Insuring with the elephant

PACICC research suggests that although the financial health of Canadian insurers is intrinsically tied to the fortunes of US and other international insurers, the solvency of Canadian insurers is not as endangered by Hurricanes Katrina, Rita, and Wilma as one might think.

Hurricanes Katrina, Rita and Wilma were a series of events with a large direct impact on American insurers. Their impact on the insurance industry has been global, however, and highlights the potential exposure of the Canadian industry to foreign events.

Reinsurance has long been global, but more recent consolidation among primary insurers has led to the formation of large insurance groups and conglomerates. As a result, the size and number of complex insurance organizations spanning national borders has increased. Overall, the international nature of the insurance industry brings important benefits to insurance consumers. The international scope of the industry increases competition, permits greater risk diversification and allows access to international sources of capital to underwrite Canadian risks.

In 1999, at the World Economic Forum, UN Secretary-General Kofi Annan stated: “Globalization is a fact of life. But I believe we have underestimated its fragility.” At that forum, he was talking about the rapid growth of international markets and the accompanying benefits, as well as the risks that also come with greater reliance on international markets. International insurance/financial groups are generally well diversified and possess strong corporate governance structures that should reduce the risk of insolvency. However when these firms do experience financial distress resulting in insolvency, the resultant impact and challenges to the guarantee fund system are considerable.

SUPERVISORY OVERSIGHT

International financial institutions are more likely to be centrally managed along lines of business, rather than managed with regard to separate legal entities, national borders, or functional regulatory authorities. Advances in information technology have made it easier to centralize the management of international financial institutions. Many such firms have centralized decision-making on corporate strategy and, to some degree, its implementation.

The growing use of intra-group arrangements adds challenges to prudential supervision, and to efficient responses if an international financial institution should fail. A.M. Best’s study of insolvency highlights the growth of these risks. Prior to 1990, the study did not find any financially impaired companies – 280 were surveyed – where the cause was attributable to the failure of an affiliate. Since 1990, 21 (or 7.4% of) financial impairments could be attributed to the financial distress of an affiliate.

The fragmentation of supervisory oversight that is inherent in a global network may delay recognition of the financial impairment of an institution. When they do occur, cross-border insolvencies further complicate an already complex winding-up process. Jurisdictions and guarantee funds may have different or conflicting approaches to insolvency. Some countries have structured their regulatory and supervisory systems to deal with financial groups in an integrated fashion. This is the case, for example, in Australia, Canada, Germany, Japan, the Netherlands, Norway, Sweden and the United Kingdom. But many countries still rely on functional regulation, with separate rules and separate solvency regulators for sub-national jurisdictions and for the banking, insurance and securities businesses. Indeed, fundamental accounting conventions, time horizons and regulatory objectives often differ across countries.

Coordination among supervisory authorities within a single country, sharing a similar legal framework, can be challenging. In the event of a failure, international coordination involving quite different legal frameworks can generate even more formidable challenges. A number of case studies have highlighted these challenges, most recently in the case of the HIH Insurance Group failure. HIH affiliated companies operated in a number of jurisdictions, including Australia, the United States, the United Kingdom, Hong Kong and Thailand. The failure of the group triggered the involvement of nearly a dozen guarantee funds or government compensation schemes. The international corporate structure of HIH, location of policies and assets and complex reinsurance arrangements were factors that required significant cooperation and communication in the protection of policyholders.

CANADIAN EXPOSURE TO INTERNATIONAL RISKS

The risk of international and cross-pillar insolvencies is highlighted by the failures of Barings (1995), Reliance Insurance Company (2000), HIH Insurance Group (2001) and Home Insurance Company (2003). To date, Canada’s exposure to international and cross-pillar insolvency has been limited, but growing. Two of the last three wind-ups of Canadian insurance companies were precipitated by the failure of parent companies in the United States. Both companies were small players in the Canadian market; yet the experience warns of the growing risks and challenges of an international insurer becoming insolvent.

Canada’s insurance market is one of the most dynamic and international insurance markets in the world. Nearly two thirds of our property and casualty insurance industry is foreign-owned. A.M. Best’s study of insurer insolvency in the U.S. insurance market did not identify foreign risks as a source of failure. Relative to the United States (where less than 10% of insurers are foreign-owned) and other jurisdictions, the risk of an insurer failure resulting from the insolvency of a foreign parent is greater in Canada.

In view of the greater international exposure of the Canadian industry, and the recent occurrence of catastrophe, PACICC’s research has reviewed the solvency risk associated with a large loss such as Hurricane Katrina occurring in a foreign jurisdiction.

HURRICANES IN 2005: IMPACT STATEMENT

A.M. Best’s study on the causes of insolvency in the United States found that 8.2% of failures in the United States (representing 21 companies) between 1992 and 2002 were as the result of a catastrophic loss. This was an increase of nearly 40% compared with the previous two decades. This moved catastrophic loss from the eighth-largest cause of insurer failure to the fourth. According to A.M. Best data, six of the 10 largest U.S. catastrophes occurred during that decade (measured in inflation-adjusted terms). Hurricane Andrew (1992) alone, with associated claims costs of Cdn$29.5 billion, caused 11 insurance companies to fail.

