22 October 2013News

Calm before the storm: preparing for the big one?

With a quiet hurricane season to date, 2013 is shaping up to be another relatively light year for global catastrophe losses. While this may provide some sense of relief for insurers and reinsurers, demographics and other trends indicate that it is only a matter of time before another market-changing event impacts industry capital and market pricing.

“A catastrophic event resulting in a $100 billion insured catastrophe loss is inevitable, and those who are thoughtfully measuring risk and proactively hedging or transferring it through accretive risk transfer will be in a significantly better position to capitalise on the resulting hardening market,” says Greg Heerde, head of Americas for Aon Benfield Analytics.

More recently, however, senior management teams have sought ways to challenge the underlying assumptions in the vendor models, seeking to develop a proprietary view of their individual company’s catastrophe risk. Impact Forecasting, Aon Benfield’s catastrophe model development team, has embraced open platform modelling since its inception more than 20 years ago.Owning the view of catastrophe risk Individual company exposure to a significant industry loss is most often determined through reliance on catastrophe models provided by third party vendors. Model results are relied upon by company management, regulators and rating agencies to determine capital adequacy. Output is also being used for pricing and underwriting decisions. Over time, reliance on results from a single model for such decision-making has moved towards a blending of multiple vendor models.

“Through Impact Forecasting, our clients are able to benefit from the frequency and severity assumptions developed by our meteorologists, seismologists, structural and civil engineers, but importantly can import their own assumptions based on knowledge of their book of business,” says Heerde.

A view of risk owned by the individual company allows for a more accurate quantification of probable maximum loss through better matching of model assumptions to the realities of individual company underwriting, claims and policy terms and conditions. It also enables a company to allocate reinsurance cost and the cost and capital to individual policies and to accurately differentiate their risk pricing on a basis consistent with their own views.

Declining cost of reinsurance capital

Once the view of catastrophe exposure is fully formed, senior management teams must decide whether to retain the exposure or to transfer to others through reinsurance or capital markets transactions. Whether companies view capital through a rating agency lens or through an economic capital method, quantifying the capital required to support catastrophe risk is essential to evaluating how much risk to retain.

“For catastrophe exposure, reinsurance has traditionally provided capital at a cost significantly below insurers’ cost of capital, and the cost of reinsurance capital is decreasing,” Heerde continued. “The cost effectiveness of reinsurance is due in part to the build-up of capital at traditional reinsurers from relatively benign catastrophe years, and the inflow of alternative capital from pension funds and other investors.”

Aon Benfield estimates that $45 billion of alternative capital has entered the reinsurance industry in the last decade, with an additional $100 billion set to enter in the next five years. Much of this capital will be dedicated to assumption of catastrophic losses. Heerde says that these dynamics have produced low single digit cost of reinsurance capital for properly structured programs.

Growth opportunities

Economic and market cycle dynamics are placing tremendous pressure on ceding companies to maintain margins and cut costs. However, using proprietary tools such as Aon Benfield’s CatScore, companies are able to recover the cost of reinsurance down to the individual policyholder level.

There is a nearly unprecedented opportunity for ceding companies to grow their underlying business by utilising reinsurance capital at its low cost, allocated down to a policy level. Geographic areas previously closed for underwriting risk control reasons may be reopened, and new product innovations may be financed with low cost reinsurance capital.

Ultimately, insurers have a tremendous opportunity to prepare for the volatility of the next “big one” and to finance sources of growth in the meantime. “Thoughtfully structured reinsurance, which may include multi-year, collateralised protections to lock in current capacity and pricing, could prove to be prescient when the first $100 billion event occurs,” says Heerde.