CATASTROPHE INSURANCE COVERS
Reinsurance contracts come in two basic forms which differ in the way the primary insurers determine premiums and losses. Proportional Reinsurance contracts share premiums and losses in a predefined ratio. Since the 1970s, non proportional reinsurance has come in and is used as substitute. Instead of sharing losses and premiums in fixed proportions, both parties agree on the insured risks, and calculate a specific premium on that basis. The typical non proportional contracts specifies the amount beyond which the reinsurers assume losses, up to an agreed upon ceiling.
Excess of loss agreements are the most common form of non-proportional reinsurance cover. For Natural catastrophes, these contracts are known as Cat XL (Catastrophe Excess of Loss) and cover the loss exceeding the primary insurers’ retention on a single catastrophic event. A major earthquake for example, is likely to affect the entire portfolio of a primary insurer, leading to thousands of claims in different lines of business, such as motor, business interruption, and private property classes. As a result, primary insurers often purchase Cat XL coverage to protect themselves against peak risks.
Catastrophe Reinsurance is a form of reinsurance that indemnifies the ceding company for the accumulation of losses in excess of a stipulated sum arising from a single catastrophic event or series of events.
What are catastrophe events?
Catastrophe events are large natural or man-made disasters that cause a significant number of claims in a region.
For Insurance purposes, an event shall include all insured losses which arise directly from the same cause, and which occur during the same period of time and in the same area.
Such cause is understood to be the peril which directly occasions the losses or where there are several perils which, in an unbroken chain of causation, have occasioned the losses, the peril which triggered the chain of causation.
Means any one accident, disaster or casualty or happening or series of accidents, disasters or casualties or happenings which take place in its entirety at a discrete time and place, and results from the same proximate cause, regardless of the number of interests insured, the number of policies responding or whether the claims arising out of the loss occurrence are made under policies issued on an occurrence basis and or claims made basis.
Cover is usually for a period of 72 hours or 168 hours depending on the nature of the catastrophic event.
Catastrophe covers are Insurance and Reinsurance arrangement to cover more than one risk which suffers loss arising from one event also referred to as an occurrence. In the absence of catastrophe excess reinsurance, insurers may restrict new business or refuse to renew existing policies after a catastrophe. Thus, catastrophe excess reinsurance benefits not only catastrophe insurance companies (by helping them to stay in business) but the market as a whole (by making catastrophe insurance more widely available).
In reinsurance terms, the classical concept of a catastrophe is that it must be specific, unexpected, sudden, shocking, and an external happening which can be located in time and place, and is the proximate cause of each and every loss to the insured's that the Insurance/Reinsurance company accumulates in order to make up its catastrophe claim, and that it will be in itself be the peril covered by the treaty.
Proximate cause is the active and sufficient force that sets into motion a train of events that brings about a result without the intervention of other forces.
Catastrophe insurance is different from other types of insurance in that it is difficult to estimate the total potential cost of an insured loss since one catastrophic event may result in an extremely large number of claims being filed at the same time. This makes it difficult for catastrophe insurers to effectively manage risk.
Reinsurance and retrocession arrangements are used along with catastrophe insurance to manage catastrophe risk. The Catastrophe Insurance cover protects the Insurance Company’s net account after making recoveries from working covers against risk of accumulations of claims arising out of one catastrophic event.
The covers are designed to indemnify the reinsured for any accumulation of losses in excess of a stipulated sum (deductible) arising from a catastrophic event which could be natural, tectonic or manmade.
Arising from the fact that there is much exposure of risks due to industrial growth and the increase in catastrophic occurrences from the Natural Events, the Insurers and Reinsurers need to know the financial implications of a catastrophic event. This consideration is important and is very useful in helping insurers to design more robust risk management processes.
The measurement and transfer of risk are at the essence of the insurance business. This has prompted the development of quantitative techniques to achieve both. They are important for the direct insurer, as well as for a potential reinsurer. In the case of catastrophic risk they become particularly relevant due to the magnitude of potential losses. A large earthquake or hurricane will impact losses in an extreme fashion such that if not adequately reserved it can cause the ruin of either the insurer or the reinsurer, with ‘catastrophic’ consequences for stockholders and society. Hence the importance of measuring risk and its transfer.
Catastrophe Insurance covers are designed to protect businesses and residences against natural disasters such as earthquakes, floods and hurricanes, and against man-made disasters such as terrorist attacks. They are usually low-probability; high-cost events which are generally excluded from standard hazard insurance Policies.
Dealing with exposure to peak risk, which relate to natural catastrophes, is the core business of the reinsurance industry. Natural Catastrophes are rooted in distinctive physical events such as earthquakes. When underwriting natural catastrophe risk, reinsurers can rely to a large extent on the fact that physical events do not correlate endogenously in the way financial risks does. To achieve geographical diversification, reinsurers offer peak risks protection not just for one country, but ideally on worldwide basis.
Premium inflows not immediately used to settle claims are invested in various assets held for meeting expected future claims. In this way, reinsurers build specific reserves called technical provisions. These constitute the largest block of reinsurers’ on-balance sheet liabilities. Insured losses are met by running down assets in line with technical reserves. To determine whether a reinsurer can withstand severe and unprecedented yet plausible insured events, regulators look for sufficient technical provisions and capital on reinsurer’s balance sheet.
