This is the third in Viewpoint’s series of guest essays
submitted by organizations that are associate members of AAIS.
For information on associate membership, contact Rick Maka, director of marketing, at
rickm@AAISonline.com or by calling 800/564-AAIS.
While Hurricane Katrina is likely the most
costly U.S. catastrophe in history, much uncertainty remains about
its ultimate impact on the insurance industry. One focus of
uncertainty is reinsurance capacity and pricing for additional 2005
per risk and catastrophe protection and for 2006 renewals. How will
reinsurers respond after Hurricanes Katrina and Rita?
Katrina is a stress test on the reinsurance
industry, just as it is on insurers, regulators, loss adjusters and
policyholders. Reinsurers expect to shoulder roughly half of the $30
billion to $60 billion of insured loss estimated to date, compared
to less than one-third of the $23 billion of insured loss from the
2004 Florida storms.1 In addition, there is the
possibility that political pressure and lawsuits could cause flood
and other excluded perils to be treated as covered perils,
potentially adding up to $44 billion to the losses moving through
the insurance market.2 Reinsurers enter the renewal
season with a large known loss and uncertainty about an equally
large coverage controversy.
When uncertainty enters the insurance
marketplace, it often exits in the form of tighter capacity, higher
rates and more restrictive terms. This is an outgrowth of the laws
of supply and demand--when demand is up and supply is down, the
market exacts a higher price for the same coverage. We believe
Katrina and Rita will have an impact on both supply and demand in
the reinsurance market in 2005 and 2006.
Hurricane Katrina has challenged insurers’
assessments of risk much like Hurricane Andrew did in 1992. In
Andrew, losses exceeded the expectations of insurers and reinsurers
by a significant margin. Similarly, as losses from Katrina continue
to grow, insurers are experiencing losses that in many cases exceed
their “worst-case” scenarios developed through the use of
catastrophe models. Katrina reminds us that cat models are just
that--models. Like all models they have weaknesses and require a
healthy dose of judgment. We believe there are three major ripple
effects from Katrina that may influence demand for catastrophe
reinsurance protection: a recalibration of catastrophe models, a
recognition that we may be in a period of increased frequency and
severity of hurricanes, and an increased focus on controlling
aggregate catastrophe exposures, driven by both internal prudence
and external forces, such as rating agencies.
Cat model deficiencies: Just as models
were adjusted after Hurricane Isabel and the 2004 Florida
Hurricanes, we can anticipate adjustments to the models and
interpretation of model output after Katrina. Exposures like demand
surge, mold remediation, insurance to value, and additional living
expense are incorporated in probabilistic loss models, but many of
these known loss components were underestimated. Demand surge is
usually expected to add 10% to 20% to the loss, but the actual
inflation rate for labor and materials in the Gulf may be closer to
40%, given the scope and the timing of the loss. Another example is
that additional living expense payments have been accelerated and
higher than modeled due to regulatory pressures and the scale of
damage. Katrina highlights the unknown as well as underestimated
exposures from extreme events. Political pressures, lawsuits, and
coverage disputes tend to increase ultimate losses. Flood losses
(and many other types of damage) are not part of the hurricane model
but could contribute a significant share of loss.
As a result, insurers are now looking beyond
model assumptions to the characteristics of a loss and adjusting
their worst-case estimates. The model produces a footprint that the
insurer can use to identify areas of high exposure accumulations
from major events. Now insurers are overlaying additional loss
factors for a more complete picture of their worst-case exposure.
They may adjust for the unique geography of the event (areas below
sea level), the legal environment (court rulings on coverage),
secondary events (levees failing, landslides) and other factors that
drive loss but are not in any models. Model answers are not final
answers.
Insurers can and should make provision for
underestimated and unknown losses in their own estimates of probable
maximum loss. With a more accurate picture of exposure, they can
make more informed reinsurance decisions. Our sense is that a trend
toward a more conservative PML estimate will generate demand for
more, rather than less, reinsurance (as well as adjustments to
coastal underwriting guidelines), but for the right reasons.
Higher frequency and severity: Whether
the result of climate change, a multi-decadal cycle related to
Atlantic sea-surface temperatures, or something else entirely, we
appear to be in a period of higher cyclonic activity. Since 1995,
the average number of Atlantic hurricanes has increased to
approximately seven per year, compared to an average of about 4.5
per year from 1970-1995.3 There is no scientific
consensus as to whether this trend will continue, but good reason
for concern that it will. Cat models use long-term averages to
estimate annual exposures, but if periods of loss frequency and
severity vary significantly over multi-year cycles, long-term
averages may not be good predictors of loss probabilities in the
shorter term. If in fact we are in a period of increased frequency
relative to the long-term average, the loss probabilities associated
with a 1-in-100 year event may actually be a much more likely
scenario in the short run.
