2 November 2012Re/insurance

A storm (inevitably) brewing

Few events have such market-changing potential as the landfall of a major US hurricane. 2005 and its trio of named storms—Katrina, Rita and Wilma—is still spoken about in hushed tones. Its losses resulted in the creation of a further class of Bermuda reinsurers and prompted signifi cant changes to the way US states—Florida in particular—approach the threat of major wind events. The prospect of another major US hurricane of the magnitude of Katrina therefore raises serious concerns. With Bermuda players accounting for a signifi cant portion of Florida and Gulf Coast reinsurance, such events raise goosebumps on-Island. But what are the implications of such an event?

The fi rst issue to consider is the loss potential of such an event. Evidently it depends on the strength of the wind event, certain topographical and oceanic factors and the location of its landfall, but worst-case scenarios are worth considering. After all, events such as Katrina can, and do, happen. Talking with Paul Hopwood, head of global property treaty at Montpelier Re and Michael Kistler, director—model solutions at RMS, it is clear that both regard the Miami hurricane of 1926 as an important benchmark against which major US wind events are measured. The hurricane, a category 4 storm, caused widespread devastation of the city and across the Florida panhandle, with the National Hurricane Center estimating that the event cost $140 to $157 billion in normalised terms. Hurricane Katrina, for its part, cost the US $96 to $125 billion in property damage.

Today, a hurricane event of the magnitude of the Miami hurricane of 1926, would likely see losses climb higher than those of that year. As Hopwood indicated, “if there was a direct hit on Miami of a category 4 hurricane it could be a very nasty number”. Kistler likewise stated that such an event would be significant, citing a figure above $100 billion in total insurance industry loss as likely. Building regulations in the state of Florida have strengthened considerably since 1926, but so too have the levels of exposure. As Hopwood outlined, the population of Florida has increased considerably in recent decades, with property exposures having risen markedly since the 1920s.

But while a hurricane strike on a major metropolitan area in Florida certainly has the potential to wreak considerable damage, there are other wind scenarios that could cause significant loss. Hopwood said that the nature of construction along the Gulf Coast—from Texas to Alabama where there is an emphasis on wood-framed constructions— means that weaker storm strikes there hold the potential to cause considerable damage. Hurricane Irene’s recent close call with New York City also raises the prospect of strikes on the Big Apple and other cities along the Eastern seaboard.

Addressing the threat posed by a storm on New York City, Kistler said that Irene “could have been much more severe. One of the more dire scenarios was a direct strike on New York City at full strength, with a storm surge wreaking havoc on mass transit and public utilities, which would could have resulted in more significant losses from a structural and business interruption standpoint”. And despite suggestions in some quarters that a major strike on the city is unlikely, Kistler said that such an event is in fact “not unprecedented. It is not so much an ‘unknown unknown’. The question is whether there is the generational memory of such events”, he said. “Matters could easily have been rather different if nature had rolled the dice a little differently.”

A further threat highlighted by RMS recently is the hazard posed by storm surges linked to large wind events. Although Kistler explained that wind events do not necessarily result in strong surges, exposure assumptions have been modified in recent years. “There is however still ongoing debate regarding storm surge post-event financial assumptions,” said Kistler. Florida does not officially include storm surge risk in its analysis of residential property risk, he said, but RMS’s clients “can implement their own view of this assumption in its software, based on their specific policy terms and unique loss history”.

Storm surge is becoming an increasingly significant component of the threat faced by coastal and low-lying areas. Following massive business interruption losses associated with the Thai floods, it is likely it will merit further close attention.

Perhaps the next question to address would be the frequency of such events. Just how regularly are such major windstorms likely to make landfall on the US mainland? As Kistler explained, hurricane landfall frequency follows a cycle, with its timeframe being slightly greater than a decade—and there have inevitably been periods of higher and lower hurricane frequency. “There is considerable debate about whether there is an upward trend as regards frequency and whether it is attributable to climate change and anthropogenic greenhouse gases. Our goal is to provide a five-year forward looking view,” he said, adding that while there was a lower frequency of storms in the 1970 and 1980s, 1995 was an “inflection point. Since then we have seen an elevation of hurricane frequency— although such an elevation is not unprecedented when one considers the historical development of hurricane frequency”. Should this elevation be sustained, it raises the prospect of further wind events hitting the US.

