finance 431: property-liability insurance lecture 20: catastrophes
TRANSCRIPT
Finance 431:Property-Liability Insurance
Lecture 20:Catastrophes
Insurance Definition of a Catastrophe
A loss that affects more than one insured and causes a loss that is in aggregate in excess of a specified level. The current commonly used level is $25 million.
For someone living in Champaign-Urbana, what is the most likely type of catastrophic loss?
A) Fire
B) Earthquake
C) Hail
D) Hurricane
E) Tornado
RMS Catastrophic Risk Map
Catastrophes
Insurable vs. Non-Insurable Catastrophes
History of Insured Losses from Catastrophes
Reasons for Growth in Catastrophe Exposure
How Insurers Deal with Catastrophe Exposure
What Is Being Done to Help Industry Cope with Catastrophes
Insurable vs. Non-Insurable Catastrophes
Ideal Criteria for an Insurable Exposure1 Large Number of Similar Exposure Units
2 Fortuitous Losses
3 Catastrophe Unlikely
4 Definite Losses
5 Determinable Probability Distribution
6 Economic Feasibility
What Makes a Loss Uninsurable?1 Large Number of Similar Exposure Units
If losses are concentrated in a particular area Earthquakes, Floods
2 Fortuitous LossesIf location and timing of losses can be predicted
Flooding downstream after upstream area affected3 Catastrophe Unlikely
If potential loss could hurt financial condition of industryTornadoes or riots can be coveredWar or nuclear disaster cannot be covered
Catastrophe Losses, 1949-1997In nominal terms
Winds Carol, Hazel Betsy Celia WindsFrederic, David
Elena, Gloria
Hugo, Quake
AndrewQuake
0
2,000,000,000
4,000,000,000
6,000,000,000
8,000,000,000
10,000,000,000
12,000,000,000
14,000,000,000
16,000,000,000
18,000,000,000
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Bill
ions
of D
olla
rs
History of Insured Losses from Catastrophes
The Costs of CatastrophesProperty 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)
Other Costs• Additional Living Expense – Temporary accommodations and expenses.• Loss adjustment expenses – Insurers usually spend a large amount of money to
service policyholders following a catastrophe. • Coverage Extensions – Business Interruption, Contingent Business Interruptions,
Civil Authority, Off Premises Power.
History of Insured Losses from Catastrophes
Significant change in size of catastrophes occurred starting in 1989
The ten largest insured losses have all occurred since 1989
Recent estimates of possible losses New Madrid Fault Earthquake $116 billionCalifornia Earthquake $77 billionFlorida Hurricane $76 billionNortheast Hurricane $21 billion
Reasons for Growth in Catastrophe Exposure
Weather Pattern Change1949-1989 Period of Unusually Good Weather (?)Recent Return to the Long Term Norm
Population Growth in At Risk Areas for HurricanesSoutheastern seacoast
Lowered Building StandardsLulled by Reduced Storm ActivityOverwhelmed by Population Growth
Mandates to Cover EarthquakesImpact of Catastrophe on Repair/Rebuilding Costs
How Insurers Deal with Catastrophe Exposure
ReinsuranceManaging Exposures
Sophisticated catastrophe modelingLimiting concentration of exposures
Monitoring by zip codeHigher deductibles
Premium IncreasesWithdrawals from Some Markets
Property Catastrophe Reinsurance Programs
Property Catastrophe Reinsurance Treaties are typically part of a program. 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
Property Catastrophe Reinsurance Programs - 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
$140M
Coinsurance
Property Catastrophe Reinsurance – Models
– 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.
Property Catastrophe Reinsurance – Models
•These models have two main components. Peril scenario generators and damage functions.•The peril scenario generators model hurricane path and wind-speed for storms and earth movement for earthquakes.•Often historical records are scrutinized and thousands of years of geological data are considered.
Property Catastrophe Reinsurance – Models
•The damage functions are engineering functions that estimate the percent of structure damage for a given wind-speed or earth movement.
•These are often a function of a structure’s– Location
– Age
– Class
– Construction
Property Catastrophe Reinsurance – Model Output
•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.
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
$0 $5,000,000 $10,000,000 $15,000,000 $20,000,000 $25,000,000 $30,000,000
Loss
Proa
bility
of Ex
ceed
ance
Property Catastrophe Reinsurance – Model Output
•Expected loss – The loss cost for various layer of reinsurance.
•PMLs (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.
Property Catastrophe Reinsurance – Model Output
RATE ON
LINE =
TREATY PREMIUM
TREATY LIMIT
Roughly equal to the probability of payment.
Rates on a property catastrophe treaty are typically quoted using the term “Rate On Line”.
What Is Being Done to Help Industry Cope with Catastrophes
California Earthquake AuthorityFlorida Hurricane Catastrophe FundHazard Mitigation Grant Program (Floods)Homeowners Insurance Availability Act
Initially introduced in 1997Not enacted yetWould provide catastrophe reinsurance
Tax Deferred Catastrophe ReservesProposals under consideration in Congress
Next Lecture
Securitization of catastrophe risk