University of Illinois
Finance 431
April 20, 2006
CATS ARE DOGS
PwC
PwC
Agenda
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What is a Catastrophe
Managing Catastrophe Risk
Property Catastrophe Reinsurance
Hurricane Katrina
Rating Agencies and Catastrophes
Final Points
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Slide 2
What is a Catastrophe
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Catastrophe Exposure in the United States
Types of Catastrophes –
Traditional
• Hurricanes / Typhoons
• Earthquakes
• Floods
• Tornados
• Man-made (fires,
explosions)
Types of Catastrophes –
Alternative
• Terrorist Acts
• Asteroids
• Tsunami
• Power Outages
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Slide 3
What is a Catastrophe
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The Costs of Catastrophes
•
•
•
Property Damage
- Homes – Most losses except for flood are covered by a traditional homeowners
policy. Storm Surge during a hurricane is considered flood and not covered.
- Cars - Vehicles are covered for most events.
- Commercial Structures – Commercial buildings and structures are generally
covered for most events including flood.
Human Casualties
- These may not correlate with economic loss (Tsunami, Galveston TX 1900)
- May have incidental impact on insured losses (Life insurance, casualty
damages)
Other Costs
- Additional Living Expense – Temporary accommodations and expenses.
- Loss adjustment expenses – Insurers usually spend a large amount of money to
service policyholders following a catastrophe.
- Coverage Extensions – Business Interruption, Contingent Business
Interruptions, Civil Authority, Off Premises Power.
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Slide 4
What is a Catastrophe
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The Rising Costs of Catastrophes
The economic costs of covering catastrophes is outpacing inflation for
the following reasons:
• Demographic Shifts – Populations are moving into more catastrophic
exposed regions.
• New Perils – The emergence of new potential risks, such as terrorism
increase the expected catastrophic loss.
• Global Economic Development – As countries develop economically the
amount of exposed property increases. This property is generally covered
by an insurance vehicle.
• Public Expectation – The public has rising expectations about their
entitlement to “be made whole” after an event.
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What is a Catastrophe
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Financing the Costs of Catastrophes
• Public – Individuals pay premiums for insurance to cover their
personal property from damage due to catastrophes and other
perils.
• Government – Uninsurable perils such as flood and war are
generally covered by the government. The government may
also subsidize private insurers (ie TRIA, FHCF, FEMA).
Insurers – Investors put capital at risk in the form of
insurance/reinsurance companies (or cat bonds) to make an
adequate return.
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Slide 6
Managing Catastrophe Risk
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Managing Catastrophe Risk
The insurance industry plays a
significant role in assuming
catastrophe risk and has
developed several products to
manage catastrophe risk. The
initial risk is written in the form
of insurance policies to either
individuals, businesses or
governments.
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Insurance companies have
several ways of managing
catastrophe risk. These
include:
•Exposure Reduction
•Government Subsidies
•Reinsurance
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Slide 7
Managing Catastrophe Risk
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Ways Insurance Companies Manage Catastrophe Risk
• Exposure Reductions – Insurers have reduced exposure to
catastrophes two main ways.
- Restriction of policy terms – Insurers have implemented
wind and hurricane deductibles which are much higher than
the standard policy deductibles. These are typically stated
as a % of a building’s value.
- Non renewal of high risk customers – Insurance companies
are non-renewing coastal properties in an attempt to reduce
exposure to wind events. This is happening in the gulf and
northeastern states.
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Slide 8
Managing Catastrophe Risk
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Ways Insurance Companies Manage Catastrophe Risk
• Government Subsidies – Federal and State governments have
legislation that assumes exposure from the insurance industry.
- California Earthquake Authority (CEA)– Insurers write
policies and cede premium and losses to the CEA.
- Florida Hurricane Catastrophe Fund (FHCF)– Subsidized
reinsurance is provided to the industry. Shortfalls funded
through statewide premium assessments.
