, including Zurich Insurance Co. and Centre Reinsurance Co. Ltd. of Bermuda, $150 million; units of American International Group Inc., $100 million; IPC Re Ltd. of Bermuda, $20 million; and Transatlantic Reinsurance Co. of New York, $15 million.

Mr. Graham projected that total commitments could hit $1.8 billion by the time the placement is wrapped up this week, an amount that should be enough to handle expected participation in the CEA.

If the total limit falls below $2 billion, each reinsurer's line would be reduced proportionally.

Mr. Graham said he had expected the gigantic placement to drain catastrophe market capacity. For one thing, many of the largest California homeowners insurers-like State Farm Mutual Automobile Insurance Co. and Allstate Insurance Co.-buy little or no reinsurance, meaning that it was not a matter of simply transferring capacity to the CEA, he said.

In addition, California property insurers are still exposed to risks not covered by the CEA, like fire following a quake, and may reinsure them. In the first year of the CEA's operation, participating reinsurers will also have "dual" exposure, transferring some policies to the CEA while remaining liable on others until renewal, Mr. Graham said.

It appears, though, that the CEA capacity is new capacity reflecting increased appetite for risk and rising surplus following two years of favorable cat experience, according to brokers.

"This is mostly new capacity, additional capacity created for this purpose," agreed Herbert N. Haag, president of Partner Reinsurance Co. Ltd. of Hamilton, Bermuda. Partner Re's own equity has grown to $1.3 billion from $950 million over the last two years on the strength of good loss experience, he noted.