Carrying Enough Capacity

Recent changes the insurance industry implemented in response to the apparent increase in the frequency and severity of natural catastrophes dominated discussions at the 2006 RIMS’ Conference in Honolulu, Hawaii.

A majority of risk managers and brokers say the biggest issue they must contend with moving forward is securing enough cat capacity, according to XL Insurance chief operating officer David Duclos.

“This is probably the most difficult property casualty market that we’ve ever seen, and it’s largely a result of the last two years of cat activity,” Duclos said in an interview during the Hawaii conference.

The market is still experiencing a shift in the way storms are modeled, according to the president of Liberty International Underwriters Canada, Mike Molony.

“The loss from Katrina really put a question mark beside the models that were being used,” Molony told Canadian Underwriter during an interview at the RIMS conference. “So now the modeling agencies are making significant changes to their models, which may or may not restrict capacity.”

Traditional models, Molony explained, did not take into account the preventative measures some insurers said were implemented prior to the occurrence of a disaster or the relief required in the post-disaster environment, nor did they take into account the effects of concurrent storm and flood damage.

As a result of lessons learned post-Karina, modeling agencies are changing their models to include short-term projections, a focus on building vulnerability and projections based on storm and demand surges. These modifications will have significant implications on insurance capital and capacity, according FM Global senior vice president and Canada division manager Perry Brazeau.

“The fear and perception right now is that by mid-year, catastrophe capacity may dry up,” Brazeau said.

Duclos agreed the availability of capacity is an issue for cat-exposed businesses that are facing a large increase in probable maximum loss (PML) estimates. As a result of these increased estimates, Duclos said, based on Risk Management Solution (RMS)’s new model, capacity will burn up quickly and companies will have to increase their capital base in order to write more business.

“We’ve gone at the market for reinsurance placement,” Duclos said. “What we’re finding is a tremendous void in terms of reinsurance capacity.”

The consensus at RIMS 2006 seems to be that in the new modeling era, changes will result in a severe shortage in capacity.

RISKY RATINGS

New capital requirements are also complicating client access to the cat covers. Ratings agencies have changed their views about the cost of capital for companies that are knowingly covering cats, which is raising some concerns within the insurance community.

Modification to cat models is expected to elicit an increase to annual average loss (AAL) projections related to cat events. This means that price of cat cover may increase by 55 to 85%, according to Duclos. If insurers and reinsurers do not accept these higher projected loss ratios, Brazeau said, there will likely be an increase in price; this means securing significant coverage may be financially taxing.

The cost of capital is another issue driving concerns about the adequacy of cat coverage. Duclos said rating agencies are altering their rating system in response to the repercussions of the 2004-05 hurricane season. Such changes will likely correlate with modifications to the cat models, meaning that ratings will now reflect the PML companies face. In addition, the ratings agencies’ new capital models, like the new cat models, will reflect additional losses related to demand and storm surge, as well as flood and business interruption.

Globally, Duclos said, the insurance market is paying much more attention to modeling agencies and the new emphasis on specific risks they are modeling. The global insurance market, it would appear, is beginning to realize how their quote can be affected by different events.

“Coverage issues that have come out of the catastrophe losses are both BI (business interruption) and CBI (contingent business interruption),” Duclos said. “Given the 9/11 losses, and now Katrina BI losses, underwriting [BI and CBI losses] is totally different. The losses from contingent BI can be almost as large as the damage.”

Companies covering an increasing number of cat-related risks are being forced to cover smaller exposures and/or buy more protection or manage their risk by increasing capital reserves. “Everybody’s priority is to enhance and strengthen risk management programs,” Duclos said.

REDUCING THE RISK

Risk managers concerned about securing cat capacity were encouraged at a RIMS 2006 session, entitled “The New Climate – Wild Weather Worries,” to take precautions to reduce risk.

Mike Burke, FM Global’s vice president and manager of catastrophe exposures, said FM Global advised policyholders to protect against losses by fortifying their facility against storm damage. Duclos also referenced FM Global’s effective cat initiatives.

“Not to tout a competitor, but FM Global was able to reduce their cat losses as a result of the guidance they gave their insureds 72 hours before the storm hit,” Duclos said.

Information gathered from insurers’ reports, as well as risk engineering and analysis reports, is used to develop an effective claim prevention tool that Duclos said is valuable for risk managers.

Burke said FM Global commissioned a study showing that out of approximately 476 insured properties, about 300 were considered “clean” locations. These locations were areas in which policyholders had followed FM Global’s recommendations for loss prevention prior to the catastrophe. The average loss in a clean location, according to Burke, was approximately US$0.37 per US$100 of coverage. An unclean location was facing an average loss of US$2.30.

Maintaining a “clean” cat portfolio is essential going forward if ratings are to be maintained and risk quelled, according to risk managers interviewed at the conference. Risk managers and insurers are anxious to keep things “tidy” because of the uncertainty of what kind of cat loss the impending storm season will bring.

John Johnstone, executive vp and national director risk management at Aon Canada, said in an interview that although capital supporting the underwriting sector is still adequate, the industry is apprehensive going forward.

“Everyone is hedging their bets” by securing enough coverage to feed risks similar to last year’s hurricane season, Johnstone said. “If the severity [in 2006] is the same as [it was] last season, and the cat capacity is not there, than all bets are off.” In such a scenario, a reoccurrence of last year’s cats would result in a significant reduction in capacity and a tightening of rates, Johnstone said.