- Terrorism Risk Insurance Program – Covers defined acts of
terrorism.
- New initiatives are being forwarded by the industry
subsequent to Hurricane Katrina
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Slide 9
Managing Catastrophe Risk
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Ways Insurance Companies Manage Catastrophe Risk
• Reinsurance – Insurers look to the private sector to provide
coverage in various forms.
- Excess of Loss Property Catastrophe Reinsurance
- Per-Risk Excess Reinsurance*
- Facultative Reinsurance*
- Cat Bonds
*These Coverages cover large losses in addition to catastrophes
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Slide 10
Property Catastrophe Reinsurance
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Introduction to Property Catastrophe Reinsurance Treaties
• Property catastrophe treaty reinsurance is the most popular
way for insurance companies to mitigate catastrophe risk.
• Common Terms of a Property Catastrophe Treaty
- Per Occurrence – They only cover losses from a distinct
catastrophic event.
- Excess of Loss – They have a fixed limit of coverage and
have a fixed retention.
- Two Loss Warranty – At least two insured structures must
be damaged for the treaty to apply. Catastrophic damage
to a single structure is covered by facultative contracts or
risk excess treaties.
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Slide 11
Property Catastrophe Reinsurance
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…More Treaty Terms
• Covers losses for a distinct period (usually 12 months)
regardless of when the underlying policy was written.
• Reinstatement Provisions –Should one event occur that causes
losses to the policy, the reinsurer must offer an additional
reinstatement of the limit at the premium rate. The reinsurer is
usually forced to offer one reinstatement. After two events the
primary insurer must renegotiate another treaty.
• Hours Clause – An hours clause defines the duration of the
catastrophe. This is typically 72 hours. The retention and limit
apply to all losses during the occurrence. Should the catastrophe
last more than 72 hours, the limit may be reinstated.
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Slide 12
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance Programs
$140M
Reinsurer B
$100M
Property Catastrophe Reinsurance
Treaties are typically part of a program.
This program would be stated as follows:
•Reinsurer A is taking an 80% share of the
layer 80x20. This translates into Reinsurer
A is reimbursing the primary carrier for
losses in excess of $20 Million per
occurrence up to a limit of $80 Million.
Reinsurer A
$20M
•Reinsurer B is taking an 80% share of the
layer 40x100.
•The primary insurer is responsible for any
$0
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losses in gray or above $140 Million.
April 2006
Slide 13
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance Programs - Coinsurance
$140M
Reinsurer B
$100M
Reinsurer A
$20M
$0
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Primary insurers are usually not able to
cede 100% of the loss. The portion they
retain in called coinsurance.
Coinsurance is required to avoid the two
following forms of adverse selection.
• Writing large amounts of catastrophe
exposed risk because they have
reinsured the risk away.
• Not controlling losses during the
claim settlement process after the
event has occurred.
Coinsurance
April 2006
Slide 14
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Models
• In the past insurers used to look at long term analysis of
catastrophe data to assess the cat potential and price
insurance. This technique may still be used to price freeze
and or tornado risks.
• Today computer models dominate the risk management
landscape of the property catastrophe insurance markets.
• There are a handful of models available although three
companies dominate the market (AIR, RMS, EQECAT).
• The models are stochastic in nature and estimate damages for
thousands of years at a time. This gives a picture of not only
the average of expected value but the entire loss distribution.
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Slide 15
What is a Catastrophe
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Property Catastrophe Reinsurance – Models
•These models have two
main components. Peril
scenario generators and
damage functions.
•The peril scenario
generators model
hurricane path and windspeed for storms and
earth movement for
earthquakes.
•Often historical records
are scrutinized and
thousands of years of
geological data are
considered.
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Slide 16
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Models
The damage functions are engineering functions
that estimate the percent of structure damage for a
given wind-speed or earth movement.
