Articles - Catastrophe Risk Trends in Insurance, Finance, and Modeling

   

  It’s estimated that there was over $250 billion of economic loss world- wide associated with catastrophes in 2010—only $38 billion of it insured. The cause was a succession of meteorological and geological evils of seemingly biblical proportions: five severe weather events (tornadoes, hail, severe thunderstorm winds), one major winter storm (snow, icing, cold temperatures, and damaging winds), two earthquakes, and two floods, layered on top of lesser winter storms, severe weather, flooding, tropical cyclone activity, earthquakes, and wildfires.

  Looking ahead, the Tropical Meteorology Project at Colorado State University forecasts the 2011 hurricane season will be exceptionally active. It’s been five years since a major hurricane has struck the U.S. coast. Are we due? And, more important, what should we do?

  Managing Catastrophe Risk

  Catastrophe risk increasingly is on many governments’ radars. In 2010, for instance, Brazil authorized a $2.3 billion disaster fund for weather risk and agriculture. The Indian government was in contact with Swiss Re last year about writing catastrophe bonds, and according to the Weather Risk Management Association, the Indian weather risk market could grow in several years from a few hundred million dollars today to $2.0 billion.

  “The concept of using weather risk management tools is being accepted by more and more organizations around the world,” says Sandeep Ramachandran, director of property and specialty at Swiss Re.

  Countries in the Asia Pacific region are particularly vulnerable to weather risk. Subject to some of the most devastating catastrophes in the world, many Asian Pacific countries, according to a recent Guy Carpenter study, also are significantly underinsured for cat risk. China is one of many countries that could benefit from a national catastrophe insurance pool but has been unable to reach consensus on how to go about establishing one. A study of crop insurance in China that was published by Berlin’s Humboldt University in 2010 cited 17 distinct Chinese agricultural regions that are subject to systemic weather risk. This diversity makes affordable crop insurance prohibitive and a national cat pool difficult.

  Even developed nations and their political subdivisions are reconsidering their options. In the wake of Hurricane Andrew in 1992, Florida established the Florida Hurricane Catastrophe Fund. More recently, in an effort to entice global reinsurers to write Florida business, Florida legislators have reduced col- lateral requirements. In Australia, which suffered some $6 billion worth of damage in recent flooding, the government is considering a tax on Australians above a certain income level to help pay for rebuilding the country. When interviewed on a local Australian radio show, Mark Senkevics, head of Swiss Re in Australia and New Zealand, disagreed with that strategy. “We would like to see some form of insurance from government rather than a levy after the event,” Senkevics told radio listeners.

  Insurance or Investment?

  Most catastrophe risk that’s covered by the insurance industry is still written as traditional insurance/reinsurance, rather than financed through securitization. Because of excess industry capital, rates for such coverage declined again in 2010. At the beginning of 2011, it was expected that rates would continue to soften, owing mostly to surplus capital and the absence of large-scale cat events. Elena Didita, a director at Everest Re who specializes in catastrophe modeling and reinsurance analysis, says there were few surprises coming out of the January 2011 renewal season.

  “Traditional reinsurance market clients bought limits and structures very comparable to last year,” Didita says, explaining that one reason for this was the presence of attractive pricing for covers. Some other factors being weighed by experts, Didita says, are the presence of excess capital and the absence of large-scale loss events in the United States.

  Tim Pollis, a fellow of the Casualty Actuarial Society and a vice president at Willis Re in Minneapolis, agrees. “The market seems to be overcapitalized for P/C reinsurance in total. On top of that, some reinsurers are reallocating capital internally from casualty towards property, where the rates aren’t as soft and the tails are shorter,” he says, noting that “within property reinsurance, this increases the overcapitalization.”

  At the same time, the alternative risk transfer market, in which cat risk is seen as an investment vehicle, has exploded. Re- insurers represented 25 percent of investor market share in 2010, while funds dedicated to insurance-linked securities took 46 percent. Low interest rates and difficult traditional bond markets have helped to encourage investors to look at the securitization market. The Cayman Islands are the leading offshore market for listed catastrophe bonds. There are more than 70 bonds, with a value totaling more than $7 billion, listed on its stock exchange. This dwarfs Bermuda’s less than $2 billion market for cat bonds, although Bermuda is working to become the preferred domicile for insurance-linked securities.

  While there is a relatively small group of funds that specialize in insurance-linked investments, the market is maturing rapidly. Frank Majors of Nephila Capital, quoted in a Jan. 6, 2011, article in the New York Times, said, “We’ve graduated from the science project mode of the early 2000s to being an actual market.” Nephila Capital currently manages approximately $3 billion of insurance-related investments.

  New financial products are being considered at the home- owner level, as well. Weather Risk Solutions’ hurricane risk landfall options (Hurlos) are available for sale as complementary insurance to homeowners when a hurricane threatens landfall. (The CME Hurricane Index is used as the basis for hurricane futures and options traded on the Chicago Mercantile Exchange.) The group of homeowners that guesses the areas of landfall correctly shares the proceeds of the Hurlo.

