Catastrophes __________ Finance 431

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Catastrophes __________ Finance 431
Property-Liability Insurance Spring 2005James
Matusiak FCAS,MAAASenior Vice President Chief
ActuaryPXRE Reinsurance Ltd.
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Introduction

• What is a Catastrophe
• Insuring Catastrophes
• Managing Catastrophe Risk
• Reinsurance
• Case Studies
• Final Points

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What is a Catastrophe?

• CATASTROPHE   
• A great, often sudden calamity.
• A complete failure a fiasco The food was cold,
  the guests quarreled the whole dinner was a
  catastrophe.
• The concluding action of a drama, especially a
  classical tragedy, following the climax and
  containing a resolution of the plot.
• A sudden violent change in the earth's surface a
  cataclysm.
• U of I losing in the NC game.
• Insurance Services Office defines a catastrophe
  as an event causing insured losses greater than
  25 Million.

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What is a Catastrophe?

• Types of Catastrophes Traditional
• Hurricanes / Typhoons
• Earthquakes
• Floods
• Tornados
• Man-made (fires, explosions)

• Types of Catastrophes Alternative
• Terrorist Acts
• Asteroids
• Tsunami
• Power Outages

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What is a Catastrophe?

• The Costs of Catastrophes
• Property Damage
• Homes Most losses except for flood are covered
  by a traditional homeowners policy. Storm Surge
  during a hurricane is considered flood and not
  covered.
• Cars - Vehicles are covered for most events.
• Commercial Structures Commercial buildings and
  structures are generally covered for most events
  including flood.
• Human Casualties
• These may not correlate with economic loss
  (Tsunami, Galveston TX 1900)
• May have incidental impact on insured losses
  (Life insurance, casualty damages)

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What is a Catastrophe?

• The Hidden Costs of Catastrophes
• Demand Surge An increase in prices due to an
  shortage of the supply of labor and materials
  following a catastrophe.
• Business Interruption Loss of income related to
  damage to a commercial structure is usually
  covered as part of a commercial property policy.
  Other incidental loss such as lost tourism is not
  covered.
• Workers Compensation Any worker who is injured
  by a catastrophe while at work is entitled to
  benefits.
• Loss adjustment expenses Insurers usually spend
  a large amount of money to service policyholders
  following a catastrophe.

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What is a Catastrophe?

• The Rising Costs of Catastrophes The economic
  costs of covering catastrophes is outpacing
  inflation for the following reasons.
• Demographic Shifts Populations are moving into
  more catastrophic exposed regions.
• New Perils The emergence of new potential
  risks, such as terrorism increase the expected
  catastrophic loss.
• Global Economic Development As countries
  develop economically the amount of exposed
  property increases. This property is generally
  covered by an insurance vehicle.

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What is a Catastrophe?

• Financing the Costs of Catastrophes
• Public Individuals pay premiums for insurance
  to cover their personal property from damage due
  to catastrophes and other perils.
• Government Uninsurable perils such as flood and
  war are generally covered by the government. The
  government may also subsidize private insurers
  (ie TRIA, FHCF)
• Insurers Investors put capital at risk in the
  form of insurance/reinsurance companies (or cat
  bonds) to make an adequate return.

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Insuring Catastrophes

• The Insurance Mechanism THE PLAYERS

Government
Taxes
Losses
Primary Insurance Company
Policyholder
Premiums
Losses
Premiums
Reinsurer
Losses
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Insuring Catastrophes

• The Insurance Mechanism The Nature of the Game

• Year-to-year underwriting results for a
  catastrophe exposed insurer are much more
  volatile.
• Investors generally demand a higher return for
  the additional volatility.
• To manage the risk of catastrophes insurers have
  several options
• Do not write in catastrophe exposed areas.
• Limit writings in catastrophe exposed areas.
• Buy reinsurance.

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Managing Catastrophe Risk

• In the past insurers used to look at long term
  analysis of catastrophe data to assess the cat
  potential and price insurance. This technique
  may still be used to price freeze and or tornado
  risks.
• Today computer models dominate the risk
  management landscape of the property catastrophe
  insurance markets.
• There are a handful of models available although
  three companies dominate the market (AIR, RMS,
  EQECAT).
• The models are stochastic in nature and estimate
  damages for thousands of years at a time. This
  gives a picture of not only the average of
  expected value but the entire loss distribution.

