The Consequences of Catastrophes

By Gary Kerney

Much has been written about the lull in catastrophe activity in 2006 and 2007 compared with the two prior years. The same respite was anticipated for the beginning months of 2008. That turned out not to be the case.

Through the end of June, ISO’s Property Claim Services® (PCS®) declared 25 catastrophes. Although subject to change as PCS moni­tors the loss reports, the 25 catastrophes have cost insurers nearly $10 billion. This has been, by far, the worst six-month period U.S. insurers have faced since 1994, when the Northridge earthquake caused more than $12 billion in insured property damage.

Most of the loss so far has been caused by severe weather, generally involving damaging winds, large hail, flooding, and tornadoes. Most uncommon has been the level of tornado activity. With more than 1,250 recorded tornadoes, this year has also been the deadliest since 1999; the 115-plus fatalities reported so far are three times the 25-year average for January through June. The first half of 2008 produced record-breaking severe thunderstorm activity, but insured losses — while above average — were not extreme.

On top of the extraordinary catastrophe activity, we are facing the seasonal hurricane forecasts with trepidation. The general consensus among hurricane forecasters — including the team at Colorado State University, Tropicalstormrisk in London, and the U.S. National Oceanic and Atmospheric Administration — is that the 2008 hurricane season (June 1 to November 30) could result in above-average hurricane activity.

In the absence of major hurricane damage this year, it is not likely that the insured loss will rival losses incurred in the hurricane years of 2004 and 2005. The megacatastrophes that resulted from four Florida hurricanes in 2004 and the likes of Katrina and Wilma in 2005 created consequences rarely experienced before. Those events produced new twists on old issues.

For example, since at least Hurricane Andrew, the industry has been aware of “demand surge,” the increased cost of construction due to the number of properties needing replacement or repair following major disasters. But beginning in 2004, following the four hurricanes that made landfall in Florida, demand surge has taken on a whole new meaning. In the aftermath of Hurricane Charley, which struck near Port Charlotte in southwestern Florida, some homeowners were told by contractors that it would be three years before their homes could be replaced. The number of contractors and laborers was not sufficient to make the necessary repairs because so many homes were affected.

An even more onerous example developed in the aftermath of Hurricane Wilma in 2005. Prior to the hurricane, many insurers figured that the screened enclosures surrounding pools or patios added $6,000 to $8,000 to home values. Those structures were severely damaged by flying debris during the hurricane. The demand for material and labor to repair or replace those structures soared. In the end, replacing individual enclosures cost more than $25,000 — a significant increase paid for by insurers.

Other major consequences result from megacatastrophes:

• class action lawsuits spurred in part by a lack of appropriate coverage for perils that are ultimately uninsured
• finding sympathetic juries for trials of those accused of perpetrating insurance fraud
• the debt incurred by the National Flood Insurance Program and other public entities, such as windpools, which require taxpayers to assume long-term debt to support recovery efforts
• the political furor from either personal loss experience or from the perception of utter breakdown in response and recovery efforts
• a change in the way insurers manage risk and exposure, which often includes increased premiums, higher deductibles, or nonrenewed policies

Ultimately, it is a question of who will pay and how. There are no easy answers.

Another development is the global outlook that some insurers and reinsurers are adopting today. They recognize the worldwide extent of the risk they face. These companies must evaluate the consequences of their ability to pay when major catastrophes strike in diverse locations around the globe. Today, a number of insurers are concerned with the effect of near-concurrent European windstorm or flood, United States hurricane or earthquake, Japanese typhoon or earthquake, and Australian cyclone or Chinese earthquake.

*As of August 2008

This exposure comes back to the consequences of managing risk. While a company may face a large exposure in the policies it underwrites in Florida, it must concurrently evaluate the risk it and its policyholders face daily somewhere else in the world.

Another activity gaining growing support from the insurance industry is securitization. The basic motive behind insurance-linked securities (ILS) is the ability to transfer catastrophe risk to the capital markets. Insurance-linked securities take different forms. The most prolific may be Industry Loss Warrants. Other instruments include catastrophe bonds, swaps, derivatives, and other “over-the-counter” products. In the end, each is designed to provide an insurer with access to capital to settle claims, thereby providing policyholders with confidence that their claims will be paid following a major disaster.

Some ILS transactions today use insured property loss estimates and other catastrophe-related information from PCS. Similar information would be invaluable to the insurance industry in other regions of the world. One consistent complaint is the deficiency of information on disasters outside the United States regarding the costs, claims, frequency, and individuals and communities affected.

In the end, though, individuals should take responsibility for recognizing risk and doing something about it. One should not move to Florida without understanding the risk of hurricanes. The same is true for earthquakes in California, tornadoes in Kansas, and winter storms in the Northeast.

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