  There are some fears that the Dodd-Frank Wall Street Reform and Consumer Protection Act—or some other government intervention—could hamper the nascent catastrophe finance industry through calls for increased transparency. Hedge funds don’t seek exceptional sunshine on their transactions, and some say that derivatives laws that have as-yet unknown side effects may make insurers and institutional investors timid about entering into catastrophe bond agreements. This pessimistic scenario, however, remains speculative. And according to an article that ran in Best Wire on Jan. 17, 2011, Willis Capital Markets expects investors to shrug off Dodd-Frank considerations and plow ahead.

  Turning advantage into opportunity

  There are many elements to consider when issuing insurance- linked securities. In an excellent online article published in Q Finance, Morton Lane, a director of the master’s program in financial engineering at the University of Illinois, detailed the following:

  ·   Identify risk concentrations      

  ·   Quantify the loss consequence of such concentrations

  ·   Design an offsetting structure to transfer risks to capital markets with the help of agents

  ·   Engage a placement agent or investment banker

  ·   Engage a risk-modeling firm

  ·   Decide on the denomination of loss measures

  ·   Choose your investment vehicle location (often the Cayman Islands or Bermuda)

  ·   Review structure, design, price, and alternatives to ensure suitability.

  Solvency II, the set of European insurance regulations set to go into effect in 2013, should increase demand for insurance-linked securities. Solvency II is expected to more fully acknowledge capital market solutions in calculating insurers’ and reinsurers’ required capital. But under proposed Solvency II rules, European insurers will have to be prepared for a $50 billion local catastrophe. That’s expected to soak up a lot of capital.

  “With Solvency II impacting not only European entities— Bermuda would soon follow, is the widespread opinion—and bringing ever closer scrutiny of cat risk to the forefront of executives’ agendas, the question remains whether the industry (primaries, reinsurers, brokers) needs additional impetus to continue refining, investing resources, and innovating the way cat risk is analyzed, measured, and transacted,” says Didita of Everest Re. “That impetus has, many times, been in the form of a significant event or an aggregation of sizable occurrences,” Didita continues. “Do we have the wisdom to act before it happens? Right now, we have the advantage of foresight (the most tools available ever), insight (cat risk analysis is practiced, at least in theory, at all points of the chain of information in the industry), and hindsight (past events have been analyzed and reanalyzed extensively). Will we turn these advantages into opportunities?”

  Some companies, it seems, are. In Singapore, for example, Aon Benfield has sponsored research on catastrophe risk at the Institute of Catastrophe Risk Management and at Nanyang Tech. The Global Earthquake Model and OpenGeo have partnered on web-based applications. And the Willis Research Network, a subsidiary of the global insurance and reinsurance broker Willis Group, is supporting academic research and the development of new risk models and applications in the area of climate and weather risk at a consortium of more than 20 universities. The group’s intent, according to its website, is to encourage collaboration among universities, insurers, reinsurers, catastrophe modeling companies, government research institutions, and other nongovernmental organizations in the area of climate risk.

  Modeling the Risk

  Not surprisingly, growth in the alternative risk transfer market has sparked similar growth in catastrophe modeling. Willis Re has released detailed models of Latin America cities such as Bogotá, São Paulo, and Santiago. Aon Benfield has put together a comprehensive typhoon risk model of Asia, while Equecat’s 2010 Asian typhoon model received the innovation of the year award from the Asia Insurance Review. In other recent action:

  ·   AIR, the Boston-based catastrophe-modeling firm, has updated its European wind risk model to include the   results of engineering studies and building code data.      

  ·   Guy Carpenter, along with JBA Consulting and Intermap Technologies, has launched a probability flood model of France.

  ·   Aon Benfield has identified Japan, Chile, Indonesia, the Caribbean, and Cascadia in the Pacific Northwest as regions where mega-earthquakes most likely will occur.

  ·   GfKGeoMarketing has designed a more precise map of the Philippines—an area that is especially susceptible to weather risk—that can be used inside existing catastrophe models.

  ·   The University of Nevada, Reno is creating a U.S. earthquake simulation facility that by 2013 should allow for bigger scale models of buildings and bridges.

  ·   The Institute for Business & Home Safety is building a facility in South Carolina in which actual hailstorms, wildfires, wind- driven rain, hurricanes, and other windstorms can be created.

  ·   The M8 earthquake simulation unveiled at the Supercomputing 2010 conference promises better earthquake models through improved computation.

  On the theory that more information is a good thing, it’s hard to argue against this profusion of models. But some have. Karen Clark & Co., a consulting company formed by Karen Clark, the founder of AIR, has criticized the catastrophe risk modeling industry for what it calls the “hurricane frequency paradox.” Modeling firms may be seeing increased catastrophic activity because they are better able to detect and measure activity—not necessarily because the level of activity has in- creased. The paradox is most visible in models that show landfall activity as decreasing, despite increasing observed hurricane frequencies.

