Finance 431: Property-Liability Insurance Lecture 20: Catastrophes

Insurance Definition of a Catastrophe A loss that affects more than one insured and causes a loss that is in aggregate in excess of a specified level. The current commonly used level is $25 million.

For someone living in Champaign- Urbana, what is the most likely type of catastrophic loss? A)Fire B)Earthquake C)Hail D)Hurricane E)Tornado

RMS Catastrophic Risk Map

Catastrophes Insurable vs. Non-Insurable Catastrophes History of Insured Losses from Catastrophes Reasons for Growth in Catastrophe Exposure How Insurers Deal with Catastrophe Exposure What Is Being Done to Help Industry Cope with Catastrophes

Insurable vs. Non-Insurable Catastrophes Ideal Criteria for an Insurable Exposure 1Large Number of Similar Exposure Units 2Fortuitous Losses 3Catastrophe Unlikely 4Definite Losses 5Determinable Probability Distribution 6Economic Feasibility

What Makes a Loss Uninsurable? 1Large Number of Similar Exposure Units If losses are concentrated in a particular area Earthquakes, Floods 2Fortuitous Losses If location and timing of losses can be predicted Flooding downstream after upstream area affected 3Catastrophe Unlikely If potential loss could hurt financial condition of industry Tornadoes or riots can be covered War or nuclear disaster cannot be covered

History of Insured Losses from Catastrophes

The Costs of Catastrophes Property Damage Homes – Most losses except for flood are covered by a traditional homeowners policy. Storm Surge during a hurricane is considered flood and not covered. Cars - Vehicles are covered for most events. Commercial Structures – Commercial buildings and structures are generally covered for most events including flood. Human Casualties These may not correlate with economic loss (Tsunami, Galveston TX 1900) May have incidental impact on insured losses (Life insurance, casualty damages) Other Costs Additional Living Expense – Temporary accommodations and expenses. Loss adjustment expenses – Insurers usually spend a large amount of money to service policyholders following a catastrophe. Coverage Extensions – Business Interruption, Contingent Business Interruptions, Civil Authority, Off Premises Power.

History of Insured Losses from Catastrophes Significant change in size of catastrophes occurred starting in 1989 The ten largest insured losses have all occurred since 1989 Recent estimates of possible losses New Madrid Fault Earthquake $116 billion California Earthquake $77 billion Florida Hurricane $76 billion Northeast Hurricane $21 billion

Reasons for Growth in Catastrophe Exposure Weather Pattern Change Period of Unusually Good Weather (?) Recent Return to the Long Term Norm Population Growth in At Risk Areas for Hurricanes Southeastern seacoast Lowered Building Standards Lulled by Reduced Storm Activity Overwhelmed by Population Growth Mandates to Cover Earthquakes Impact of Catastrophe on Repair/Rebuilding Costs

How Insurers Deal with Catastrophe Exposure Reinsurance Managing Exposures Sophisticated catastrophe modeling Limiting concentration of exposures Monitoring by zip code Higher deductibles Premium Increases Withdrawals from Some Markets

Property Catastrophe Reinsurance Programs Property Catastrophe Reinsurance Treaties are typically part of a program. This program would be stated as follows: Reinsurer A is taking an 80% share of the layer 80x20. This translates into Reinsurer A is reimbursing the primary carrier for losses in excess of $20 Million per occurrence up to a limit of $80 Million. Reinsurer B is taking an 80% share of the layer 40x100. The primary insurer is responsible for any losses in gray or above $140 Million. Reinsurer A Reinsurer B $0 $100M $20M $140M

Property Catastrophe Reinsurance Programs - Coinsurance Primary insurers are usually not able to cede 100% of the loss. The portion they retain in called coinsurance. Coinsurance is required to avoid the two following forms of adverse selection. –Writing large amounts of catastrophe exposed risk because they have reinsured the risk away. –Not controlling losses during the claim settlement process after the event has occurred. Reinsurer A Reinsurer B $0 $100M $20M $140M Coinsurance

Property Catastrophe Reinsurance – Models –In the past insurers used to look at long term analysis of catastrophe data to assess the cat potential and price insurance. This technique may still be used to price freeze and or tornado risks. –Today computer models dominate the risk management landscape of the property catastrophe insurance markets. –There are a handful of models available although three companies dominate the market (AIR, RMS, EQECAT). –The models are stochastic in nature and estimate damages for thousands of years at a time. This gives a picture of not only the average of expected value but the entire loss distribution.

Property Catastrophe Reinsurance – Models These models have two main components. Peril scenario generators and damage functions. The peril scenario generators model hurricane path and wind- speed for storms and earth movement for earthquakes. Often historical records are scrutinized and thousands of years of geological data are considered.

Property Catastrophe Reinsurance – Models The damage functions are engineering functions that estimate the percent of structure damage for a given wind-speed or earth movement. These are often a function of a structure’s –Location –Age –Class –Construction

Property Catastrophe Reinsurance – Model Output An insurer would input information on his book of business into the model. The output would include expected value estimates and an exceedance curve similar to the one of the left. Using management judgment and risk tolerances the insurer can begin to manage its risk.

Property Catastrophe Reinsurance – Model Output Expected loss – The loss cost for various layer of reinsurance. PMLs (Probable maximum loss) – This is generally stated with an associated annual frequency. –250 Year PML = $500 Million –500 Year PML = $1,500 Million These imply: 1.On average a loss of at least $500 Million will occur every 250 years. 2.On average a loss of at least $1.5 Billion will occur every 500 years.

Property Catastrophe Reinsurance – Model Output RATE ON LINE = TREATY PREMIUM TREATY LIMIT Roughly equal to the probability of payment. Rates on a property catastrophe treaty are typically quoted using the term “Rate On Line”.

What Is Being Done to Help Industry Cope with Catastrophes California Earthquake Authority Florida Hurricane Catastrophe Fund Hazard Mitigation Grant Program (Floods) Homeowners Insurance Availability Act Initially introduced in 1997 Not enacted yet Would provide catastrophe reinsurance Tax Deferred Catastrophe Reserves Proposals under consideration in Congress

Next Lecture Securitization of catastrophe risk