Catastrophe Insurance: Victory Won

– Battles to Come

Dr George Walker

Honorary Research Fellow Aon Benfield Analytics Asia Pacific

The Escalation of Insured Catastrophe Losses

17 years Prior to 1987 Maximum Annual Loss $12.2 Billion Average Annual Loss $7.2 Billion

10 years 1987-1996 Maximum Annual Loss $44.7 Billion Average Annual Loss $25.2 Billion

10 years 1997-2006 Maximum Annual Loss $119.2 Billion Average Annual Loss $38.2 Billion

(Swiss Re Data 2010 US$)

Maximum Event Losses

1970-1986 < $2.5 B 1987 - European Floods $6 B 1989 - Hurricane Hugo $8 B 1991 - Typhoon Mireille $9 B 1992 - Hurricane Andrew $24.9 B

1994 – Northridge EQ $20.8 B 2001 -9/11 $23.1

2005 - Hurricane Katrina $72.3 B 2009 – Hurricane Ike $20.5 B

(Swiss Re Data 2010 US$)

Impact on Catastrophe Reinsurance Industry

Early Nineties Huge Impact – Particularly Lloyds

Mid 2000’s

Reinsurance Industry Remained Remarkably Healthy

Still is Healthy

Despite Global Financial Recession

A Victory Won

After Andrew

Identified Major Weakness

Empirical Risk Assessment (Extrapolation from Past Losses)

Corrected it with New Tools

Catastrophe Loss Risk Modelling Dynamic Financial Analysis (Scientific Forward Projection of Losses & Fund Performance)

Cause for Celebration - BUT

Cannot Assume The Future

Will be Extrapolation of The Past

The Primary Reasons for Big Increase in Losses

Big increase in wealth

Big increase in diversity of wealth

Big increase in concentrations of wealth

Especially in extreme hazard prone areas

Mitigation efforts lagged development

Is This The Pattern Of The Future ?

and

Yes To Increasing Magnitude and Frequency

of Large Event Losses

No to current overwhelming dominance

of North America relative to Asia

Asian Demographics Relative to North America and Europe

Population 4 times as large

GDP about half but increasing at over twice the rate

Urbanisation in NA/Europe is tapering off – in Asia is increasing rapidly from much lower base

As is insurance penetration

Add to This

Increasing complexity – of which you have heard much at this conference

Inevitable surprises – of which you have also heard

Increasing political interference reflecting changing expectations of society

Which Means

If the

Commercial Catastrophe Insurance Industry

Is to Remain Healthy

And Reap the Opportunities

Arising From These Changes

There will be More Battles to be Won

Will Not be Spread Evenly Across Sectors

First Battle

Across the Board – Surprises – “Watch The Gap”

Surprise is the Consequence of an Event Not Modelled or Not Well Modelled

Current Models dominated by current need in North America for Maximum Event Losses – Hurricanes & Earthquakes

In Asia Flood as important as Typhoon & Earthquake

Increasing Frequency is as serious as increasing Magnitude requiring all potential insured hazard losses to be modelled

Commercial & Industrial Lines - Complexity

Complex structure of business operations and dependence on infrastructure makes modelling contingent business interruption very complex

Models need to model infrastructure damage and other interdependencies

Another “Big Gap”

Battle No. 1 – Expanding Scope of Models

Big technical challenge to industry

Will be expensive

Who will pay for it? Who should do it?

Should model development be Competitive or Collaborative

Is there a role for academic development of open source models - eg GEM?