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Managing Catastrophe Risk

• These models have two main components. Peril
  scenario generators and damage functions.
• The peril scenario generators model hurricane
  path and windspeed for storms and earth movement
  for earthquakes.
• Often historical records are scrutinized and
  thousands of years of geological data are
  considered.

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Managing Catastrophe Risk

• The damage functions are engineering functions
  that estimate the percent of structure damage for
  a given windspeed or earth movement.
• These are often a function of a structures
• Location
• Age
• Class
• Construction

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Managing Catastrophe Risk

• Key Terms
• Expected Loss Mean of average loss for a given
  year.
• PML (Probable maximum loss) This is generally
  stated with an associated annual frequency.
• 250 Year PML 500 Million
• 500 Year PML 1,500 Million

• These imply
• On average a loss of at least 500 Million will
  occur every 250 years.
• On average a loss of at least 1.5 Billion will
  occur every 500 years.

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Managing Catastrophe Risk

• Exceedance Curves

• An insurer would input information on his book of
  business into the model.
• The output would include expected value estimates
  and an exceedance curve similar to the one of the
  left.
• Using management judgment and risk tolerances the
  insurer can begin to manage its risk.

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Reinsurance

• A Typical Reinsurance Program for a Primary
  Carrier

• This program would be stated as follows
• Reinsurer A is taking an 80 share of the layer
  80x20. This translates into Reinsurer A is
  reimbursing the primary carrier for losses in
  excess of 20 Million per occurrence up to a
  limit of 80 Million.
• Reinsurer B is taking an 80 share of the layer
  40x100.
• The primary insurer is responsible for any losses
  in gray or above 140 Million.

140M
Reinsurer B
100M
Reinsurer A
20M
0
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Reinsurance

• A Typical Reinsurance Program for a Primary
  Carrier

• Coinsurance
• Primary insurers are usually not able to cede
  100 of the loss. The portion they retain in
  called coinsurance.
• Coinsurance is required to avoid the two
  following forms of adverse selection.
• Writing large amounts of catastrophe exposed
  risk because they have reinsured the risk away.
• Not controlling losses during the claim
  settlement process after the event has occurred.

140M
Reinsurer B
100M
Reinsurer A
20M
0
Coinsurance
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Reinsurance

• Common Terms of a Property Catastrophe Treaty
• Per Occurrence They only cover losses from a
  distinct catastrophic event.
• Excess of Loss They have a fixed limit of
  coverage and have a fixed retention.
• Two Loss Warranty At least two insured
  structures must be damaged for the treaty to
  apply. Catastrophic damage to a single structure
  is covered by facultative contracts or risk
  excess treaties.
• Covers losses for a distinct period (usually 12
  months) regardless of when the underlying policy
  was written.

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Reinsurance

• Common Terms of a Property Catastrophe Treaty -
  More
• Reinstatement Provisions Should one event occur
  that causes losses to the policy, the reinsurer
  must offer an additional reinstatement of the
  limit at the premium rate. The reinsurer is
  usually forced to offer one reinstatement. After
  two events the primary insurer must renegotiate
  another treaty.
• Hours Clause An hours clause defines the
  duration of the catastrophe. This is typically
  72 hours. The retention and limit apply to all
  losses during the occurrence. Should the
  catastrophe last more than 72 hours, the limit
  may be reinstated.
• Follow the Fortunes (Found on most reinsurance
  contracts) Should a coverage dispute
  adversely/favorably impact the primary company,
  the reinsurer will follow the fortunes of its
  customer.

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Reinsurance

• Property Catastrophe Reinsurance
• Rates on a property catastrophe treaty are
  typically quoted using the term Rate On Line.

RATE ON LINE
TREATY PREMIUM

TREATY LIMIT
Roughly equal to the probability of payment.
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Reinsurance

• Property Catastrophe Reinsurance
• Property catastrophe reinsurers take a large
  amount of financial risk

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Reinsurance

• Property Catastrophe Reinsurance
• Property catastrophe reinsurers take advantage of
  geographic diversification. They write treaties
  all over the world with the idea that Japan is
  not correlated with Florida is not correlated
  with California. This is simple financial
  management. Adding uncorrelated risks decreases
  the overall volatility of the portfolio.
• Property catastrophe reinsurers are not in a
  position to take large amounts of investment
  risk. Should a catastrophe occur they require a
  large amount of cash in a short period of time to
  pay claims.
• Property catastrophe reinsurers use
  retrocessional, or reinsurance of reinsurance, to
  manage risk.

