Megacatastrophes: Risk Acceptance and Claims Management

By Gary Kerney

For insurers and reinsurers, the consequences of megacatastrophes are both major and unique. The term “megacatastrophe” — used to describe 1992’s Hurricane Andrew and 2005’s Katrina — also describes the ultimate effects of four hurricanes that struck Florida in 2004. The impact of those events is measured in ­billions of dollars.

Then there was Ike. The hurricane was a Category 2 tropical cyclone and was expected to have a limited impact on the Gulf Coast. However, Ike was so big it created a storm surge akin to a Category 4 hurricane. As if that were not enough, the remnants of Ike traveled northward, causing billions of dollars in damages to the Midwest and Great Lakes region. Many people were simply not prepared for the breadth of destruction caused by this ­hurricane.

Risk management challenges are prevalent in nearly all levels of commerce and society. Factors such as underinsurance or the total lack of insurance prevent some homeowners and business owners from ever recovering from a major catastrophe. The loss of tax revenues, jobs, and commerce exacerbate the negative economic consequences. “Loss amplification” or “demand surge” — the increased cost of construction due to the number of properties needing replacement or repair following a major disaster — is another concern. And by far the most insidious impact is the time required to rebuild.

For some residents of New Orleans, the rebuilding process continues even now — four years after Hurricane Katrina. They have had to move from their neighborhoods and live elsewhere while their homes are rebuilt. If their jobs are still available, they must make arrangements to get to and from work. Employers must recognize the effects of such megacatastrophes on the lives of employees. It is necessary to realize the impact and important to address ways to help employees cope and recover.

It is also true that issues affecting the business of ceding insurers will usually have a similar effect on reinsurers. While reinsurers may see reduced payments in some scenarios, the end result is likely to be the same in terms of financial performance.

And there are other major consequences of megacatastrophes.

Class action lawsuits can be spurred in part by lack of appropriate coverage for perils that are ultimately uninsured. The outcomes influence final payments for damage, sometimes uninsured damage. Increased legal costs can be shared with reinsurers. Decisions regarding coverage will also involve reinsurers.

Finding unbiased juries for trials of those accused of perpetrating postcatastrophe insurance fraud has been difficult in some areas. Many in the jury pools have been in circumstances similar to those of the individuals on trial. Jurors may therefore have sympathy for the plight of the accused, making it hard to get convictions.

The costs incurred by the National Flood Insurance Program and other publicly supported entities require taxpayers to assume long-term debt to support recovery efforts. At the same time, revenues are reduced for insurers and reinsurers that compete to insure much of the same property. Some risks are truly not insurable in the private market and benefit from publicly supported organizations. Other risks are insurable — at a fair price that reflects the risk of loss. If government entities, such as the Florida Hurricane Catastrophe Fund, are providing coverage at prices below the anticipated costs, the effect on private insurers will be negative. The presence of such entities could prevent insurers and reinsurers from offering competitive insurance coverage.

The political furor from personal loss experience and the perception of utter breakdown in response and recovery efforts have affected insurers and reinsurers. In Florida, political action described as necessary to blunt the impact of rate increases or nonrenewal efforts has created questionable recovery mechanisms. Many wonder if Floridians can recover from a major catastrophe in a timely fashion.

Changes in the way insurers manage risk and exposure often include increased premiums, higher deductibles, or nonrenewed policies. Changes like those in everyday insurance decisions have an impact on reinsurers as well.

The development of a global exposure is an issue for many ­reinsurers today. As economic conditions improve in developing nations, the need for insurance grows. This poses new concerns and requires new thinking about risk and exposure and new ways to provide the needed insurance.

In addition to the growing global exposure, there is also the threat of concurrent catastrophes. Reinsurers must evaluate the consequences of their ability to pay when major catastrophes strike in diverse locations around the world.

Insurers have dealt with the impact of multiple events in the past. Examples include Hurricane Hugo and the Loma Prieta earthquake in 1989; Hurricane Andrews and Iniki in 1992; the four Florida hurricanes of 2004; Katrina, Rita, and Wilma in 2005; and the six landfalling tropical systems in 2008. Multiple catastrophe claims in near time can diminish the adjusting capabilities of any organization. The need to serve numerous policyholders becomes very complicated. In addition, insurers and reinsurers must meet the expectations of stockholders, ­regulators, politicians, and the media in the way claims from catastrophes are handled. Managing the claims process in those situations can result in unforeseen delays. Understanding that this can happen may contribute to a better recovery with a smaller negative impact on a business.

One alternative gaining growing support from the insurance industry is securitization. Insurance-linked securities (ILS) provide the ability to transfer catastrophe risk to capital markets. Insurance-linked securities take different forms. The most prolific may be Industry Loss Warranties (ILW). Other instruments include catastrophe bonds, swaps, derivatives, and other “over-the-counter” products. In the end, each is designed to provide an insurer or reinsurer with access to capital to settle claims, thereby ensuring policyholder confidence.

These investment opportunities have attracted hedge funds, ­pension plans, investment banks, and individual investors. The amount of capital raised through such transactions remains a small portion of the capital needed to pay catastrophe-related claims. In the years ahead, however, invested capital is expected to grow significantly and will likely also change the way insurers and reinsurers approach the acceptance of risk and the claims management response to megacatastrophes.

The factors described here contribute to the growing concern surrounding recovery. Risk managers in any role must identify and plan to mitigate not only the effect of risks they know but also the impact of risks and circumstances they have not faced previously. As we have learned especially in recent years, the impediments to swift recovery and the “return to normalcy” are often unanticipated and very harmful.

Gary Kerney is assistant vice president of ISO’s Property Claim Services® (PCS®) division.