Second Battle

Escalating Disaster Costs Not Restricted to Insurance

Average Annual Global Economic Cost of Disasters

(Current US$)

1960’s 10 Billion

2000’s 100 Billion

A 10-fold Increase in Real Terms

Dominantly in Developed Countries – eg US

(40% Insured almost all in developed economies) [Ball Park Estimates by Author based on Munich Re data]

Creating Issues for Society

The increasing cost of disasters and their impact on national and international development – particularly in respect of the developing world Increasing gap between what community expects in terms of financial protection from hazard losses and what it gets at household and small business level – particularly in developed world Both are essentially political issues – but also catastrophe insurance issues

Development Issue Particularly for Asia

Already many of largest urban concentrations are in Asia, many in hazard prone areas

Mitigation policies no better than in US during past 40 years

Asia will increasingly become scene of most costly disasters – eg recent Japanese EQ & Tsunami

Most of Asia still part of developing world

Escalating Disaster Costs Pose Threat to Development

Disaster Management

Planning Preparation Response Recovery

Sustainable Development

Environment Energy Etc Human Development

World Development is focussed on Sustainability

Disaster Risk Reduction now seen as major global objective within

Framework of Sustainable Development

Driving Definition of Disaster

A serious disruption of the functioning of a community or a society causing widespread human, material, economic or environmental losses which exceed the ability of the affected community or society to cope using its own resources. A disaster is a function of the risk process. It results from the combination of hazards, conditions of vulnerability and insufficient capacity or measures to reduce the potential negative consequences of risk.(UNISDR, 2004)

Catastrophe Insurance Seen As Important Component

Catastrophe Micro-Insurance

Disaster Management

Catastrophe Insurance Pools

Government Disaster Funds

Commercial Perils Insurance

Catastrophe Insurance

Planning Preparation Response Recovery

Rehabilitation Repair Reconstruction Funding

Government Relief

Savings Charity

Sustainable Development

Environment Energy Etc

Loans

Reinsurance Catastrophe Bonds Contingent Debt Etc

Human Development

Isn’t This Great News ?

“What wonderful news” you say

BUT

Very Different From Traditional Driver

Property insurance developed over 300 years ago to protect assets of the rich minority Became relatively universal in west as a result of dispersion of wealth within population Primary objective remained individual protection of assets Based on indemnity principle – cover of damage costs

Voluntary participation taken as a given Governments stepped in only if insurance industry deemed hazards uninsurable – eg NZ EQ, US Flood, Spain

System transposed to Asia essentially unchanged

Another Driver of Change In Developed Countries

General population in developed countries increasingly views protection from natural hazards, both economically and in terms of health and safety, as a social right. Get upset with insurance companies limiting their liability to claims Putting pressure on governments to ‘make’ insurance companies provide universal cover

What Have New Drivers in Common ?

Both directed at household and small (family) business. Not an issue for major commercial and industrial insurance.

Both look on insurance as a universal community social service, not a commercial business transaction

Government disaster insurance schemes seen as solution

Battle No. 2 – Personal Lines Catastrophe Insurance

Establishing a Role for the Commercial Insurance Industry in the

Provision of Universal Catastrophe Insurance at Household/Small Business Level

in face of Increasing Government Involvement

More an Insurer than Reinsurer Issue

Desired Outcome

A system which can provide a

Socially Adequate Level of Catastrophe Cover

Universally to the General Population

at an Affordable Cost

Consistent with Disaster Risk Reduction

The Issues

Universality of coverage – Population & Hazards

Affordability & Social Acceptability

Parametric v Indemnity

Sustainability

Mitigation

Volatility of premiums

Costs of Competition v Political Costs

Universal and Affordable

Commercial provision of insurance underpinned by

Insurer defined ‘Insurable’ risks

Insurer determined premiums based on indemnity of loss or value

Individual freedom of policyholder to insure

Inconsistent with

Provision of universal affordable catastrophe cover

Human tendency to downplay extreme risks – need compulsive element

Indemnity v Parametric

Indemnity Lower limit of premium fixed

Claims – costly and slow process

Prone to moral hazard

Luxury not all can afford – All or Nothing

Parametric No lower limit to premiums

Claims – cheap and quick process

Low moral hazard

Purchase what can afford – Neither All nor Nothing

Socially Adequate, Affordable, Universal & Sustainable

Accept that policyholder will carry some risk There will be a minimum amount of cover to meet criteria of social adequacy To be universally affordable Government may need to subsidise premiums of poorest – proper use of taxpayer funds To be sustainable Government may need to carry some of risk associated with extreme events along with policyholders and insurance fund