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Reinsurance

• Industry Loss Warranties
• Industry loss warranties pay a fixed amount based
  of the amount of industry loss. For example, a
  20 Million ILW with a 5 Billion trigger, would
  pay the purchaser 20 Million in the event of a
  5 Billion or greater industry loss.
• Industry loss amounts are published by PCS
  (Property Claim Services) for US losses and SIGMA
  (a division of Swiss Re) for other losses around
  the world.
• These expose the purchaser to basis risk, or the
  risk that the purchaser has a large loss but the
  industry does not.
• These are currently an easy way to enter the
  property catastrophe reinsurance market. Many
  hedge funds are getting into this arena.

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Reinsurance

• Property catastrophe reinsurance suffers from
  market cycles where prices fluctuate.
• This fluctuation is caused by a buildup of
  capital if it has been some time since the last
  catastrophe.
• Reinsurers need to make an adequate return on
  their capital so they either need to write more
  premium (increase supply) or return capital to
  shareholders.

• Market Cycles

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Reinsurance

• Cat Bonds
• Bonds issued to cover catastrophe risk were
  developed subsequent to Hurricane Andrew. These
  bonds are structured so that the investor has a
  good return if there are no qualifying events and
  a poor return if a loss occurs. Losses are
  triggered on an industry index.
• The advantage of these vehicles is that you gain
  access to the large capital available in the
  financial markets and that the bonds diversify a
  standard investment portfolio.
• The disadvantages is that they expose the issuer
  to basis risk, they have large issuing costs and
  that they are not readily understood by the
  investment community.

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Case Studies

• Hurricane Andrew 1992 A painful lesson for the
  industry
• Recently re-categorized as a Category 5
  hurricane.
• Eleven property casualty insurers became
  insolvent.
• Eradicated every dollar of profit ever made on
  homeowners insurance in the State of Florida.
• Spurred the proliferation of catastrophe
  modeling.
• Increase the amount of reinsurance purchased.
• As a result the State of Florida created the FHCF
  (Florida Hurricane Catastrophe Fund) to provide
  subsidized reinsurance to the homeowners
  insurance industry.
• After Andrew insurer implemented hurricane
  deductibles to reduce the annual premiums. This
  increased the burden on homeowners.

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Case Studies

• World Trade Center 2001 More painful lessons
  for the industry
• Largest single loss in US history. 32.5 Billion
  in insured loss.
• Effected several lines of business, including
  workers compensation, life insurance, aviation,
  business interruption.
• Several coverage disputes remain to be settled.
• As a result, the US Government created the TRIA
  (Terrorism Risk Insurance Act) to provide a
  backstop for the insurance industry in the event
  of terrorist acts.
• Subsequent to WTC, billions of dollars of capital
  flowed into the industry to replace the capital
  lost.

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Case Studies

• 2004 Still assessing . . .
• Worst worldwide natural catastrophe year in terms
  of insured loss.
• Massive loss of life due to the Tsunami in Asia.
  Due to the underdevelopment, the insured loss was
  relatively low.
• Four major hurricanes struck the US.
• Massive damage to Grenada, Grand Cayman and gulf
  oil assets.
• Eradicated every dollar of homeowners
  underwriting profit made since Hurricane Andrew
  in 1992.
• The reinsurance industry was largely unaffected
  by the loss.
• Large amount of political pressure regarding the
  financial burden of multiple hurricane
  deductibles.
• The catastrophe models were shown to have
  deficiencies in producing timely loss estimates.
• Demand surge was severely underestimated and was
  as much as 30 for the later storms.

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Final Points

• The coverage of catastrophes is an evolving
  process.
• Catastrophes are highly political.
• Catastrophe risk effects all industries.

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Final Points

• If anyone has any additional questions or
  comments please feel free to contact me
• James Matusiak
• PXRE Group Ltd.
• PXRE House
• 110 Pitts Bay Road
• Pembroke HM08
• Bermuda
• [phone]
• james.matusiak_at_pxre.com