Reinsurers are taking a new view of aggregates in the wake of last year's catastrophes. By Adrian Leonard.

Conventional wisdom once dictated that the maximum foreseeable loss from Manhattan's World Trade Center was about a hundred million dollars. Insurers imagined that a fire could damage maybe ten floors of one of the Twin Towers before it was contained. No underwriter's nightmare scenario included the collapse of even one of the landmark skyscrapers, let alone both.

This is not the only assumption that has been proved false in recent months. Despite the widespread market understanding that contingent business interruption (BI) would one day blow up, few underwriters bothered to admit it.

The potential for nasty correlation between workers' compensation and catastrophe risk was broadly acknowledged, but almost nobody was sufficiently concerned to do anything about it. Credit and surety risk generally was seen as a relatively safe and profitable corner of the market, until many carriers were hit hard on both halves of the balance sheet when Enron fell. Overall, 2001 was characterised by the repeated shaking of soft-market complacency by unexpected events.

Swiss Re: back to basics
"Our first reaction was to go back to basics with respect to conditions," said Alfred Bloch, head of group risk management at Swiss Re in Zurich. "At the 1/1 renewal, we made changes with respect to what is covered and what is not. Now we have to determine what was achieved, and what the risk landscape looks like. Nobody thought about it during the soft market."

Swiss Re will focus on two areas: the potential for extremely large losses from individual risks, and for accumulation when a massive event causes losses over a whole district or city. In principle, the former can be addressed through limits, such as for terrorism. Mr Bloch said that has largely been achieved since September 11. "Most underwriters have successfully introduced sub-limits for terrorism, in the region of the estimated maximum fire loss." Those wanting more cover must buy it explicitly, and at Swiss Re such exposures are subject to "fully-fledged accumulation control".

The potential for district-wide losses is more complicated. "If a whole quarter is bombed and cannot be used, it is a huge issue for business interruption," Mr Bloch said. "We are only at the starting point on such risks. We imagine we will have to introduce regional limits for certain perils." Such territorial limits are not a new concept - consider natural catastrophe - but Mr Bloch suggested existing controls are insufficient. "It is not only terrorism. Fire is not under control on a regional level." He mentioned dramatic fires in Oakland, California about a decade ago, and more recent fires in Sydney. "You have all kinds of accumulations in the portfolio that are extremely difficult to control."

For terrorism exposures, Swiss Re intends to limit its exposures by city as well as by account.

Work is ongoing to assess other perils, and will culminate in mid-year proposals to the Executive Board in advance of 2003 renewal planning. Practitioners from across the group began to meet in late March in a series of `what-if' workshops to consider what could go catastrophically wrong in their line of business, and to explore how it could impact on other lines. Yet Mr Bloch did not wish to add too much egg to the pudding.

"I have my doubts about the overall interline accumulations. We have correlations, as we do with all catastrophe events, but for Swiss Re WTC is still, primarily, a property event."

SCOR: industrial v urban
Other reinsurers are similarly sanguine, focussing on the detail. Serge Osouf, president and chief operating officer of SCOR, said the group has not substantially changed its approach to aggregate assessment, but has realised that accumulation can occur in places other than heavy industrial zones. "We were always careful about property and contingent business interruption in industrial environments," he said, "but WTC and Toulouse have brought to light that accumulation is a risk also in urban areas." While stressing that SCOR has not suffered badly from either event, he pointed out that the Toulouse loss on September 21 last year, where damage stretched to a three kilometre radius around the chemical fertiliser plant, highlights the need to consider correlation of property losses with life and liability lines.

SCOR has begun a programme to identify potential hot spots for urban and industrial accumulation, both in general and in its portfolio. "The exposure in industrial platforms is well known and understood, whether it is chemical or petrochemical exposures such as Houston and Rotterdam, or natural perils, like earthquake in Taiwan and Silicon Valley," Mr Osouf said, "but we need to take into account the concentration of populations in administrative platforms like New York, Tokyo, the City [of London] and La Défense [in Paris]. They have a high concentration of values and a very large accumulation of people."