  Karen Clark & Co. argues that modeling firms have overestimated the Atlantic hurricane risk in the United States over the past five years—in which insured losses were significantly lower than projected. In a blog posted on the Lloyd’s website, Trevor Maynard, manager of emerging risks for Lloyd’s, responded to this criticism by using a single die example: Even though the expected value of a single die roll is 3.5, you could still roll it several times and have it average out to be significantly less than 3.5. That outcome, however, doesn’t necessarily mean that there is anything wrong with the original die. Trends for catastrophe risk in insurance, finance, and modeling all clearly show strong growth. On the theory that an ounce of prevention is worth a pound of cure, this is something in which all can take some comfort.

  Claude Penland is an associate of the Casualty Actuarial Society and a member of the Academy. He manages the Pittsburgh-based industry news website, ClaudePenland.com, and reports on catastrophe risk trends at CatRisky.com.

  Editor’s Note: This article was already written and in layout when the March 11 earthquake and ensuing tsunami struck the Japanese coast. Some of the information in the article about the potential for large-scale cat events in 2011 is therefore outdated.

   

  Resources

  Ahmed, Azam, “Investors Bet on Catastrophe Bonds,” New York Times, Jan. 6, 2011. http://nyti.ms/g3pp5j

  “AIR Unveils Enhanced European Cyclone Model,” National Underwriter Online News Service, Sept. 15, 2010. http://bit.ly/eyY40L

  “Asia cat losses are significantly underinsured,” Reuters, Oct. 26, 2010. http://bit.ly/hjKOeB

  Bradshaw, Gavin, “Kane to pursue ILS/ ILW Business in Middle East,” Captive Review, Sept.17, 2010.       http://bit.ly/gSug5L

  “Brokers Foresee 2011 Surge in Insurance-Linked Securities,” Bestwire, Jan. 17, 2011. http://bit.ly/ft3epU

  “Catastrophe Bonds advised for Australia, says Swiss Re,” Artemis, Feb. 10,2011.http://bit.ly/gYVtQB

  Ellis, Amy, “Aon Benfield annual cat report reveals $38bn loss for (Re)insurers in 2010,” Postonline.co.uk, Dec. 16,  2010.http://bit.ly/fv7sFq

  Finkel, Lori, “Aon Benfield Produces Asian Risk Model,” Insurance Networking News, July 22,2010.http://bit.ly/gX4lSC

  “Florida Hurricane Insurance: Fact File—2010,” Insuring Florida.org, June 2010. http://bit.ly/hg20Pb

  Gould, Jonathan, “Hannover Re sees boost from New York insurance rule,” Reuters, Jan. 11, 2011. http://reut.rs/fgmSnt

  Hofmann, Mark, “Forecaster sees very active 2011 hurricane season,” businessinsurance.com, Dec. 8, 2010.http:// bit.ly/eocAZ6

  “HURLOs want to bring hurricane hedging to everyone,” Artemis, Aug. 27, 2010.http://bit.ly/bCPB8R

  “Indian Weather Market Could See Dramatic Growth, Says Weather Risk Management Association,” World PRwire, May 11, 2010.http://bit.ly/eoNusW

  “Karen Clark & Company Issues Third Annual Report Examining Performance of Near Term Hurricane Models,” Business Wire, Jan. 18, 2011. http://bit.ly/hA3NIT

  “Keeping Up With Changing CAT Modeling Technology,” Insurancenewsnet.com, Nov. 1, 2010. http://bit.ly/hum4c9

  “Lane, Morton, “Issues in Issuing Insurance-Linked Securities,” QFinance, http://bit.ly/hsxfeN

  “‘M8’ Earthquake Simulation Breaks Computational Records, Promises Better Quake Models,” Science Daily.com, Nov. 23, 2010.http://bit.ly/dhN1WZ

  “Maynard, Trevor, “Dice Seriously Underestimating Risk,” Lloyd’s blog, Jan. 21, 2011.http://bit.ly/eCPTlE

  “Mortimer, Sarah, “New investors help to spur growth in cat bond sector,” Reuters, Jan. 24, 2011. http://reut.rs/h0qW0t

  “New maps of the Philippines support insurers assessment of Cat risk,” GISLounge.com, Sept. 15, 2010. http://bit.ly/hOxRzA

  Suess, Oliver, “Solvency II Tests European Insurers With EU36.7 Billion Storm,” Bloomberg, Oct. 25, 2010. http://bloom.bg/e26oza

  “Swiss Re said to be in talks with Indian government about catastrophe bond cover,”     Artemis,  Nov.17, 2010.http://bit.ly/chx2TB

  “World Catastrophe Reinsurance Market: Part III, Catastrophe Model

  “Developments, Impact of Changing Regulations,” GC Capital Ideas.com, Sept. 22, 2010.http://bit.ly/btgQUS

  Xu,Wei, Okhrin, Ostap, Odening, Martin, and Ji, Cao, “Systemic Weather Risk and Crop Insurance: The Case of China,” Humboldt University, Berlin, October 2010.                     http:// bit.ly/gXMU3P