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Catastrophe Insurance: Victory Won
– Battles to Come
Dr George Walker
Honorary Research Fellow Aon Benfield Analytics Asia Pacific
The Escalation of Insured Catastrophe Losses
17 years Prior to 1987 Maximum Annual Loss $12.2 Billion Average Annual Loss $7.2 Billion
10 years 1987-1996 Maximum Annual Loss $44.7 Billion Average Annual Loss $25.2 Billion
10 years 1997-2006 Maximum Annual Loss $119.2 Billion Average Annual Loss $38.2 Billion
(Swiss Re Data 2010 US$)
Maximum Event Losses
1970-1986 < $2.5 B 1987 - European Floods $6 B 1989 - Hurricane Hugo $8 B 1991 - Typhoon Mireille $9 B 1992 - Hurricane Andrew $24.9 B
1994 – Northridge EQ $20.8 B 2001 -9/11 $23.1
2005 - Hurricane Katrina $72.3 B 2009 – Hurricane Ike $20.5 B
(Swiss Re Data 2010 US$)
Impact on Catastrophe Reinsurance Industry
Early Nineties Huge Impact – Particularly Lloyds
Mid 2000’s
Reinsurance Industry Remained Remarkably Healthy
Still is Healthy
Despite Global Financial Recession
A Victory Won
After Andrew
Identified Major Weakness
Empirical Risk Assessment (Extrapolation from Past Losses)
Corrected it with New Tools
Catastrophe Loss Risk Modelling Dynamic Financial Analysis (Scientific Forward Projection of Losses & Fund Performance)
Cause for Celebration - BUT
Cannot Assume The Future
Will be Extrapolation of The Past
The Primary Reasons for Big Increase in Losses
Big increase in wealth
Big increase in diversity of wealth
Big increase in concentrations of wealth
Especially in extreme hazard prone areas
Mitigation efforts lagged development
Is This The Pattern Of The Future ?
and
Yes To Increasing Magnitude and Frequency
of Large Event Losses
No to current overwhelming dominance
of North America relative to Asia
Asian Demographics Relative to North America and Europe
Population 4 times as large
GDP about half but increasing at over twice the rate
Urbanisation in NA/Europe is tapering off – in Asia is increasing rapidly from much lower base
As is insurance penetration
Add to This
Increasing complexity – of which you have heard much at this conference
Inevitable surprises – of which you have also heard
Increasing political interference reflecting changing expectations of society
Which Means
If the
Commercial Catastrophe Insurance Industry
Is to Remain Healthy
And Reap the Opportunities
Arising From These Changes
There will be More Battles to be Won
Will Not be Spread Evenly Across Sectors
First Battle
Across the Board – Surprises – “Watch The Gap”
Surprise is the Consequence of an Event Not Modelled or Not Well Modelled
Current Models dominated by current need in North America for Maximum Event Losses – Hurricanes & Earthquakes
In Asia Flood as important as Typhoon & Earthquake
Increasing Frequency is as serious as increasing Magnitude requiring all potential insured hazard losses to be modelled
Commercial & Industrial Lines - Complexity
Complex structure of business operations and dependence on infrastructure makes modelling contingent business interruption very complex
Models need to model infrastructure damage and other interdependencies
Another “Big Gap”
Battle No. 1 – Expanding Scope of Models
Big technical challenge to industry
Will be expensive
Who will pay for it? Who should do it?
Should model development be Competitive or Collaborative
Is there a role for academic development of open source models - eg GEM?