These are often a function of a structure’s
• Location
• Age
• Class
• Construction
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Slide 17
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Model Output
•An insurer would input
12.00%
Proability of Exceedance
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
$0
$5,000,000
$10,000,000
$15,000,000
Loss
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$20,000,000
$25,000,000
$30,000,000
information on his book of
business into the model.
•The output would include
expected value estimates
and an exceedance curve
similar to the one of the left.
•Using management
judgment and risk tolerances
the insurer can begin to
manage its risk.
April 2006
Slide 18
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Model Output
Expected loss – The loss cost for various layer of
reinsurance.
PMLs (Probable maximum loss) – This is generally
stated with an associated annual frequency.
• 250 Year PML = $500 Million
• 500 Year PML = $1,500 Million
These imply:
1. On average a loss of at least $500
Million will occur every 250 years.
2. On average a loss of at least $1.5
Billion will occur every 500 years.
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Slide 19
Property Catastrophe Reinsurance
Property Catastrophe Reinsurance – Model Output
Rates on a property catastrophe treaty are typically quoted using the term
“Rate On Line”.
RATE
ON =
LINE
TREATY PREMIUM
TREATY LIMIT
Roughly equal to the probability of
payment.
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Slide 20
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Reinsurers
• Property catastrophe reinsurers take advantage of geographic
diversification. They write treaties all over the world with the
idea that Japan is not correlated with Florida is not correlated
with California. This is simple financial management. Adding
uncorrelated risks decreases the overall volatility of the
portfolio. This premise also raises the profit or risk load
charged in areas with high cat risk.
• Property catastrophe reinsurers are not in a position to take
large amounts of investment risk. Should a catastrophe occur
they require a large amount of cash in a short period of time to
pay claims. This is changing as more are engaging in credit
facilities to assist with post-event cash flow.
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Slide 21
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Reinsurers
Property catastrophe reinsurers manage
their risk very much like their customers.
One vehicle is retrocessional coverage:
• Retrocessional coverage is
reinsurance for reinsurers. It is very
expensive due to the risk and
uncertainty of the underlying exposure.
• There is a lot of parameter uncertainty
because the retrocessionaire is so far
removed from the original risks.
• “Retro” writers generally cannot
purchase traditional reinsurance
because of market spiral.
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Loss Ratios
Primary
Prop Cat
Retro
Year
Insurer
Reinsurer
Writer
1
69.1%
0.0%
0.0%
2
97.3%
123.4%
191.9%
3
71.5%
0.0%
0.0%
4
114.0%
289.5%
1022.7%
5
95.2%
102.4%
87.2%
6
66.0%
0.0%
0.0%
7
91.2%
61.7%
0.0%
8
35.8%
0.0%
0.0%
9
17.1%
0.0%
0.0%
10
54.0%
0.0%
0.0%
April 2006
Slide 22
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Reinsurers
• In addition to retrocessional coverage, reinsurers also manage
risk using:
- ILWs
- Cat Bonds
- Cat Swaps
- “Side cars”
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Slide 23
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – ILWs
• Industry loss warranties pay a fixed amount based of the
amount of industry loss. For example, a $20 Million ILW with a
$5 Billion trigger, would pay the purchaser $20 Million in the
event of a $5 Billion or greater industry loss.
• Industry loss amounts are published by PCS (Property Claim
Services) for US losses and SIGMA (a division of Swiss Re)
for other losses around the world.
• These expose the purchaser to basis risk, or the risk that the
purchaser has a large loss but the industry does not.
• These are currently an easy way to enter the property
catastrophe reinsurance market. Many hedge funds are
getting into this arena.
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Slide 24
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Cat Bonds
• Bonds issued to cover catastrophe risk were developed
subsequent to Hurricane Andrew. These bonds are structured
so that the investor has a good return if there are no qualifying
events and a poor return if a loss occurs. Losses can be
triggered on an industry index or on an indemnity basis.
• The advantage of these vehicles is that you gain access to the
large capital available in the financial markets and that the
bonds diversify a standard investment portfolio.
