The world’s largest insured catastrophe loss of 2007 occurred in Europe. Dr David Maréchal and Dr Jane Toothill warn underwriters not to underestimate the region’s loss potential.

Europe is often seen as a safe bet for catastrophe underwriters, compared with the loss-potential of a US earthquake or Japanese tropical cyclone. However, losses from natural catastrophes have steadily increased in Europe in recent decades, putting insurers and reinsurers under growing pressure.

The most destructive windstorm of the 2006-2007 winter season was Kyrill, which caused significant damage to forests, property and infrastructure in the UK, France, the Netherlands, Belgium, Germany and other Central and Eastern European countries. The economic loss attributable to the windstorm is estimated at ?7.7bn ($11.3bn) and representative for the European market of a 10-year return period loss for windstorm. However, this is less than the total economic loss suffered from windstorms Anatol, Lothar and Martin in December 1999, estimated at ?17.2bn ($25.3bn).

All washed out

Flood is also a major European peril, and the potential direct damages are enormous. The value of assets in fluvial and coastal floodable zones was evaluated in 2000 at ?300bn in the UK alone (Burgess et al). This figure does not include business interruption, which can greatly increase the final cost of a large flooding event.

In recent years, rain-induced flooding events have hit Europe on a large scale, affecting several river basins and causing damage in many countries. In August 2002, a long lasting rainfall cell affected Germany, the Czech Republic, Austria, Slovakia and Hungary in addition to Spain and Italy. The heavy rainfall caused devastating flooding on the Elbe, Danube, Inn and Salzach.

The event generated an economic loss of around ?20bn, making it one of the most expensive natural catastrophes in European history. In summer 2007, extensive flooding in north-eastern England in June and central and south-western England in July caused insured losses estimated at over ?4.5bn.

Storm surge flooding is also liable to cause large-scale losses in Europe. During the night of 31 January 1953, a storm surge wave flooded low-lying areas around the North Sea, claiming 2,000 lives in the Netherlands, the UK and Belgium. In 1962, another storm surge event caused a number of flood defences along the German coast to breach, resulting in the loss of 300 lives.

Following these events, major engineering projects were implemented to protect the zones at risk and to mitigate the potential impact of storm surge. These included the Delta project in the Netherlands and the Thames Flood Barrier in the UK. These protection systems prevented the occurrence of major damage in November 2007 when the Netherlands and the UK experienced their worst storm surge for 20 years.

Despite the recent improvements made to flood protection systems in Europe, the risk of large-scale flooding is still very much present. In the Netherlands for instance, half of the population live in areas below mean sea level, and the value of assets in these zones represent several hundreds of billions of Euros. In Hungary, just below half of the country is exposed to fluvial flooding and only 25% of the country is directly protected by primary defences.

Increasing losses

“Despite the recent improvements made to flood protection systems in Europe, the risk of large-scale flooding is still very much present

Many potential causes could lead to an increase in losses from natural catastrophes. These include rising insured values, higher vulnerabilities of goods due to technological developments such as electronics, increased concentration of risks in high-exposure areas, changes to insurance coverage and increasing event frequency or severity.

Increases in total insured values are driven by factors such as population growth within the European Union (which has increased by 20% in the last 40 years), increases in the value of insured goods, the liberalisation of insurance markets in Central and Eastern Europe and increased insurance penetration.

The market penetration has significant variations across countries. For instance, it represents only 5% for households and for flood in Italy where flood insurance is optional, but 100% in France where it is compulsory. These variations are often dictated by national policies and three systems coexist in European countries: private (eg Germany or the UK), governmental (eg state insurers cover buildings in 19 Swiss cantons) and governmental for compensations only (eg the Calamities Compensation Act in the Netherlands or the Cat Nat pool in France).

The vulnerability of risks has also increased through a larger concentration of insured values in high-risk areas, in some cases due to an over-confidence in flood protection systems. This increase in the concentration of risks in certain areas, such as city centres, gives the potential for a single event to generate a large insured loss.

