Changing Climate of Exposure

Catastrophe losses in recent years have prompted a discussion within the industry, as well as among regulators, government, and others, about the property and casualty industry’s financial capacity to handle catastrophe risk. From a solvency perspective, “the industry” is less of interest than the capacity of individual insurers – which show varying degrees of financial strength – to avoid the fate of being wound up and liquidated. In 2005, catastrophic losses reduced earnings for most Canadian and U.S. insurers, but had limited impact on capital or solvency. This is partly duetolessons learned more than a decade ago from Hurricane Andrew. Since 1992, insurers have further spread their risk across product lines and geographic markets. They have also developed risk models, better utilized the reinsurance market and most importantly, have raised rates in high-risk areas.

Five insurance companies – four based in the hurricane-prone Florida market and a small Bermuda-based reinsurer – became insolvent due to catastrophe losses from the 2005 storms. More have reassessed their distribution of risk and/or sought to adequately price for a higher-risk environment.

The recent magnitude of insured catastrophe losses – totalling more than CD$94 billion worldwide in 2005, including severe weather and industrial disasters – are clearly an important risk to P&C insurer solvency. As a result, insurers are paying closer attention to their catastrophe exposure. Tillinghast Towers Perrin’s 2005 enterprise risk management survey found that 79% of P&C insurers included catastrophe risk as part of their risk management and capital considerations.

INSURANCE IN CLIMATE OF CHANGE

French novelist Marcel Proust once said: “A change in the weather is sufficient to recreate the world.” Recent experience suggests he might be right in the context of insurers’ exposure to catastrophic losses. According to Environment Canada, spring temperatures increased since the ’50s, and the four warmest years have occurred since 1998. Scientific evidence, outlined by the Intergovernmental Panel on Climate Change (IPCC), warns warmer temperatures could increase the storm severity, potentially resulting in more and larger losses for insurers.

Catastrophes in Canada have had a greater impact on insurer financial results in the last decade than ever before. Data on catastrophe losses shows a dramatic increase in losses in recent years. Between 1985 and 1995, insured catastrophe losses, adjusted for inflation, totalled CD$1.7 billion. Since 1995, the scale of catastrophe losses has grown nearly four-fold, with losses totalling CD$6.7 billion (see Figure 1 on Page 44).

Several reasons explain this loss trend, including an increase in population and the simultaneous concentration of people and property values in large centres, the development of highly exposed regions, aging infrastructure, and changes in the natural environment such as global warming (and related regional effects). These factors are unlikely to change, and therefore insurer exposure to catastrophe losses can be expected to increase.

CLIMATE CHANGE AND SOLVENCY

According to A.M. Best’s study of insurer insolvency in the United States, catastrophe losses caused 8.2% of financial impairments (21 companies) between 1992 and 2002. This was an increase of nearly 40% compared with the previous two decades, moving catastrophic loss from the eighth largest cause of insurer impairment to the fourth. Since that study, another half dozen companies have failed as a result of catastrophe losses. Overall, there is a reasonably strong (negative) correlation between the financial health of the U.S. property and casualty insurance industry, measured by return on equity, and the size of catastrophe losses between 1988 and 2005. While catastrophe losses remain an important cause of insolvency, the improved risk management practices discussed earlier have weakened this correlation by half since the mid-1990s.

Although insured losses from natural disasters in Canada have demonstrated an upward trend during the past decade, they remain relatively low compared to total industry claims costs. Excluding the large losses of 1998 and 2005, catastrophe losses contribute only 1.2 points, on average, to the combined ratio (see Figure 2). Data on insured losses and industry profitability (ROE) show insignificant correlation between the two (-0.03%), with a one-year lag. The large catastrophe losses incurred in 1998 and 2005 both fortuitously occurred in strong earnings environments, permitting the industry to absorb the losses without experiencing an insolvency. Nevertheless, natural disasters have contributed to a small number of companies exiting the market through voluntary run-off.

Despite limited financial exposure to U.S. hurricane and other catastrophe losses, Canadian insurers experienced their largest catastrophe-related claims ever in 2005 – more than CD$2 billion in estimated total insured losses. In August 2005, an Ontario storm caused more than CD$500 million in estimated insured losses, becoming the most costly insured event in Ontario history. Alberta experienced severe flood-related losses in 2005 ( up to an estimated CD$300 million), making the floods that province’s most expensive natural disaster in nearly 15 years. Not restricting catastrophe losses to severe weather events, the January 2005 Suncor oil sands fire generated an estimated insured loss of more than CD$1 billion in business interruption and property insurance claims.

TIMING IS EVERYTHING

Had all of these events occurred in 2001 – in an environment of weak profitability and eroding capital – losses of a similar magnitude would have eliminated 9.7% of the industry’s total equity (after accounting for reinsurance recoverables). As a result of such losses in 2001, the probability of insurer insolvency, in addition to the two failures that did occur in that year, would have increased. PACICC estimates up to four additional companies could have been placed at risk. This observation highlights both the risk that catastrophe losses may pose to the industry, and the importance of healthy earnings, capital and timing.

RISK OF INSOLVENCY

The upward trend in historical catastrophe losses and the increase in insurers’ potential losses have led regulators, insurers and rating agencies to pay increasing attention to how insurers manage their catastrophe risk. This observed trend in extreme losses suggests a potential shift in loss distribution. The type of risk exposure affects the shape of the distribution. For example, increases in average annual losses – which might occur with more frequent and severe downbursts – may shift the entire loss distribution to the right. Increases in extreme losses – which may occur with more severe inland windstorms, but without any increase in frequency – will elongate the distribution. The Association of British Insurers (ABI) study on the financial risks associated with climate change illustrates the impact of this changing loss environment (see Figure 3).

Catastrophe exposures place special demands on insurer capitalization and reinsurance arrangements, so they require a distinct risk management approach. From a solvency perspective, if an insurer continues to price its policies, maintain capital or reinsurance cover at the original loss climate level despite the fact it is a new loss climate, then the probability of insolvency increases. How might this occur? Since catastrophe events are infrequent, there may be uncertainty identifying if there is a change in the loss environment. And even when a change in the loss climate is identified, it may be difficult to determine the actual new underlying loss distribution and price it adequately. These uncertainties increase the importance of capital management and solvency challenges surrounding catastrophe losses.

CONCLUSION

Overall, the Canadian catastrophe loss environment, while
less severe than that of the United States, appears to be increasing. Fortunately, as a result of improved risk management, as well as the good fortune of having the two largest catastrophe loss years occur during years of strong profitability, the Canadian P&C industry has been able to weather catastrophic loss events with few insurer insolvencies. But this luck may not continue to hold. And Marcel Proust may have been correct all along: if the recent increase in the severity of catastrophe losses is any indication, the Canadian P&C insurance industry will remain vulnerable to catastrophe losses.