Second Battle
Escalating Disaster Costs Not Restricted to Insurance
Average Annual Global Economic Cost of Disasters
(Current US$)
1960’s 10 Billion
2000’s 100 Billion
A 10-fold Increase in Real Terms
Dominantly in Developed Countries – eg US
(40% Insured almost all in developed economies) [Ball Park Estimates by Author based on Munich Re data]
Creating Issues for Society
The increasing cost of disasters and their impact on national and international development – particularly in respect of the developing world Increasing gap between what community expects in terms of financial protection from hazard losses and what it gets at household and small business level – particularly in developed world Both are essentially political issues – but also catastrophe insurance issues
Development Issue Particularly for Asia
Already many of largest urban concentrations are in Asia, many in hazard prone areas
Mitigation policies no better than in US during past 40 years
Asia will increasingly become scene of most costly disasters – eg recent Japanese EQ & Tsunami
Most of Asia still part of developing world
Escalating Disaster Costs Pose Threat to Development
Disaster Management
Planning Preparation Response Recovery
Sustainable Development
Environment Energy Etc Human Development
World Development is focussed on Sustainability
Disaster Risk Reduction now seen as major global objective within
Framework of Sustainable Development
Driving Definition of Disaster
A serious disruption of the functioning of a community or a society causing widespread human, material, economic or environmental losses which exceed the ability of the affected community or society to cope using its own resources. A disaster is a function of the risk process. It results from the combination of hazards, conditions of vulnerability and insufficient capacity or measures to reduce the potential negative consequences of risk.(UNISDR, 2004)
Catastrophe Insurance Seen As Important Component
Catastrophe Micro-Insurance
Disaster Management
Catastrophe Insurance Pools
Government Disaster Funds
Commercial Perils Insurance
Catastrophe Insurance
Planning Preparation Response Recovery
Rehabilitation Repair Reconstruction Funding
Government Relief
Savings Charity
Sustainable Development
Environment Energy Etc
Loans
Reinsurance Catastrophe Bonds Contingent Debt Etc
Human Development
Isn’t This Great News ?
“What wonderful news” you say
BUT
Very Different From Traditional Driver
Property insurance developed over 300 years ago to protect assets of the rich minority Became relatively universal in west as a result of dispersion of wealth within population Primary objective remained individual protection of assets Based on indemnity principle – cover of damage costs
Voluntary participation taken as a given Governments stepped in only if insurance industry deemed hazards uninsurable – eg NZ EQ, US Flood, Spain
System transposed to Asia essentially unchanged
Another Driver of Change In Developed Countries
General population in developed countries increasingly views protection from natural hazards, both economically and in terms of health and safety, as a social right. Get upset with insurance companies limiting their liability to claims Putting pressure on governments to ‘make’ insurance companies provide universal cover
What Have New Drivers in Common ?
Both directed at household and small (family) business. Not an issue for major commercial and industrial insurance.
Both look on insurance as a universal community social service, not a commercial business transaction
Government disaster insurance schemes seen as solution
Battle No. 2 – Personal Lines Catastrophe Insurance
Establishing a Role for the Commercial Insurance Industry in the
Provision of Universal Catastrophe Insurance at Household/Small Business Level
in face of Increasing Government Involvement
More an Insurer than Reinsurer Issue
Desired Outcome
A system which can provide a
Socially Adequate Level of Catastrophe Cover
Universally to the General Population
at an Affordable Cost
Consistent with Disaster Risk Reduction
The Issues
Universality of coverage – Population & Hazards
Affordability & Social Acceptability
Parametric v Indemnity
Sustainability
Mitigation
Volatility of premiums
Costs of Competition v Political Costs
Universal and Affordable
Commercial provision of insurance underpinned by
Insurer defined ‘Insurable’ risks
Insurer determined premiums based on indemnity of loss or value
Individual freedom of policyholder to insure
Inconsistent with
Provision of universal affordable catastrophe cover
Human tendency to downplay extreme risks – need compulsive element
Indemnity v Parametric
Indemnity Lower limit of premium fixed
Claims – costly and slow process
Prone to moral hazard
Luxury not all can afford – All or Nothing