Changing climate

Wind and flood hazard conditions have also shown considerable fluctuation in some areas of Europe. Storminess over Europe has increased over the past few decades, but the number of windstorms generated over the Atlantic Ocean has decreased over the last 100 years. However, this decrease has been accompanied by a seasonal shift, with a tendency towards calmer summers and more intense winters, and a poleward shift in cyclone tracks. Together, these changes have resulted in an intensification of winter storms over Europe.

For fluvial flood, several national studies have failed to establish a statistically significant link between weather patterns and event frequencies and severities. Flooding is a complex process which depends upon a variety of factors including precipitation, soil and land use conditions, to name but a few. An increase in flood discharge can also result from direct alterations to the water channel as well as changes in the river catchment, such as urbanisation, new agricultural practices, reforestation or deforestation.

A significant increase in flood discharges has been observed for some basins subject to snow melt flooding, due to temperature increases. In this case, the change in peak flood discharge is linked to a shift in the timing of the flood, which occurs earlier in the season.

Climate system processes are complex and chaotic by nature. Feedback mechanisms between various climate processes make the system nonlinear. Once a threshold forcing value has been crossed, small changes in initial conditions can create large disturbances to the climate. Given the added complexity of a warming climate, the accurate prediction of changes to the frequency and severity of extreme natural catastrophes represents a considerable challenge.

For winter storms, two competing factors are expected to affect the frequency and intensity of storm formation. The first suggests that in a warmer climate, heat transfer will intensify between the atmosphere and the ocean, causing an increase in storm intensity and size. The second suggests that as polar regions warm more than the tropical oceans, the temperature difference at the polar front (along which most storms develop) will decrease, leading to a reduced frequency of winter storms, since less transfer of energy will be required. There is much scientific debate over which of these feedbacks will have the dominant effect on future storm formation, and various climate models in use show slightly different results.

“The concentration of risks in certain areas, such as city centres, gives the potential for a single event to generate a large insured loss

The uncertainty over storminess in the future means it is not possible to come to any conclusions about the future levels of storm surge activity in Europe. However, it is evident that coastal areas will become more exposed to flooding due to sea level rises resulting from the thermal expansion of the oceans and the melting of glaciers and polar ice caps.

Cat bond solutions

For the insurance industry, increasing exposure of large portfolios to natural catastrophes may require stricter risk management measures. It also offers new business opportunities, as illustrated by the growing demand for new and innovative risk transfer mechanisms.

To date, over $20bn in cat bonds has been issued globally, and the use of these solutions is expected to grow significantly in the coming years. Although capital market solutions have typically focused on the lowest-frequency/highest-severity perils worldwide, there is a growing appetite for securitisation of non-peak risks.

In 2007, the first cat bond covering flood was issued when the $150m Blue Wings cat bond provided German insurer Allianz with the ability to transfer natural hazard risk in several territories, including potential river flood losses in the UK, to the capital markets. The Blue Wings transaction used a parametric trigger with an index based on flood depths at 50 selected reference locations.

In practice, flood depths are far from simple to measure, but river discharges, which are simpler to gauge, do not necessarily correlate simply with flood loss. Use of modelled loss triggers is only possible with the development of sophisticated and credible loss models – and at present such a model is lacking for many territories in Europe.

Given an increased availability of widely accepted flood modelling solutions, there is tremendous potential for other insurers to use innovative capital market solutions to deal with not only windstorm, but also river and coastal flood in Europe and elsewhere. Such deals offer several advantages for issuers, including the provision of multi-year protection, and can be especially attractive to investors who aim to diversify their portfolio.

Deals may be structured on a parametric basis or with ultimate net loss triggers that would indemnify insurers against their actual flood losses. Other innovations could involve the use of a multi-country wind or flood index or aggregate industry loss index, on which index-linked cat bonds, industry loss warranties or derivatives could be traded.

The insurance industry depends on risk to exist, and has the ability to quickly adapt to changing conditions, whether they be in the natural or financial world. Whether by growth in the volume and type of securitisation deals, or by new risk transfer solutions yet to be conceived, the insurance industry has the resilience to adapt to the changing level of risk faced in Europe.

Dr Jane Toothill is head of European model development and Dr David Maréchal is catastrophe model developer at Guy Carpenter Instrat.