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The Katrina effect Growing CAT exposures require new thinking By Michael J. Moody, MBA, ARM
For the most part, the insurance industry has always had trouble with catastrophe risk exposures. Insurance by its nature is much more attuned with aggregate exposures that have probabilities that are more predictable. And while the industry has depended primarily on high layers of reinsurance to provide protection from infrequent catastrophic losses, in recent years, the adequacy of this system has been called into question much more frequently. The first major event that got insurers/reinsurers thinking about the effects of a major catastrophic loss was Hurricane Andrew that came within an eyelash of a direct hit on Miami but, at the last minute, took a more southerly track and found Homestead, Florida. Even so, this catastrophe managed to tally over $24 billion in losses, setting the stage for the next record-breaking event. The losses from 9/11 stand as the largest man-made U.S. disaster, and it once again called into question the ability of the industry to survive a major catastrophe. Recently, 2004 proved to be another challenging year for property underwriters when four separate hurricanes found their way across the state of Florida. And while no single event appeared to dethrone Hurricane Andrew, taken in total, the hurricane season of 2004 once again raised the bar on the extent of catastrophic potential. Little did we know at the time that a lady named Katrina would have such a profound impact on all of our lives during 2005. The insurance industry witnessed first hand a worst-case scenario, and it was not pretty. As of this writing, final Hurricane Katrina figures are still unknown, but current estimates of insured losses are in the $40 billion to $60 billion range. Total losses, insured and uninsured, are projected in the $100 billion to $150 billion range. By anyone’s standards, even with incomplete data, Katrina was a record-setting event. CATS to the rescue Over the course of the past 20 years, underwriters have been searching for ways to access the capital markets and spread some of the high layer risks. Insurance-linked securities or catastrophic bonds (CAT bonds) were introduced in 2001 and have steadily gained limited favor with both the insurance industry and investors. The primary investor attraction typically associated with CAT bonds has been their superior interest rates, which have historically been significantly higher than the going rates of other investment vehicles. The other big draw has been the zero-beta aspects of the bonds, which have no correlation to the stock market or interest rates. These types of investments can help diversify an institutional investor’s portfolio and, as a result, are highly prized in today’s investment arena. Accordingly, interest in CAT bonds has grown. This interest from the investment community has resulted in the introduction of another, similar type of insurance-linked security known as “industry loss warranties” (ILWs). While the basic concept is similar to CAT bonds—covering large loss exposures that are associated with natural disasters such as hurricanes and earthquakes—they differ in a number of ways. The most obvious difference is that ILWs cover losses from events where the industry-wide insured loss exceeds some predetermined threshold. In essence, this makes the operative trigger for ILWs an industry loss rather than the company’s own loss. The trigger amount can vary by geography, level, and kinds of events that contribute to it. As a result, there is significantly more flexibility in ILWs than CAT bonds. Other major differences between the two investments are that ILWs typically attach at lower limits then CAT bonds. Transactional costs typically associated with CAT bonds have been reduced with ILWs and, as a result, they are increasing in availability and acceptance by the insurance industry and the investment community. Bottom line, ILWs can provide another method for insurers/reinsurers to access the capital market while designing a cost-effective catastrophic protection program. The Katrina effect The year 2005 will be remembered as once again raising the bar regarding catastrophic loss activity. It was not only the sheer number of storms—where we beat a record with Tropical Storm Alpha that had stood since 1933 and still were adding to that record as of this writing—but also the intensity of some of the storms that was most notable. Looking over the named storms that occurred during 2005, it is clear that as populations move closer and closer to the U.S. coastlines, we are greatly increasing our exposure to large losses. This migration to the costal regions is expected to continue and, as long as someone is there to help defray the cost to rebuild, people will keep coming and large catastrophic losses will continue to occur. At the time of this writing, it appears that both industry loss warranties and CAT bonds will have some loss involvement as a result of the 2005 storm season. According to several industry sources, a number of ILW investors will suffer losses from Katrina. Additionally, many believe that further losses could occur to ILWs due to the “second loss” wording that is a common feature of these programs. Hurricanes Rita and Wilma may have triggered such losses. Generally, it is believed that many of the ILWs that are currently written will experience some losses. Losses to CAT bonds are expected to be much less since they typically have a higher attachment point than ILWs. Initially, it was thought that there would be no CAT bond losses that would come out of Katrina. However, there now appears to be at least one bond that will experience some loss activity. The CAT bond that is expected to have a call made against it is a $190 million bond that covers a portion of Zurich Financial Service’s U.S. windstorm exposures. The bond, known as Kamp Re 2005, is triggered if Zurich’s Katrina losses exceed $1 billion. This was a transaction that was put together by Swiss Re Group in August 2005 and, in addition to the wind exposures, it also covered earthquake losses that could result from activity on the New Madrid Fault area, which is located in the Midwest and centered near St. Louis, Missouri. Several other CAT bonds are rumored to have minor claims activity as a result of 2005’s hurricane activity, but only Kamp Re 2005 had been made public as of this writing. Exact claims figures are difficult to come by for both ILWs and CAT bonds. Since these are private placement investments, there is no public announcement of involvement of either. Rather, it is usually the bid and ask price of the individual investment that will provide some indication of the claims activity. Since most of these investment vehicles have been oversubscribed in the past, many of them trade at figures in excess of 100%. Should the price fall below the 100%, chances are high that the investor community either anticipates a loss or is aware of a loss. The real questions that will come out of the Katrina effect are: Will investors continue to want to invest in these types of investment vehicles? Will a complete payout of Kamp Re 2005 dampen the investment community’s enthusiasm for insurance-linked securities? Only time will tell what long-term effect Katrina will have on the market, but many believe that investors will continue to be interested in these forms of investments. There are several key reasons for this optimistic prognosis. Insurance-linked investments will continue to be a good source for developing a diverse portfolio. Additionally, the higher rates of return will still receive favorable attention from the investment community. And finally, ILWs and CAT bonds should continue to be an acceptable investment vehicle and, as a result, a larger, more liquid marketplace will be established. From the insurance industry standpoint, insurers and reinsurers will welcome the faster payouts that will come from these products because the money is already set aside. Rethinking catastrophe covers Conventional wisdom has always held that reinsurance is the most cost-effective form of capital available for insurers. But will this concept remain after the Katrina losses are paid? Based on the fact that, season after season, we continue to raise the bar on property losses, one can certainly question the applicability of a complete reinsurance option. Given this situation, the insurance industry must begin to rethink the whole concept of cost-effective capitalization. There is little doubt that catastrophic potential will continue to grow and the need for increased insurance limits will need to follow. But in many ways, it appears that the insurance industry has pushed the envelope with regard to available limits and will need to establish a different source of capital to combat the issues associated with catastrophic loss exposures. And the capital markets appear ready, willing and able to assist in this important area. Some in the insurance industry have fought the entry of the capital markets into this arena. In the process they have threatened the viability of the industry. Dealing with rating downgrades, the need for additional capital replenishment, and even concerns about the continued viability of some individual insurers following each new catastrophic event is not the best way to handle this problem. Whether or not Katrina turns out to be a cycle-changing event or just results in selective hardening in the property insurance arena, the insurance industry and the capital markets must both embrace those concepts that take full advantage of the resources of the capital market. Not to do so would be risking the viability of the insurance industry. * |
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