Parametric No lower limit to premiums
Claims – cheap and quick process
Low moral hazard
Purchase what can afford – Neither All nor Nothing
Socially Adequate, Affordable, Universal & Sustainable
Accept that policyholder will carry some risk There will be a minimum amount of cover to meet criteria of social adequacy To be universally affordable Government may need to subsidise premiums of poorest – proper use of taxpayer funds To be sustainable Government may need to carry some of risk associated with extreme events along with policyholders and insurance fund
Mitigation
Mitigation fundamental to sustainable disaster risk reduction – and affordable catastrophe insurance Insurance industry reactive not proactive – insurance more often a disincentive to mitigation – unlike approach to fire, theft, motor, etc Only significant exception is Fiji Risk rated premiums basic requirement
Volatility
After a major event loss reinsurers tend to punish those who have suffered loss by steep increases in premiums – to get their money back even though contrary to principle of insurance
Not socially acceptable or consistent with sustainable development or social acceptability which looks for stability of pricing – based on rational risk assessment not knee jerk response
Government schemes less susceptible to this volatility – better able to spread costs over time
Costs of Competition
Ungern- Sternberg Proposition
Catastrophe insurance has fixed basic price, usually small. All other costs add to this. Marketing costs of private enterprise outweigh inefficiencies of government
Demonstrates by European examples –
Spain, Britain, Switzerland, France, Germany
(Ungern-Sternberg, Efficient Monopolies, 2004)
But Other Advantages for Government Like Tax
Catastrophe insurance losses by their nature are volatile – mostly low losses but occasionally very large ones Reinsurance solves major portion of this by distributing risk geographically, but insurance companies still have accumulation of retentions In good years cat insurance yields significant profits which are taxed plus income from reserves also taxed inhibiting build up of reserves Government net income not taxed allowing more rapid build up of reserves and distribution of risk over time providing more stable premiums
And Efficient Use of Capital
A public company under pressure from shareholders to use capital in an efficient manner on an annual basis
Optimum amount of capital to manage given amount of risk and provide adequate return to shareholders
Government (& Mutual & Private) Funds not under this restraint
By using a combination of reinsurance (geographical spread) and capital reserves plus borrowing (spread overtime) Government can reduce volatility more than private industry and thus offer lower premiums
But Also Political Costs
Just look at mess in the US where Governments trying to control catastrophe insurance on short term basis
Decision making based on political expediency, not rational actuarial analysis
In Europe generally less political interference but highlights political risks
Battle Plan
A Workable Framework be developed that enables Insurance Industry to participate in a Sustainable Profitable Manner and achieve Required Outcome based on: Socially acceptable sharing of cat risk between
insurance fund, taxpayer and individual policyholder Minimisation of competition costs Isolation of catastrophe insurance from other business Untaxed accumulation of catastrophe reserves Risk rated premiums to encourage mitigation Isolation from political control
Is there Any Good News ?
Fundamentals of Insurance are relatively simple Already have Tools and Methodology to address technical issues There is previous Experience and Pioneering Initiatives to build upon
Fundamental Basis of All Insurance
Reduce the Coefficient of Variation of
Risk to a Manageable Level
by Combining
Many Independent Risks
of
Similar Statistical Characteristics
Using the Central Limit Theorem
Methodology & Tools
Financing Arrangements
Premium Collection & Claims Management
Administrative Structure Disaster Insurance Scheme
Premiums
Policy Conditions
Affordability
Sustainability
Operations
Hazard Risks
Building Vulnerabiity
Building Inventory
Experience & Experimentation
In the West
Significant number of schemes which meet desired outcome with varying degrees of success
In the East
Some exciting experiments in the area of catastrophe micro-insurance in China, India and Indonesia Lessons to be learnt from Taiwan EQ scheme Becoming an area of academic research – eg NTU ICRM
Who Will Lead The Insurance Industry Into Battle?
Concluding Remarks
A Challenging but exciting time for Catastrophe Insurance Needs energetic able people who are not afraid of challenging the status quo Asia will be the dominant battlefield The battles can be won