Even though the signals of hurricane frequency
trend can be concealed by normal climate variability, there is
widespread acceptance of the loss severity trend: rising coastal
property values and population density drive up loss severity from
hurricane events. Insured coastal values have roughly doubled in the
past decade, and coastal population density continues to grow.
Partially due to this demographic shift, six of the ten largest
insured losses from hurricanes (in constant dollars) have occurred
in the last 15 months. Put another way, more events meet our
previous definition of an extreme event. One result is that insurers
need higher reinsurance limits for the worst case and more
reinstatements to address the possibility of higher frequency.
Aggregate management and prudence:
Prudent management teams are rethinking exposures to catastrophic
loss and how to best manage them. The use of reinsurance is a
large component of this reevaluation process.
Some insurers will have exhausted all of their catastrophe
reinsurance protection, exposing them to all adverse loss
development. As Katrina losses rise, insurers assume a larger share
of the total loss simply because many insurers will be “out the
top” of their protection.5 When this happens, insurers
bear the full brunt of loss development and cannot contain their
costs. Katrina also demonstrates correlation risk, in that insurer
aggregates may include types of loss not thought connected with
hurricane events. More to the point, management cannot assure owners
of what that their ultimate costs will be.
Boards of directors may take a more active role
in examining gross and net exposure to catastrophes. Where large
dollars are at risk, boards may question reinsurance quantity as
well as quality, e.g., the collectibility of reinsurance. Their duty
of care compels the exposure inquiry. Senior executives may also be
more involved in running models and testing results, functions
previously delegated to outside advisers or brokers. In a world of
heightened corporate responsibility, Katrina puts catastrophe
management on the agenda. In this setting, the likely result is
conservatism, or demands for higher limits, more reinstatements and
highly-rated (A or above) reinsurers.
Every observation about demand applies to
reinsurance companies, too. Reinsurers use models and have managers
and boards scrutinizing gross and net exposure. Their new perception
of risk will shape their willingness to commit capacity to the
reinsurance market. The Katrina stress test has a few distinct
effects on reinsurance supply. The observations below are based on
statements by reinsurance company managements to the press and
client input from industry conferences. The reactions are global and
not specific to any company, but they ripple through the entire
reinsurance market in which all companies operate.
Higher PMLs and lower capacity: The
estimated reinsurance share of Katrina, 50% or approximately $25
billion, is more than one-third the policyholder surplus for the
U.S. reinsurance industry. Property catastrophe loss from Katrina is
not spread evenly across the industry so several reinsurers are
disproportionately affected. Since this same segment would be
sources of 2006 renewal protection, it is fair to say that renewal
capacity will be less than it was a year ago.
Reduced capacity will not be limited to the
reinsurers heavily impacted by Katrina. All reinsurers with property
business are reviewing PMLs under new worst-case scenarios before
deciding how much capacity to commit to the renewal market. Some
reinsurers use cat models and then apply correlation factors to
develop their own probable maximum loss estimates. A more
conservative approach is to add up all reinsurance limits on
contracts with catastrophe exposures in a particular zone. Whatever
method is adopted, we expect that reinsurers will be more thoughtful
and probably more conservative in deploying capacity.
Reduced retrocessional support: Retrocessional
markets provide reinsurance support to other reinsurers. They serve
worldwide reinsurance capacity needs by redirecting capital to the
companies and geographic markets promising the greatest returns.
Since sizable Katrina losses will impact this market, we expect that
retrocessions will be more costly, and harder to find at any cost.
New capital in the market may ease the shortfall, but prices will
still be calibrated with post-Katrina assumptions and higher risk
calculations. At least for 2006 renewals, new capital is not likely
to slow the upward price trend.
In a tight retrocessional market (and any
reinsurance or insurance market), selectivity rules and capacity
will be allocated to those clients with strong relationships and
profitable business. Even long-term clients can expect demands for
more information about risks and modeling adjustments, so reinsurers
can have more confidence in their management of aggregate exposures.
These insurers may pay more for reinsurance support, but they should
be able to secure renewal quotes from their current reinsurers. The
same may not be true for insurers and reinsurers seeking new covers
or new participants in their reinsurance programs.