In meteorological terms, Katrina was the third largest hurricane to make landfall in the United States. While Andrew had higher wind speeds at landfall, the width of Katrina’s hurricane force winds at landfall was twice the extent of Andrew. The extent of the damage was largely due to the breadth and strength of the wind. The subsequent storm surge that flooded New Orleans exacerbated the damage. Tillinghast Towers-Perrin estimates every insurer writing property coverage in the southeastern United States, and most reinsurers around the world, will have losses stemming from Katrina.

Estimates related to Hurricane Katrina expected insured losses of between Cdn$17 billion and Cdn$71 billion, depending on the source of the estimates, making it the largest-ever US catastrophe. Third-quarter US industry results reported by ISO identified Cdn$40.9 billion in Katrina related losses, exceeding most lower range estimates. The insurance losses resulting from Katrina, as estimated by Tillinghast Towers-Perrin, are unusual in that they are expected to be distributed evenly across the primary and reinsurance markets, with a small amount (1% to 3%) being absorbed by capital markets. In contrast, after the four hurricanes that made landfall in the U.S. in 2004, up to two-thirds of the losses were borne by primary insurers and an estimated one-q
uarter to one-third of the losses were borne by reinsurers. Losses associated with Hurricane Rita are much less than Katrina – paid claims to date related to Rita are Cdn$5.6 billion by the end of the third quarter with estimated insured losses of up to Cdn$8.2 billion. US insured losses associated with Hurricane Wilma are estimated to be between Cdn$2.4 billion and Cdn$14.3 billion. Losses from the three hurricanes are an estimated Cdn$48.9 billion to Cdn$93.5 billion, with Katrina accounting for three quarters of the total.

U.S DISASTERS AND CANADIAN INSURERS

There is a moderately strong negative correlation between the financial health of the U.S. industry (as measured by return on equity) and the size of catastrophe losses between 1988 and 2004. In fact, the correlation coefficient (a statistical measure of the relationship between two variables) is -33%. However, this relationship masks some significant changes that have occurred since Hurricane Andrew. The correlation coefficient between catastrophe losses and financial health was much stronger for the period 1988 to 1996 (-88%) than since 1996 (-4%). The results are similar when compared against insolvency rates.

This suggests that in the early ’90s, the US property and casualty industry was much more vulnerable to catastrophe exposures than it is now. The growth in the relative proportion of failures caused by catastrophes between 1992 and 2004 is primarily due to the large number of failures associated with Hurricane Andrew. Improved accounting and corporate governance of insurers over the ’90s further reduced the proportion of failures related to these factors. These two factors, rather than an increase in catastrophe related failures, account for the increase in the relative importance of catastrophe related failures found in the A.M. Best study. The correlation of financial health for the Canadian industry to North American catastrophe losses is virtually zero (1%), suggesting that historically the insolvency risk to PACICC member companies from U.S. catastrophes has been low.

INDUSTRY PREPARATION

Despite the large losses expected from Katrina, Rita and Wilma, in general, the solvency implications are expected to be modest. For most affected insurers, Katrina, Rita and Wilma will reduce earnings in 2005 but should have a limited impact on capital. This is due in part to the lessons learned from Andrew. Since 1992, insurers have been better at spreading their risk out geographically. They have also developed risk models, better utilized the reinsurance market and have raised rates in higher risk areas.

Reflecting this, only one small insurer became insolvent as a direct result of last year’s storms, during which four hurricanes made landfall in Florida. Considering that these storms generated Cdn$32.4 billion in insured losses, the solvency implications were much less severe compared to a decade earlier. To date in 2005, although four insurers have been downgraded (only one – a reinsurer – into the vulnerable range) and another two dozen insurers have been placed under review by rating agencies, but there has only been one reported failure due to Katrina, Rita or Wilma (a small, Bermuda-based reinsurer). Industry observers in the United States note the industry is better prepared now than it was 15 years ago to handle large hurricane losses.

Overall, Canadian exposure to Hurricanes Katrina, Rita and Wilma should be limited. There are 23 PACICC members with parent company exposure to Katrina, Rita and Wilma. However, the rating agencies appear to continue to have confidence in these companies, as none have had their financial strength rating downgraded.

CANADIAN EXPOSURE

Historically, P&C insurance company failures in Canada have been closely linked to the Canadian insurance cycle. However, the risk of an insurer failure resulting from the insolvency of a foreign parent is greater in Canada than in many other countries. In the past, catastrophic losses have been an important cause of insurer failure in the United States, and hurricanes Katrina, Rita and Wilma represent the largest insured catastrophe loss experienced by the U.S. insurance industry.

Fortunately, insurers are better prepared to respond to such risks today than a decade and a half ago. Nonetheless, the risk of insolvency from a catastrophe remains real, and the total impact of Katrina, Rita and Wilma will need to be evaluated in the fullness of time. The cautionary tone of the U.N. Secretary-General about our tendency to underestimate the risks of globalization remains relevant today.