The occurrence of a major natural event dents the reinsurer’s underwriting profitability. A combined ratio of 100% is not sustainable for an extended period. The only relief is that according to statistics, reinsurance payments show that claims are usually settled over an extended period. On average, 63% of the ultimate obligations are paid within the first year, and 82 % within two years. It takes more than five years after a natural disaster strikes for the cumulative payout to reach 100%.
In dealing with the consequences of peak catastrophe risks, the industry has gravitated towards a distinctive market structure. One important element is the size of the Reinsurance Companies. Assessing and pricing a large number of different potential physical events involves risk management capabilities and transaction costs on a large scale. Balance sheet size is therefore an important tool for a reinsurer to maintain a physical diversification on a global scale.
When analyzing catastrophic risk, traditional measures for evaluating risk, such as the probability of probable maximum loss (PML), valuate risk (VAR), Tail VAR, and others can become really impossible to obtain analytically in certain types of insurance, such as earthquake. The processes of earthquake generation, shock wave diffusion, damage to buildings, etc. are very complex and their interaction makes their analysis even more so. It is necessary to bring together the expertise of geophysicists, structural engineers, actuaries, financial experts and others in order to construct a model that represents the overall process reasonably well.
In many countries earthquake catastrophic risk is measured in terms on the probable maximum loss (PML), an extreme quantile of the corresponding loss distribution. Given the available information it can be very difficult for an insurer to measure this risk. However, since the distribution of losses due to earthquakes for a large portfolio of risks will usually be unknown the only way to quantify risk may be through simulation.
Proper simulation can only be met if the exposure data is gathered in a systematic way and one of the ways is through catastrophe modeling. The value of Insurance, especially in the aftermath of catastrophic events, needs to be communicated to people.
Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.
Catastrophe bonds emerged from a need by insurance companies to alleviate some of the risk they would face if a major catastrophe occurred, which would incur damages that they could not cover by the premiums, and returns from investments using the premiums, that they received. An insurance company issues bonds through an investment bank, which are then sold to investors. These bonds are inherently risky, generally BB, and usually have maturities less than 3 years. If no catastrophe occurred, the insurance company would pay a coupon to the investors, who made a healthy return.
On the contrary, if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. Investors include hedge, catastrophe-oriented funds, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered the principal is paid to the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in the Coastal areas prone to hurricane Risks, then it might wish to pass some of this risk on, so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a Cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane is experienced, then the investors would make a healthy return on their investment. But if a hurricane were to occur, and trigger the cat bond, then the principal initially paid by the investors would be forgiven, and instead used by the sponsor to pay its claims to policyholders.
The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew.
Among insurance –linked securities Catastrophe Bonds are the main instrument for transferring reinsured disaster risks to financial markets. The exogenous nature of the underlying risks support the view that catastrophes bonds provide effective diversification unrelated to financial market risks.
The issuance of Catastrophe bonds involves financial transactions with a number of parties. At the centre is the Special Purpose Vehicle (SPV) which funds itself by issuing notes to financial market participants.
The SPV invests the proceeds in securities, mostly governments bonds which are held in collateral trusts. The Sponsoring Reinsurer receives these assets in case a natural disaster materializes as specified in the contract. Verifiable physical events, such as storm intensity measured on Beaufort scale, serve as parametric triggers for catastrophe bonds. Investors recoup the full principal if only no catastrophe occurs. In contrast to other bonds, the possibility of total loss is part of the arrangement from inception, and is compensated ex ante by a higher coupon.
Despite expert’s high expectations, the Catastrophe Bonds market has remained relatively small. Very few bonds on the other hand have been triggered to date and payments to Reinsurers from these bonds are small when compared to the sum of insured losses.
The Global Financial Crisis also dealt a blow to this market. The year 2008 saw a rapid decline in catastrophe bonds issuance, reflecting generalized funding pressure and investor concern over the vulnerability of insurance entities. The crisis also demonstrated the securitization structures introduce additional risks, through linkages between financial entities. A case in point was the Lehman Brothers bankruptcy in September 2008. Four Catastrophe bonds were impaired, not due to natural catastrophes, but because they included a total return swap with Lehman Brothers acting as counterparty. Following Lehman’s failure, these securitization arrangements were no longer fully funded, and their market value plunged. Investors thus learned that catastrophe bonds are not immune to unnatural disasters such as major institutional failures.
Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or inequities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments, as long as they are not triggered.
Key categories of investors who participate in this market include hedge funds, specialized catastrophe-oriented funds, and asset managers. Life insurers, reinsurers, banks, pension funds, and other investors have also participated in offerings.
A number of specialized catastrophe-oriented funds play a significant role in the sector.
Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy.
Most catastrophe bonds are issued by special purpose reinsurance companies domiciled in the Cayman Islands, Bermuda, or Ireland. These companies typically participate in one or more reinsurance treaties to protect buyers, most commonly insurers (called "cedants") or reinsurers (called "Retrocessionaires").
The sponsor and investment bank who structure the cat bond must choose how the principal impairment is triggered.