• The disadvantages is that they expose the issuer to basis risk,
they have large issuing costs.
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Slide 25
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Cat Swaps
• Generally between two sophisticated parties.
• Reinsurer A will have too much exposure in one area and
Reinsurer B will have over-exposure in an uncorrelated zone.
• The two parties will agree on indexes which are typically
general reinsurance programs in the market and design a
treaty whereby losses are triggered by the experience of the
index treaties in the particular zones.
• Both are exposed to significant basis risk.
• This is attractive since, theoretically, no profit changes hands
and the cost of the protection is small from an allocated capital
standpoint.
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Slide 26
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Side cars
• These vehicles came into existence in the past few years.
• A hedge fund that wishes to get into the reinsurance business
will start a special purpose vehicle with a reinsurer.
• This is usually capitalized by both parties.
• The side car assumes a portion of the exposure from the
reinsurer in the form of a reinsurance contract.
• The reinsurer is able to reduce its exposure.
• The hedge fund is able to get into reinsurance without:
- Hiring underwriters
- Buying models
- Getting rated by the rating agencies.
Finance 431
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April 2006
Slide 27
Property Catastrophe Reinsurance
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Property Catastrophe Reinsurance – Side cars
• These vehicles came into existence in the past few years.
• A hedge fund that wishes to get into the reinsurance business
will start a special purpose vehicle with a reinsurer.
• This is usually capitalized by both parties.
• The side car assumes a portion of the exposure from the
reinsurer in the form of a reinsurance contract.
• The reinsurer is able to reduce its exposure.
• The hedge fund is able to get into reinsurance without:
- Hiring underwriters
- Buying models
- Getting rated by the rating agencies.
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April 2006
Slide 28
Hurricane Katrina
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Hurricane Katrina Changed the Industry
• Largest insured loss ever as the insurance costs are
approaching $50 Billion.
• This does not include the government’s tab of an estimated
$200 Billion.
• Estimates of damages produced by the models for storms
similar to Katrina were grossly understated.
• Several reinsurers were impaired by the losses incurred from
Hurricane Katrina.
• Reinsurance demand and prices went up by significant
percentages (Was it enough?)
• Models were/are being adjusted for the multi-decadal changes
in hurricane activity, driving up loss costs.
• Rating agencies imposed stricter rules for capital adequacy.
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Slide 29
Rating Agencies
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Rating Agencies Have a Significant Impact on Property
Catastrophe Insurance and Reinsurance
• The major rating agencies, AM Best and S&P publish financial
strength ratings for insurers and reinsurers.
• Ratings are indicative of financial strength and are used by
buyers of (re)insurance to select counterparties.
(Re)insurance is not useful if you cannot collect recoveries
after an event.
• The key factors analyzed by the rating agencies are:
- Financial performance
- Exposure to catastrophes
- Strength of management
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April 2006
Slide 30
Rating Agencies
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Rating Agencies Have a Significant Impact on Property
Catastrophe Insurance and Reinsurance
• Reinsurers typically cannot write any business if their rating is
below a certain level. (Typically “A”)
• Rating agencies have become much more focused on cat risk
after the past few years of significant losses.
• Their quantitative models consider aggregate PMLs and the
impact of such events on the financial statements. Previously
only event PMLs were considered.
• Actual Katrina loss results were compared against peers and
previously supplied estimates to determine the potential for
downgrades.
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Slide 31
Conclusion
Conclusions
• If you work in insurance, catastrophes will affect you.
• Catastrophe risk is an increasing cost for society.
• The property catastrophe reinsurance business is very
complex.
• New vehicles are being created to mitigate catastrophe risk.
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April 2006
Slide 32
Follow-Up
• Should you need any assistance please contact me at:
James Matusiak
PricewaterhouseCoopers
One North Wacker
Chicago, IL 60606
james.matusiak@us.pwc.com
Finance 431
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April 2006
Slide 33