The Impact of Catastrophes on Property Insurance
January 1994
Executive Summary
Introduction
In the United States, four of the five most severe individual catastrophes from 1950 to 1992 have occurred since the beginning of 1989. The largest of these catastrophes was Hurricane Andrew, with insured losses totaling $15.5 billion.
In the aftermath of these catastrophes, it became clear that even larger catastrophes were possible if they hit more densely populated areas. For example, if Hurricane Andrew had hit Miami, the losses could have exceeded $40 billion. [1]1. Craig Van Anne and Thomas Larsen, "Estimating Catastrophe Losses with Computer Models," Contingencies, March/April 1993, p. 45. The estimate is based on EQE International's WINDCAP program.
Population in storm-prone areas has been steadily growing. From 1970 to 1990, the Southeast Atlantic Coast had a nearly 75 percent increase in population density — far surpassing the countrywide increase of more than 20 percent. This expansion coincided with a 20-year lull in the occurrence of intense hurricanes. A return to a more normal level of intense hurricane activity — as experienced from 1910 to 1970 along this coast — could lead to potentially larger losses than those of Hurricane Andrew.
This study discusses:
- catastrophic events and the stresses — economic and otherwise — recent catastrophes have caused the industry;
- the potential financial problems insurers, reinsurers, and other risk-bearers would face if a major catastrophe were to hit a heavily populated urban area;
- the steps that have already been taken and suggestions for other actions to help handle future catastrophe losses; and
- some new directions that are under consideration to produce more accurate loss costs for catastrophes.
Stress in the Marketplace Due to Recent Storms
The recent severe catastrophe losses, along with the realization that even larger catastrophes are possible, have caused great stresses in property/casualty insurance markets. Some reported instances follow.
Impediments to Claim Settlements, Demand Surge, and Unanticipated Costs
Recent catastrophes were so devastating that they spawned unique barriers to settling all the claims at once — including transportation and communications breakdowns, and a "demand surge" in materials, labor, and living costs — which increases costs much more than if each loss had occurred separately.
Insolvencies
The seven insolvencies in Florida following Hurricane Andrew and the insolvency of Hawaii's largest insurer following Hurricane Iniki delayed claim payments to insureds and increased costs for surviving insurers and, ultimately, the public.
Overly Concentrated Exposures
Many insurers realized that their exposures were too concentrated in hurricane-prone areas and attempted to reduce their writings in these areas. In some jurisdictions, regulators restricted cancellations and nonrenewals of Homeowners policies.
Reinsurance Shortages
Reinsurers, who were subject to the same stresses as primary insurers, reacted by raising rates and reducing coverage, causing additional stress on the insurance mechanism.
Reinsurance alone cannot be expected to solve the problems of a major catastrophe. Domestic reinsurers that wrote over 50 percent of the ceded reinsurance in 1991 had a combined surplus of $16.4 billion at the end of 1992. This is far less than the possible losses from a major catastrophe.
Responses/Potential Solutions to Reduce the Impact of Catastrophes
In response to these stresses, insurers have sought and, in may cases, received substantial rate increases. [2]2. David Satterfield, "A Year Later, Andrew Still Wreaks Havoc on Florida," The Journal of Commerce, August 23, 1983, p. 8A.'
Other reported responses, and suggested solutions, include the following:
Methods of Spreading Losses
Government Pools
Government, either the federal government or a state government, could set up an insurance pool with the power to borrow money, assess premium taxes, and require insurers to pay premiums. Recently, Florida passed legislation setting up a government pool with these powers.
New Offshore Reinsurance Capacity
The expansion of reinsurance capacity provides a traditional way of spreading risk. More than $4.1 billion in new capital has been infused into at least 12 new reinsurers since November 1992.
Catastrophe Reserves
Current accounting rules could be changed to allow insurers to set up catastrophe reserves. Catastrophe reserves would be workable if their use were restricted to catastrophe losses and insurers were allowed to treat them as losses, making them a deductible expense in determining income taxes.
Catastrophe Futures and Options
Publicly traded catastrophe futures and options are designed to spread some of the risk from catastrophic events beyond insurers and reinsurers to the wider capital markets, thereby providing primary insurers and reinsurers with a possible hedge for their catastrophe losses.
Loss Mitigation Measures
Building Code Enforcement
The grading of local governments according to their building code standards and their level of enforcement and compliance could provide incentives to municipalities to reduce catastrophe losses. The Insurance Institute for Property Loss Reduction (IIPLR) — formerly the National Committee on Property Insurance (NCPI) — and Insurance Services Office, Inc. (ISO) are currently developing and testing a system for grading building codes and their enforcement by municipalities. Those municipalities with effective building codes that are well-enforced should exhibit better loss experience and receive a better grade.
Geographic Diversification
Recently developed computer technology provides insurers with the tools to improve management information systems for underwriting individual risks and tracking the geographic accumulation of exposures. Such monitoring should help insurers identify geographic concentrations, measure the potential for their aggregate losses from catastrophes, assess their underwriting strategy, and more favorably position themselves for reinsurance negotiations.
Changes in Policy Forms and Coverages
Insurers can also respond to catastrophe-induced stress by controlling costs and making affordable coverage available by changing policy forms and coverages. After 1992's catastrophes, some insurers adopted a variety of measures involving deductible changes, limits changes, and caps on guaranteed replacement coverage.
Improving Catastrophe Ratemaking and Forecasting
The current ISO catastrophe ratemaking formula is based on actual loss data over an extended time period. This mitigates the effect of an occasional large loss by substituting a long-term average for a short-term number in the ratemaking formula.
A problem with this approach is that the current conditions may differ from those underlying the historical data due to changes in land use, population densities, construction techniques, and building codes. The experience period can also be marked by atypical lulls in catastrophes.
Recently, computer simulation models have been developed, which can link simulated long-term natural disaster information with current demographic information to provide expected catastrophe losses. ISO expects these procedures to produce more accurate loss costs for catastrophes.
Simulation models for hurricanes should use long-term records to derive estimates of hurricane frequency and intensity. ISO could not find unequivocal support for the use of more recent conditions, such as a possible global warming, in catastrophe ratemaking procedures.
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