In practice, that means using scenarios to model the cost of a tower collapse or a big explosion in all of the exposed zones identified, calculating losses from property damage, BI, personal accident, life and other lines. "These are the scenarios we are trying to build up. If the risk is not variable, we will have to decide whether to reinsure it, or not to cover it, and if we do cover it, what to charge." SCOR's catastrophe accumulation team is working on the model, but the challenge is complicated because primary premium loadings for catastrophic events rarely last. "Large losses create a disruption in statistical data, so you need a special load over many years to account for the accumulation of values. But the extra premium for big risks tends to disappear in a soft market."

SCOR is working to ensure underwriting practice is disciplined, he said. "Too many soft market blanket polices were issued and unnamed properties insured under property covers and general contingent business interruption policies. There should be greater transparency in this potential exposure. Wordings need to be tightened." Mr Osouf said SCOR has begun to be "much more restrictive with fringe covers and frills," by identifying them and ensuring they are priced, curbed or limited. "We believe the industry in general should pay more attention to these exposures."

Hannover Re: capital-based approach
Hannover Re Executive Board member Jürgen Gräber said the WTC loss prompted his company to revise its risk-based capital system. "We have allocated higher capital costs to our writings, which indirectly says that we assume there is a higher correlation, and a higher clash situation." Like the others, Hannover Re's response is two-phased: an initial reactive adjustment, followed by supplementary fine-tuning based on actuarial analysis. "We asked, what would lead to stability for our capital allocation model? We calculated that a 76-year return period would lead to a stable capital model, moved it forward to a significantly shorter return period, and artificially fixed it to a date where we want it to be."

In short, Hannover Re's loss assumptions have changed. "We have revised our claim expectation, the basic underlying calculation of long-term burning cost. That number is loaded for administration costs, for contingencies, and for capital costs and brokerage, so the new capital cost is now part of our quotation process," Mr Gräber said. The result is that Hannover Re has changed the parameters of its pricing software, in some cases doubling the capital cost of its underwriting.

While the pricing engine calculates, Hannover Re's accumulation control system assesses correlation. "We looked again at correlation factors, during a strategic retreat of the Executive Board, and identified positive correlations in all of the property/casualty segments." Those correlations had already been identified, but have been recalculated, Mr Gräber noted. "A higher positive correlation means you have to reduce the assumed benefit of diversification, and increase your writing of uncorrelated exposures to balance it." In addition, Hannover Re has calculated the potential clash between life reinsurance and property/casualty lines, and found very little positive correlation in its own portfolio.

Responses included a reassessment of the reinsurer's group-wide combined ratio volatility, and the redefinition of an acceptable level of volatility over the entire distribution curve. "Depending on whether the volatility arising from the portfolio is acceptable or not, we will either reduce our writings, or buy limited retrocession. But we basically monitor our aggregates on a gross basis," Mr Gräber said. As with all the reinsurers questioned, he highlighted the need for transparency of risk data. "We can only be as good as the data we get. We will ask all our customers to supply even more information on the top risks worldwide."

GE ERC: workers' comp
In the US, questions about correlation have renewed concerns about workers' compensation. Hoyt Wood, executive vice president of GE ERC Global Underwriting, said his company had beefed up its efforts to get a better understanding of its workers' comp exposure. GE is involved in the market both as a primary and excess insurer, and as a reinsurer, and has taken a tough line of late. "At every level we demanded more information on where the exposures are, and will continue to be more diligent."

Previously the geographic risk data GE had required was limited to payroll figures broken down by state. But that was insufficient for accurate assessment of urban exposures. "Workers are on the move, and it is hard to be very precise, but clearly we can get much better. For clients with a large risk, we will demand more information," Mr Wood said. Already the effort has impacted on underwriting decision-making. "Where we find huge accumulations, we are narrowing our limit, or simply withdrawing."

Going forward, modeling the impact of catastrophic events on workers' compensation portfolios will become more important. "The catastrophe modelers are developing workers' compensation models, and we are testing one of those," he said, adding that work on correlation between catastrophe and workers' compensation is long overdue. "The industry has been worried about natural catastrophe and workers' comp as long as I have been involved, but, typically for our industry, didn't do much about it. Modelers are just now getting off the ground in terms of overlaying population demographics with hurricane and earthquake exposures."