Top 10 most damaging Atlantic Basin historical storms

The market responds

Addressing the implications of a major loss event of the magnitude of the Miami storm of 1926, Hopwood said that the market would be able to pay for a loss of that size, “but that it would likely place enormous strain on a state such as Florida, particularly considering the amount of exposure Citizens [the state-backed insurer] has to such events”. At the same time, commercial insurers in the state would face “significant difficulties” coping with the fallout from a major event.

Counterparty risk would be of particular concern, although Hopwood said that reinsurers place extremely strong emphasis on qualitative as well as quantative analysis. “There are around 50 Florida domestic property insurers in the state. In order to provide reinsurance protection, credit risk and examination of the exposures of cedants is now viewed with even more importance by reinsurers.” The extent of exposures realised following Katrina encouraged the state of Florida to step in, with increasing levels of re/insurance provision being provided by the state post-2006.

The increasing involvement of the State of Florida in the provision of coverage is one of the challenges facing the re/insurance industry post-Katrina. Following sharp upticks in catastrophe reinsurance pricing from losses in 2005, Florida felt it necessary to step in and provide significant insurance relief through rate limitations and expansion of mitigation credits for homeowners. In addition the Florida Hurricane Catastrophe Fund (FHCF) was expanded and provided artificially low reinsurance pricing for Florida carriers. As Hopwood explained, “property catastrophe pricing experienced sharp increases in 2006 throughout the US and especially for Florida. Due to increased reinsurance costs, Florida domestic insurers sought to pass these costs on to consumers, which resulted in a public outcry. Consequently the following year the state stepped in with measures such as the expansion of the FHCF, increased wind mitigation credits and controls on property insurance rates”.

“These measures effectively reduced the amount of coverage provided by the private reinsurance market. We have to learn from that,” said Hopwood. The FHCF took away a portion of Florida’s reinsurance market and the industry will have to take that particular lesson as a salutary reminder that relations with clients need to be long-term in their outlook. As Hopwood explained, “I don’t think that large spikes in pricing are in the long-term interest of clients or reinsurers.”

"Modelling companies have become increasingly conservative in their outlook of risk and more innovative in their view of exposure, tackling such issues as strom sruge and inland exposure."

Innovations were not limited to state responses. As Hopwood outlined, following “a watershed year for the industry in 2005” modelling companies have become “increasingly conservative in their outlook of risk and more innovative in their view of exposure, tackling such issues as storm surge and inland exposure”. While this has provided re/insurers with a better view of potential exposures, it has also increased likely insured losses in the US.

At the same time there have been increasing levels of alternative capital entering the cat space post-Katrina, with investors in search of returns and insurers looking to diversify their sources of reinsurance. Florida-backed Citizens Property Insurance, for example, opted for the insurance-linked securities (ILS) route, issuing the largest ever cat bond, $750 million, in 2011 Alternative plays are likely to become a permanent and increasingly prominent part of the cat landscape, particularly in the US.

“Following Katrina many reinsurers were able to raise new capital almost overnight. However, I don’t know if in today’s capital markets reinsurers will be able to do that as quickly,” Hopwood added.

Levels of ILS and alternative capital structures, coupled with strong industry capital, suggest that while the capital is there to respond to future events, the nature of the response will differ. A bricks and mortar response is now far less likely. Instead ILS, sidecars and collateralised plays seem the likely order of the day following a major event. Their speed to market will serve to mute sharp upticks in pricing, but such developments appear part of the ongoing evolution of the market.

US wind risk remains a significant portion of Bermuda players’ book of business. Rates will as a result be watched with interest. Asked whether pricing reflects the levels of exposure the industry potentially faces, Hopwood said that he felt it largely did. The US wind market had seen an uptick in pricing in the summer of 2011 and he added that this price development had continued through January 1 this year, with a moderate rate increase experienced at the mid-year renewals.

Losses in the US Midwest, a spate of global cat losses in 2011 and changes to RMS 11 had all played their part. “For most parts of the US the rates are adequately priced right now,” he said. During a troubled period on other lines, US property cat has been a substantial portion of Bermuda books. “Bermuda has always been a significant US cat market, extending meaningful support to states like Florida,” concluded Hopwood. That looks set to continue. A major US hurricane event is unlikely to change that dynamic.