Catastrophes __________ Finance 431 – Property-Liability Insurance – Spring 2005 James Matusiak FCAS,MAAA Senior Vice President & Chief Actuary PXRE Reinsurance Ltd.

2 Introduction What is a Catastrophe Insuring Catastrophes Managing Catastrophe Risk Reinsurance Case Studies Final Points

3 What is a Catastrophe? CATASTROPHE A great, often sudden calamity. A complete failure; a fiasco: The food was cold, the guests quarreled the whole dinner was a catastrophe. The concluding action of a drama, especially a classical tragedy, following the climax and containing a resolution of the plot. A sudden violent change in the earth's surface; a cataclysm. U of I losing in the NC game. Insurance Services Office defines a catastrophe as an event causing insured losses greater than $25 Million.

4 What is a Catastrophe? Types of Catastrophes –Traditional Hurricanes / Typhoons Earthquakes Floods Tornados Man-made (fires, explosions) Types of Catastrophes – Alternative Terrorist Acts Asteroids Tsunami Power Outages

5 What is a Catastrophe? 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)

6 What is a Catastrophe? The “Hidden” Costs of Catastrophes Demand Surge – An increase in prices due to an shortage of the supply of labor and materials following a catastrophe. Business Interruption – Loss of income related to damage to a commercial structure is usually covered as part of a commercial property policy. Other incidental loss such as lost tourism is not covered. Workers Compensation – Any worker who is injured by a catastrophe while at work is entitled to benefits. Loss adjustment expenses – Insurers usually spend a large amount of money to service policyholders following a catastrophe.

7 What is a Catastrophe? The Rising Costs of Catastrophes – The economic costs of covering catastrophes is outpacing inflation for the following reasons. Demographic Shifts – Populations are moving into more catastrophic exposed regions. New Perils – The emergence of new potential risks, such as terrorism increase the expected catastrophic loss. Global Economic Development – As countries develop economically the amount of exposed property increases. This property is generally covered by an insurance vehicle.

8 What is a Catastrophe? Financing the Costs of Catastrophes Public – Individuals pay premiums for insurance to cover their personal property from damage due to catastrophes and other perils. Government – Uninsurable perils such as flood and war are generally covered by the government. The government may also subsidize private insurers (ie TRIA, FHCF) Insurers – Investors put capital at risk in the form of insurance/reinsurance companies (or cat bonds) to make an adequate return.

9 Insuring Catastrophes The Insurance Mechanism – THE PLAYERS Policyholder Primary Insurance Company Reinsurer Government Premiums Taxes Premiums Losses

10 Insuring Catastrophes The Insurance Mechanism – The Nature of the Game  Year-to-year underwriting results for a catastrophe exposed insurer are much more volatile.  Investors generally demand a higher return for the additional volatility.  To manage the risk of catastrophes insurers have several options: Do not write in catastrophe exposed areas. Limit writings in catastrophe exposed areas. Buy reinsurance.

11 Managing Catastrophe Risk 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.

12 Managing Catastrophe Risk  These models have two main components. Peril scenario generators and damage functions.  The peril scenario generators model hurricane path and windspeed for storms and earth movement for earthquakes.  Often historical records are scrutinized and thousands of years of geological data are considered.

13 Managing Catastrophe Risk  The damage functions are engineering functions that estimate the percent of structure damage for a given windspeed or earth movement.  These are often a function of a structure’s Location Age Class Construction

14 Managing Catastrophe Risk Key Terms  Expected Loss – Mean of average loss for a given year.  PML (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.

15 Managing Catastrophe Risk Exceedance Curves  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.

16 Reinsurance A Typical Reinsurance Program for a Primary Carrier 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

17 Reinsurance A Typical Reinsurance Program for a Primary Carrier 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 Coinsurance $140M

18 Reinsurance  Common Terms of a Property Catastrophe Treaty Per Occurrence – They only cover losses from a distinct catastrophic event. Excess of Loss – They have a fixed limit of coverage and have a fixed retention. Two Loss Warranty – At least two insured structures must be damaged for the treaty to apply. Catastrophic damage to a single structure is covered by facultative contracts or risk excess treaties. Covers losses for a distinct period (usually 12 months) regardless of when the underlying policy was written.