An accumulation monitoring system for workers' compensation is in the pipeline. "For workers' comp catastrophe [that is, reinsurance of insurers' exposure to unlimited workers' compensation liabilities], we can express our limits as an aggregate per occurrence, and when we reach our risk appetite, we quit," Mr Wood said, pointing out his company's recent resolve in the area. "We have seen a lot of opportunities to write workers' compensation cat covers, because the life market [in its appetite for workers' comp cat] has totally dried up. Frankly, we missed a lot of that because we were pretty tough with our game to measure exposure per zone. Going forward, we will be just as diligent in monitoring accumulation as we are with cat." Ultimately, he predicted reinsurers will require cedants to model workers' comp accumulation, just as they do with property cat exposures. "How long that takes to happen, who knows, but ultimately it will."

If workers' compensation was a side issue during renewals, property - and particularly BI - was front-of-mind. However, underwriting choices were based on intuition rather than modeling. "Decisions were made to control exposure, but not in as sophisticated a fashion as we would expect going forward." As in Europe, everyone asked for greater disclosure and tighter terms. "All the markets were tougher on clients in terms of the information they wanted, and primary companies were tougher on the latitude they will give up in their forms. We saw many more standard forms than manuscripted ones, and in BI, a return to the need for true physical damage, rather than contingent BI." Everyone had modeled their BI exposures, but Mr Wood believed none of the models were sufficiently sophisticated to expose the extent of contingent BI exposure. "We need to better understand the models, and the restrictions and underlying assumptions going into them," he said.

Converium: accumulations
From the perspective of Michel Dacorogna, manager of the financial analysis and risk modeling team at Converium, accumulation risk requires attention in three areas: liabilities, assets, and combined exposure in both the asset and liability accounts. "An example is Enron," he said of the latter. "Some insurance companies had surety reinsurance on Enron deals, and also held Enron bonds in their investment portfolio."

Converium tackles each area differently, with liability accumulation risk managed through the pricing process. "We always price our deals against our portfolio," he said. "That favours the spread of risk. We do it in all lines, which should help us find spots where we have less exposure." Converium's credit and surety underwriting team has built a special software tool to control accumulation of credit exposures in the line, which takes into account the unusual feature of the business: exposure is not to the insured, but to third parties. "You can sell to thousands of people, but the exposure tends to be with a few big companies, making accumulation control very important," he said. Converium's tool calculates its exposure to each third party, and couples the findings to those companies' credit risk profiles. "If we see lots of exposure with some risky companies, we first engage in a dialogue with cedants. We might refuse a portfolio because of the exposure."

As for `double exposure' accumulation risk, Converium uses the tool to identify about a dozen large insurance exposures in its portfolio to companies with a higher-than-average default probability, and instructs asset managers to avoid investment in those companies. "You cannot have too big a list, or it restricts the asset manager, so we limit to companies with the largest exposures and the highest risk. That is the most important measure we have for avoiding double exposure." Mr Dacorogna also takes quarterly checks on currency and interest rate risks, to ensure the liability and asset portfolios are adequately matched, or that such accumulations of financial risk are adequately hedged.

Munich Re: terrorism action
"The nature and the dimension of claims after September 11 showed that reinsurers need to give more attention to risk management," a Munich Re spokesman stated. "Claims reached dimensions which had never been regarded as probable. Special emphasis has to be put on the risk of the accumulation of losses stemming from different lines of business, or from insurance and financial risks."

Reinsurers must limit their liability, the Munich declared, stating that risk evaluation had to change, and consequently Munich Re's conditions for reinsuring large commercial risks exposed to terrorism have changed. "These conditions are increased transparency of risks, limitation of liability, extra premium for terrorism cover, and the possibility of cancellation at short notice."

Munich Re will now include in its risk assessment process an examination of terrorism exposure based on several scenarios.

"In particular, we are taking a close look at possible accumulations of risks and newly emerged correlations between lines of business," Munich Re stated, adding that clauses in treaties and facultative contracts granting the right of cancellation at short notice are "absolutely essential to give us the scope to act if a dramatic worsening of the exposure situation threatens us with financial ruin. Reinsurance can at most only cover the first wave of such loss events."

The Munich pulls no punches in its stance on terrorism. "Although there might be different approaches concerning the coverage of terrorism in the insurance market, the more or less uniform opinion says that the insurance industry alone cannot provide full terrorism cover for big industrial risks or large accumulation risks... We are convinced that the new risk dimension coming from terrorism can only be born by all parties involved: insureds, the insurance industry, and the state."

By Adrian Leonard
Adrian Leonard is a freelance insurance journalist and a regular contributor to Global Reinsurance.