Like it or not, Japan is prone to two major natural catastrophe perils: typhoon and earthquake. They present an unchanging potential for major catastrophic loss, and therefore a significant challenge for the nation and its insurance industry. It seems, however, that for many years the awareness level about the financial consequence of a serious earthquake or windstorm has not been high enough to encourage the market to establish a reasonable and sustainable post-loss financing mechanism.

This is partly because Japan has survived many devastating catastrophic events. The Kobe earthquake, the most recent catastrophe in peoples' memory, provides a remarkable example of both disaster and recovery. Unfortunately, commendable physical and financial renewal following a disastrous event can encourage alertness to catastrophe to fade, even though such recovery has nothing to do with the prevention or reduction of natural disasters. The risk remains entrenched, and the ‘so far, so good' philosophy does nothing to guarantee the same end result in the future. Therefore, a strong need for decent catastrophic risk protection remains.

An historic combination of favourable factors has shielded the insurance sector from severe financial damage from catastrophes. It has not been exposed to an imminent requirement to adopt proactive measures to cope with the potential problems brought by cat losses. That has benefited not only the insurers operating in Japan, but also, ultimately, their reinsurers.

Favourable factors
Everything is dramatically different now, as many of the favourable factors have been superseded or materially altered. Policyholders' demands on insurers in the newly-deregulated market have changed significantly. Lasting recession and mounting government debt do not help. As the industry restructures to survive the turbulent environment, market consolidation has accelerated. The concept of the ‘Japanese exception,' once a synonym for all the favourable factors, has become irrelevant. Domestic market movements and the general hardening trend in the global insurance market have triggered reinsurers' attention, and they are reviewing their capacity commitment to Japanese cat exposures.

The change presents multiple challenges both to Japan's primary insurers and to the global reinsurance community. Insurers must consider ways to continue providing meaningful protection that meets policyholders' needs, while giving special consideration to the catastrophe exposures they have accumulated. Reinsurers can no longer maintain a relaxed business attitude based on the ‘overall profitability' of the Japanese market. Gone are the days when a small amount of catastrophe capacity could be allocated in exchange for a large amount of support business, making up a nice slice of a reinsurer's global portfolio.

Views remain divided over the relevance of the typhoons which hit Japan over the past 50 years. Some question whether they represent a standard or exceptional pattern of storm activity, or if the pattern will change differently over time. Storm cover is automatically included in Japanese fire policies, which remain profitable overall when a retrospective, long-term view is taken, without consideration of the impact of deregulation. That profitability has presented a somewhat distorted view of typhoon risk, causing some to overlook its enormous, independent loss potential.

As a consequence, the primary market appears to cover storm peril free of charge, thanks to the overall good result of the fire portfolio. In reinsurance, severe underestimation of typhoon loss potential has often led to a very optimistic view. The result is opportunistic buying of windstorm excess of loss protection, with price negotiation driven mainly by burning cost arguments based on a relatively short observation period, rather than on the underlying loss exposure. Views on the right price for the upper layers, which have not been hit frequently, vary widely. In many cases, the highest limit sought would be insufficient in a worst-case typhoon loss scenario.

Although storm protection is mainly arranged on an excess of loss basis, some attention must be given also to proportional treaties, under which a few large-scale target risks are ceded. Assessment of the catastrophe loss potential of these treaties is difficult. The high quality of the target risks they protect – in terms of loss vulnerability – means it is fair to assume that the storm loss propensity of such proportional treaties is relatively low, at least compared to the general portfolio. However, if a target risk was badly hit the impact would be enormous.

Earthquake estimates
A reliable loss estimate for earthquake risk is even more difficult to establish. Exposed value is ever increasing, due not only to increasing sums insured, but also because, under deregulation, policyholders have opted to take out new or additional policies. Earthquake cover is still not automatically included in standard fire policies, so there is large scope for further increase in the marketwide aggregate, should each and every policyholder wish to buy quake cover. The problem now lies in the concentration of risks in limited zones – Tokyo Metropolitan and areas along the Pacific Ocean to Osaka – which does not help to spread the risk.

