Insured losses due to natural disasters over the last 15 years have been dramatically higher than in any similar period in history. These losses, coupled with the decline in the equities market, delivered a one-two punch to the property reinsurance sector from which it is still recovering. By Richard Clinton.
According to Swiss Re's sigma 1, "... losses arising from natural disasters have been at a clearly high, but extremely volatile level since the end of the 1980s." It goes on to say that the 15-year average insured loss for natural disasters (i.e., natural catastrophe and man-made disasters) is $14.6bn, of which $6.1bn is from man-made disasters. During this 15-year period, there were three years with insured losses exceeding $20.0bn, and yet another year came just under this mark. In 2002, the insured losses from natural catastrophes were $11.5bn, well above average.Unfortunately, this trend of higher natural catastrophe losses is continuing in 2003. Through the first nine months of this year, the insured losses due to natural catastrophes are estimated by Property Claim Services (PCS) to be $9.4 bn. Since this is a US-only estimate, it does not include the insured losses from other significant events like Hurricane Fabian (Bermuda) and Typhoon Maemi (South Korea). Adding in the insured losses from the recent wildfires in California, which EQECAT is estimating at up to $2bn, 2003 will easily surpass 2002.Rudolf Kellenberger, Deputy CEO at Swiss Re, recently commented: "... catastrophe losses are on an upward trend - from man-made as well as natural hazards. These loss potentials show no signs of decreasing as property values grow, insurance penetration reaches higher levels and value concentration in exposed coastal areas increase." 2 Compounding this problem for reinsurers is the relatively hard market for retrocessional coverage. Given the history of natural catastrophe over the last 15 years and the fact that there is every expectation that insured catastrophe losses will continue to grow, the issue facing reinsurers is how they can prepare themselves to effectively navigate their businesses through these difficult times.For the most part, reinsurers have responded to these challenges through increased use and reliance on catastrophe models, rate increases and expanded use of cat bonds and/or swaps. This combination has helped to restore property reinsurance to more profitable levels. However, there are now signs that property reinsurance rates are starting to soften, which means that reinsurers will have to be even more disciplined and efficient in using catastrophe models to improve their risk selection process. Also, while the reinsurance rates may be softening, the retrocessional market is not. As a result, more companies will be looking at the use of cat bonds and swaps to enable them to provide the necessary capacity to achieve their objectives.
Use of cat modelsEver since the introduction of catastrophe modeling software, reinsurers have been asking themselves how they can more efficiently and effectively use this technology to manage their risks. Model use still varies by company, but one common element is that virtually all reinsurers are using at least one model to manage their risk and many - including all of the major reinsurers - are using multiple models. In fact, the use of multiple models is increasing because companies have found that they cannot afford to be totally dependent on one model where changes in the modeling methodology by the vendor can have a dramatic impact on their business. The more sophisticated users also drive proprietary-pricing models, which use the catastrophe model's results, as a major component of their competitive strategy. These proprietary-pricing models enable the reinsurers to uniquely interpret risk, which they feel provides them with a competitive advantage.Overall, the catastrophe models have become mission-critical tools that must function as efficiently as possible during the peak underwriting seasons. In addition, the proliferation of catastrophe model use throughout the organisation has led to the use of such models in conjunction with an architecture that supports enterprise-wide data access and analysis capability. The new generation of client-server catastrophe models enables efficient hardware configurations using scalable, shared central PC servers to do the number crunching and user-friendly web browser interfaces on the users' desktop. This type of architecture enables the use of extensive computing power without requiring each user to have a massive PC.Modern client-server enterprise architectures have enabled speed and efficiency for individual models, but the complexity of multiple model use remains an issue. Therefore, to gain the needed efficiencies in the modeling process to improve productivity, companies will be moving towards an Integrated Catastrophe Management System (ICMS). The idea behind ICMS is to create a seamless underwriting system that captures risk or exposure data in a consistent format, processes the exposure data through one or more catastrophe models, passes the results to a proprietary pricing model and provides the end results to the underwriter. Most importantly, all of this must be done with minimal human intervention.Under an ICMS system, the underwriter or user would go to their local PC and click on the ICMS icon. The screen would then walk the user through the process, which would match the company's specific underwriting protocol. The key to the ICMS system is its flexibility in meeting the requirements of each company. In fact, the reinsurer should control the user interface so that the look and feel of the system exactly meets their needs. In other words, the interface would be independent of whatever catastrophe model(s) was doing the analysis. The ICMS system simply requires the reinsurer to send data in a consistent pre-agreed format and the same would apply to the output being provided by the ICMS system. Accumulation management can be handled either through the ICMS software using the reinsurer's interface, the standard interface provided by the catastrophe modeling company or ideally either, depending on the needs of the user.
Cat bonds and swapsIn the 1990s, reinsurers started to look at catastrophe bonds as a possible source of new capacity for catastrophe reinsurance. The driving force behind this was a series of catastrophes that led to higher rates and reduced capacity, which were very similar to the current conditions. Since then there has been a steady issuance of cat bonds - over $13bn - and it continues to be a viable alternative to traditional reinsurance/retrocessional coverage.Reinsurers are finding that in the current market, retrocessional coverage can be either unavailable or prohibitively expensive. As a result, reinsurers are looking at securitisation, since it can potentially cost less than traditional coverage and/or can provide the capacity that is not otherwise available from traditional sources. Moreover, securitisations usually provide multiyear coverage at a set price, which reduces the uncertainty and volatility of obtaining coverage. Multiyear deals also help to reduce the transaction cost by spreading it over a longer period of time. Other advantages of cat bonds include minimising credit risk and diversifying sources of capacity. Cat bonds minimise credit risk because the funds are collected upfront and are invested in investment-grade securities until they are needed. The advantage of diversifying sources of capacity is that it prepares you for changing market conditions, allowing the reinsurer to lower its long-term cost and ensure the necessary capacity is in place when needed.As a risk modeler, EQECAT has advised on $2.5bn of cat bond transactions since 1997, providing the risk assessment for 60% (by value) of the property insurance cat bonds outstanding at year-end 2002.Catastrophes will continue to have a greater and greater impact on reinsurers due to changing demographics and greater demand for insurance. Thus the challenge is how they respond to this growing demand while minimising the impact of losses on their financials. More and more reinsurers are already reacting to the changing market by implementing many of the actions discussed above, and it is likely this trend will continue until these actions become standard operating procedure for most.
References1 Sigma - No.2/2003 Natural Catastrophe and Man-made Disasters in 2002 ;2 Managing Risks in Turbulent Times - 2003 European Insurance Review.By Richard ClintonRichard Clinton is President of EQECAT Inc.