19 Reinsurance  Common Terms of a Property Catastrophe Treaty - More Reinstatement Provisions –Should one event occur that causes losses to the policy, the reinsurer must offer an additional reinstatement of the limit at the premium rate. The reinsurer is usually forced to offer one reinstatement. After two events the primary insurer must renegotiate another treaty. Hours Clause – An hours clause defines the duration of the catastrophe. This is typically 72 hours. The retention and limit apply to all losses during the occurrence. Should the catastrophe last more than 72 hours, the limit may be reinstated. Follow the Fortunes (Found on most reinsurance contracts) – Should a coverage dispute adversely/favorably impact the primary company, the reinsurer will follow the fortunes of its customer.

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

21 Reinsurance  Property Catastrophe Reinsurance Property catastrophe reinsurers take a large amount of financial risk

22 Reinsurance  Property Catastrophe Reinsurance Property catastrophe reinsurers take advantage of geographic diversification. They write treaties all over the world with the idea that Japan is not correlated with Florida is not correlated with California. This is simple financial management. Adding uncorrelated risks decreases the overall volatility of the portfolio. Property catastrophe reinsurers are not in a position to take large amounts of investment risk. Should a catastrophe occur they require a large amount of cash in a short period of time to pay claims. Property catastrophe reinsurers use retrocessional, or reinsurance of reinsurance, to manage risk.

23 Reinsurance  Industry Loss Warranties Industry loss warranties pay a fixed amount based of the amount of industry loss. For example, a $20 Million ILW with a $5 Billion trigger, would pay the purchaser $20 Million in the event of a $5 Billion or greater industry loss. Industry loss amounts are published by PCS (Property Claim Services) for US losses and SIGMA (a division of Swiss Re) for other losses around the world. These expose the purchaser to basis risk, or the risk that the purchaser has a large loss but the industry does not. These are currently an easy way to enter the property catastrophe reinsurance market. Many hedge funds are getting into this arena.

24 Reinsurance Market Cycles  Property catastrophe reinsurance suffers from market cycles where prices fluctuate.  This fluctuation is caused by a buildup of capital if it has been some time since the last catastrophe.  Reinsurers need to make an adequate return on their capital so they either need to write more premium (increase supply) or return capital to shareholders.

25 Reinsurance  Cat Bonds Bonds issued to cover catastrophe risk were developed subsequent to Hurricane Andrew. These bonds are structured so that the investor has a good return if there are no qualifying events and a poor return if a loss occurs. Losses are triggered on an industry index. The advantage of these vehicles is that you gain access to the large capital available in the financial markets and that the bonds diversify a standard investment portfolio. The disadvantages is that they expose the issuer to basis risk, they have large issuing costs and that they are not readily understood by the investment community.

26 Case Studies  Hurricane Andrew 1992 – A painful lesson for the industry Recently re-categorized as a Category 5 hurricane. Eleven property casualty insurers became insolvent. Eradicated every dollar of profit ever made on homeowners insurance in the State of Florida. Spurred the proliferation of catastrophe modeling. Increase the amount of reinsurance purchased. As a result the State of Florida created the FHCF (Florida Hurricane Catastrophe Fund) to provide subsidized reinsurance to the homeowners insurance industry. After Andrew insurer implemented hurricane deductibles to reduce the annual premiums. This increased the burden on homeowners.

27 Case Studies  World Trade Center 2001 – More painful lessons for the industry Largest single loss in US history. $32.5 Billion in insured loss. Effected several lines of business, including workers compensation, life insurance, aviation, business interruption. Several coverage disputes remain to be settled. As a result, the US Government created the TRIA (Terrorism Risk Insurance Act) to provide a backstop for the insurance industry in the event of terrorist acts. Subsequent to WTC, billions of dollars of capital flowed into the industry to replace the capital lost.

28 Case Studies  2004 – Still assessing... Worst worldwide natural catastrophe year in terms of insured loss. Massive loss of life due to the Tsunami in Asia. Due to the underdevelopment, the insured loss was relatively low. Four major hurricanes struck the US. Massive damage to Grenada, Grand Cayman and gulf oil assets. Eradicated every dollar of homeowners underwriting profit made since Hurricane Andrew in The reinsurance industry was largely unaffected by the loss. Large amount of political pressure regarding the financial burden of multiple hurricane deductibles. The catastrophe models were shown to have deficiencies in producing timely loss estimates. Demand surge was severely underestimated and was as much as 30% for the later storms.

29 Final Points  The coverage of catastrophes is an evolving process.  Catastrophes are highly political.  Catastrophe risk effects all industries.

30 Final Points  If anyone has any additional questions or comments please feel free to contact me: James Matusiak PXRE Group Ltd. PXRE House 110 Pitts Bay Road Pembroke HM08 Bermuda (441)