A remarkable difference can be seen between reinsurance treatment of wind and quake exposures in Japan so far as the former is usually arranged on an excess of loss basis, quake protection is still heavily weighted towards proportional reinsurance programmes. Excess of loss has yet to play a significant role. However, due to the nature of proportional cession, reinsurers face difficulties in containing aggregate exposure increases, and have virtually lost influence over the price of original policies. Although zonal cession limits or even event limits have been in place for many years, they are not always set effectively, and allow a large ‘air capacity' to which extent exposures can grow. Price erosion is apparent in some new products, such as multi-location first loss covers sold without proper pricing for exposure (mainly influenced by the competitive environment). Further, treaty premium funds have deprived reinsurers of their investment freedom.

Yet regardless of the various, specific problems surrounding these two major catastrophic perils, the underlying problems are the same. Let's consider how to move ahead in a jungle of many obstacles.

Most important is to establish and share a reliable probabilistic model. Only then can we carry out meaningful assessments of the respective risks and their loss potentials. Some models developed by reinsurers or consulting companies are already available. Probing and debating the reliability and accuracy of these models is a healthy procedure. Scrutinising their technical and financial characteristics will help to establish certain key figures and parameters to serve as the basis of further action.

A shortage of sound, scientific behaviour (or, more accurately, the lack of consensus to move towards constant employment of a scientific approach) leads to a market in which catastrophe cover is handled as a simple commodity in a cyclical reinsurance market. Science should, without doubt, replace the old-fashioned ‘kitty' concept based on a retrospective view of who owes what to whom. The modern re/insurance and financial sector can no longer adhere to a simple borrowing/lending-and-payback relationship. Often quoted ‘long term relationships' should be interpreted as sustainable business relationships endorsed by state-of-the-art risk assessment and financing technology, and based on recent advancements in data mining for probabilistic analysis of seismic and typhoon activity.

Potential catastrophic losses are still re/insurable, and will remain manageable by the global insurance market, so long as a proper mechanism is chosen and adequate prices are charged. Reinsurance remains an effective and affordable tool to manage catastrophic loss. The amount of capacity made available by reinsurers, the financial strength of the established players, and the effectiveness of risk sharing through a diversified, global risk portfolio should be neither underestimated nor disregarded. Therefore, we should strive to utilise it in a more sustainable way.

It is vitally important for reinsurers to optimise their capital allocations according to reasonable profit expectations from various business segments. For this reason, shifting business among geographical areas and between the lines of business is always under consideration. Yet it remains essential to efficiency to maintain a diversified risk portfolio overall. That means different cat-exposed insurers are always competing for a share of the finite sum of global reinsurance capacity, so Japanese cat reinsurance issues cannot be considered on a stand-alone basis.

Is the Japanese cat market sufficiently attractive to capital in a broader sense to make the objectives of both the primary insurers and reinsurers achievable? So long as the parameters are satisfactory, based on the agreed loss potential, and adequate return is ensured commensurate to the risks they take on, many reinsurers will maintain an appetite. However, a fair distribution of the loss burden among reinsurers, primary companies and the original policyholders has to be achieved through risk retention, according to the financial strength of primary companies, and through reasonable deductibles under original policies, or the system cannot function well and survive in the long term.

Future forward
Many issues remain to be resolved before the Japanese cat market reaches a situation considered more agreeable and sustainable by all parties involved. Of course a private insurance market is limited in what it can do, but many things can be achieved if the industry works collectively to tackle the issues arising from Japan's inherent natural catastrophe risk. The development of new and innovative risk financing mechanisms which extend beyond the traditional definition of reinsurance is one way, but the roles and responsibilities of the industry will stretch even further.

Among the tasks on the laundry list of preparation for the worst case scenario are efforts to increase risk awareness and remove complacency, to promote loss prevention and reduction measures, and to work with government in the areas where public interests can better and more efficiently serve than can the private sector. This is the significant challenge we, as the insurance sector, are facing in Japan, and it is worthwhile and rewarding to pursue.