Mitigation

Mitigation fundamental to sustainable disaster risk reduction – and affordable catastrophe insurance Insurance industry reactive not proactive – insurance more often a disincentive to mitigation – unlike approach to fire, theft, motor, etc Only significant exception is Fiji Risk rated premiums basic requirement

Volatility

After a major event loss reinsurers tend to punish those who have suffered loss by steep increases in premiums – to get their money back even though contrary to principle of insurance

Not socially acceptable or consistent with sustainable development or social acceptability which looks for stability of pricing – based on rational risk assessment not knee jerk response

Government schemes less susceptible to this volatility – better able to spread costs over time

Costs of Competition

Ungern- Sternberg Proposition

Catastrophe insurance has fixed basic price, usually small. All other costs add to this. Marketing costs of private enterprise outweigh inefficiencies of government

Demonstrates by European examples –

Spain, Britain, Switzerland, France, Germany

(Ungern-Sternberg, Efficient Monopolies, 2004)

But Other Advantages for Government Like Tax

Catastrophe insurance losses by their nature are volatile – mostly low losses but occasionally very large ones Reinsurance solves major portion of this by distributing risk geographically, but insurance companies still have accumulation of retentions In good years cat insurance yields significant profits which are taxed plus income from reserves also taxed inhibiting build up of reserves Government net income not taxed allowing more rapid build up of reserves and distribution of risk over time providing more stable premiums

And Efficient Use of Capital

A public company under pressure from shareholders to use capital in an efficient manner on an annual basis

Optimum amount of capital to manage given amount of risk and provide adequate return to shareholders

Government (& Mutual & Private) Funds not under this restraint

By using a combination of reinsurance (geographical spread) and capital reserves plus borrowing (spread overtime) Government can reduce volatility more than private industry and thus offer lower premiums

But Also Political Costs

Just look at mess in the US where Governments trying to control catastrophe insurance on short term basis

Decision making based on political expediency, not rational actuarial analysis

In Europe generally less political interference but highlights political risks

Battle Plan

A Workable Framework be developed that enables Insurance Industry to participate in a Sustainable Profitable Manner and achieve Required Outcome based on: Socially acceptable sharing of cat risk between

insurance fund, taxpayer and individual policyholder Minimisation of competition costs Isolation of catastrophe insurance from other business Untaxed accumulation of catastrophe reserves Risk rated premiums to encourage mitigation Isolation from political control

Is there Any Good News ?

Fundamentals of Insurance are relatively simple Already have Tools and Methodology to address technical issues There is previous Experience and Pioneering Initiatives to build upon

Fundamental Basis of All Insurance

Reduce the Coefficient of Variation of

Risk to a Manageable Level

by Combining

Many Independent Risks

of

Similar Statistical Characteristics

Using the Central Limit Theorem

Methodology & Tools

Financing Arrangements

Premium Collection & Claims Management

Administrative Structure Disaster Insurance Scheme

Premiums

Policy Conditions

Affordability

Sustainability

Operations

Hazard Risks

Building Vulnerabiity

Building Inventory

Experience & Experimentation

In the West

Significant number of schemes which meet desired outcome with varying degrees of success

In the East

Some exciting experiments in the area of catastrophe micro-insurance in China, India and Indonesia Lessons to be learnt from Taiwan EQ scheme Becoming an area of academic research – eg NTU ICRM

Who Will Lead The Insurance Industry Into Battle?

Concluding Remarks

A Challenging but exciting time for Catastrophe Insurance Needs energetic able people who are not afraid of challenging the status quo Asia will be the dominant battlefield The battles can be won