As the primary contact point with customers, insurance agents continue to be responsible for communicating the results of underwriting and pricing volatility, including traditional market cycles. In most cases the volatility is the result of catastrophes, and the fallout can be far reaching. We have all had to communicate significant price increases to clients, or explain why a client’s coverage is being non-renewed. Not pleasant. The most recent cycle was triggered by a series of cats, including 9/11 and Katrina, and the severe impact was felt by virtually all clients and insurance agents across the country.
The industry has searched for solutions since then because the sheer magnitude of the catastrophe exposure may be more than the insurance industry can assume. There has been significant discussion about governmental solutions to both man-made cats (terrorism, for example) and natural cats. Governmental bodies have stepped in as well. Florida has effectively taken over the homeowners market though Citizens and their cat pool.
Most of us in the industry would prefer a non-governmental solution to cat exposure, and any suggestion that there is a private, financial solution to catastrophe exposure should be met with serious consideration. A recent article in The New York Times Magazine on August 26th describes one such solution, cat bonds, in a manner that is easy to understand (see here). This should be required reading for anyone in the insurance business. While the primary subject is catastrophe bonds, the article by Michael Lewis (Liar's Poker, Moneyball..., The New New Thing...), provides an excellent summary, from 10,000 feet, of how the insurance industry's assessment of catastrophe exposure has changed over time.
Central to the insurance business's ability to economically insure our society's risks is independence of exposure - independence provides predictability across a large population. Cat exposure is not independent, and is different from the typical exposure commonly insured:
An insurance company could function only if it was able to control its exposure to loss. Geico sells auto insurance to more than seven million Americans. No individual car accident can be foreseen, obviously, but the total number of accidents over a large population is amazingly predictable. The company knows from past experience what percentage of the drivers it insures will file claims and how much those claims will cost. The logic of catastrophe is very different: either no one is affected or vast numbers of people are. After an earthquake flattens Tokyo, a Japanese earthquake insurer is in deep trouble: millions of customers file claims. If there were a great number of rich cities scattered across the planet that might plausibly be destroyed by an earthquake, the insurer could spread its exposure to the losses by selling earthquake insurance to all of them. The losses it suffered in Tokyo would be offset by the gains it made from the cities not destroyed by an earthquake. But the financial risk from earthquakes — and hurricanes — is highly concentrated in a few places.
Highly concentrated, correlated exposure is not something the insurance market, or even the reinsurance market, can retain in great amounts.
Cat exposures have become so large that experts doubt the insurance industry can sustain the largest even with the broad spread provided by global reinsurance markets. However, financial markets can easily absorb the magnitude of large cat risks.
The article describes the efforts by John Seo of Fermat Capital Management to provide relief in the financial markets through cat bonds, which is possible because experts are finding that cat exposure is quantifiable, if not independent.
Catastrophe risk is fundamentally different from normal risk. It deals with events so rare that experience doesn’t help you much to predict them…You lack information. You don’t know what you don’t know. The further out into the tail you go — the less probable the event — the greater the uncertainty.
Insurance companies, John Seo says, are charging customers too much — or avoiding their customers altogether — instead of sharing their risk with others, like himself, who would be glad to take it.
If this sounds like a marketing piece for cat bonds, it is. But cat bonds can be an effective way to move significant risk out of the insurance market to the financial markets. The devil is in the details, and the article ignores the difficulty of matching cat bond triggers with exposure in an insurer’s portfolio of risk. In this, reinsurance is a better developed risk transfer solution. But a good, important read.
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