More contractual conditions: Tighter
contract terms often follow a major loss event as reinsurers
incorporate lessons learned into their renewal offers. It is too
early to say which proposed terms, if any, would emerge in bound
contracts. However, cat-related provisions tend to come into
discussions at these times and probably will for 2006 renewals. A
short list of possible clauses includes Hours clauses, Industry Loss
Warrantees, Rating Downgrade triggers, and Mold exclusions/sublimits.
Discussions of ex gratia coverage, follow the fortunes, policy
reformation and access to records may also arise. Since some rating
downgrade provisions will be triggered in the wake of Katrina,
insurers are weighing their options and deciding whether to replace
downgraded reinsurers, demand security or do nothing. Such security
concerns may be wrapped into 2006 renewal negotiations and
placements.
The Hours Clause has particular relevance to
Katrina losses. Most cat covers limit a hurricane occurrence to 72
hours and many reinsurers were expanding that limit to 96 hours.
Applying the Katrina timeline, four days separated the Florida
landfall from the Gulf Coast landfall. Under a 72-hours limitation,
Florida claims cannot be combined with Mississippi or Louisiana
claims into a single occurrence. If Florida losses do not reach the
retention, there is no recovery. The benefit of a longer hours
clause to any insurer will depend on the event, book of business and
specific reinsurance terms, but usually longer is better for cedents.
For the exception, consider the insurer who already exhausted
reinsurance limits with Gulf Coast losses. Adding in the Florida
claims does nothing to change the result--it is still net loss.
Since longer is usually better, insurers may seek longer hours
clauses and some reinsurers may revert back to 72-hour limits.
Higher reinsurance security: The initial
wave of rating agency actions leaves fewer reinsurers firmly in the
“A” and higher categories6. A.M. Best downgraded two reinsurers
to below “A” and placed 22 companies under review with negative
implications; three additional reinsurers already under review are
on notice that the agency will focus on Katrina losses. Standard
& Poor’s downgraded three reinsurers and placed eight
companies on credit watch with negative implications.
Before Katrina, S&P raised its risk-based
capital calculations for reinsurers. Aggregate exposure is now
measured on the basis of a more extreme event combined with all
occurrences for that year. This higher RBC standard has the effect
of raising PMLs for financial strength calculations, which in turn
raises the ratings bar for reinsurers. Fewer reinsurers will make
the “A” grade but insurers should have more comfort doing
business with those reinsurers that do.
These are uncertain times for insurers and
reinsurers, and not just because of natural catastrophes. The
question of terrorism coverage looms large as expiration of TRIA
approaches. If TRIA is not renewed, reinsurance capacity will be
curtailed further for many of the same property per risk and
property catastrophe programs battered by Katrina, and to some
degree for casualty business.
In uncertain times, there is great value in
having firm offers in a reasonable time frame. If a promise of a
renewal quote by December 21 is not kept, there are fewer options
left in a tight market. The earlier reinsurance markets are
approached with quality submissions, the more time and options
exist, allowing the insurer to be selective in a market dominated by
reinsurer decisions. Supply and demand are economic forces driving
the broad reinsurance market, but individual insurers can still
perform better than market to secure reinsurance protection for the
2006 renewal season.
Tom Hulst is a vice president and treaty
account executive based in Stamford, Conn. and is responsible for
treaty reinsurance in the Mid-Atlantic region. Tom also serves as
Gen Re’s property catastrophe business development specialist.
1 As of October 13, RMS estimates
Katrina insured loss at $40 - 60 billion, and AIR at $34 billion.
See also Towers Perrin, “Hurricane Katrina: Analysis of the
Impact on the Insurance Industry” (Oct. 2005).
2 AIR Worldwide, AIR Worldwide Estimates Total Property
Damage from Hurricane Katrina’s Storm Surge and Flood at $44
Billion (Sept. 29, 2005) at www.air-worldwide.com.
3 National Oceanographic and Atmospheric
Administration, at www.aoml.noaa.gov. For frequency statistics,
see NOAA; for cost statistics, see Insurance Information Institute
at www.iii.org.
4 For statistics on coastal population and property
value growth, see AIR, “The Coastline at Risk: Estimated Insured
Value of Coastal Properties” (Sept. 21, 2005) at www.air-worldwide.com;
and NOAA, “Population Trends Along the Coastal United States:
1980 - 2004” (Sept. 2004) at www.noaa.gov.
5 “Towers Perrin Report: High-Level Katrina Losses to
Take Lighter Toll on Reinsurers,” BestWire Services (Oct. 7,
2005).
See Towers Perrin Katrina
report, Note 1, for collective rating information.
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by Thomas A. Hulst
