CATASTROPHE – MEANING, ANALYSIS and IMPACT ON INSURANCE

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CATASTROPHE – MEANING, ANALYSIS and IMPACT ON INSURANCE

What is a Catastrophe?

“CAT”, the abbreviation for Catastrophe in the insurance parlance refers to the possibility of exposure to an accumulation of losses from one event. In other words, a single event causing loss to more than one risk at the same time is normally referred to as a catastrophic event. It can be a natural event, like, earthquake, flood, volcanic eruption, wildfire, hurricane, landslide, pandemic, and winter storm or can be a man-made event like the one that affected the twin towers at New York on 9/11, industrial contamination and technological failure.

Recent Trends

The severity and frequency of insured losses on account of natural disasters have significantly increased in recent years. Although it is debatable whether an increasing frequency of hurricanes and floods may be attributed to climate change like global warming, it is certain that concentration of values in catastrophe-prone areas has brought about an increase in the amount of damages. Natural catastrophes remain unpredictable despite technical advances. The terrorism is the main cause for the man-made disasters throughout the world. Terrorism has caused losses of unprecedented magnitude in the past, even raising doubts about the continued insurability of such risks. The nature, type and severity of the past losses do not serve as a guide anymore to predict and quantify the future losses. There is also a considerable change in the demographics of risks – increase in population and value at risk, which act as the main driver for increase in the cost of catastrophic losses.

The Problem of Catastrophe Risk and Insurance

The increased frequency and severity of the catastrophes has dramatically altered the insurance environment. Insurers and Reinsurers face difficult challenges on account of increased catastrophe risk. The insurance industry focuses more on industry capacity, reinsurance, and securitization. Insurers and reinsurers find it hard to raise their prices to more adequate levels and decrease their exposure to catastrophe losses. They are forced to look for ways to diversify their exposure through reinsurance and securitization.

?Is catastrophe risk uninsurable?

The effect of terrorist attacks and the intensity of hurricane losses, wild fires created a scenario what insurance textbook writers call an “uninsurable risk”. Hurricane Ian, considered to be the deadliest, surpasses the loss caused by earlier hurricanes. It resulted in a widespread increase in the reinsurance prices besides creating capacity constraints. Though many are financially strong to meet their obligations, there is no denial of the fact that they are humbled. Whether it is justified, or not, private insurance markets do face a problem in providing capacity for catastrophe risks of such high magnitude. In fact, the larger the loss from a catastrophe event, it is infrequent and unlikely to be correlated with the price of a global market index, so it is certainly diversifiable. (Catastrophe Insurance, Capital Markets and Uninsurable Risks – Dwight M Jaffee and Thomas Russell _ The Wharton School, University of Pennsylvania).?The surge in catastrophe losses has caused insurers, regulators, legislators, and others to question whether the property and casualty insurance industry has the financial capacity to handle the growing catastrophe risk. The main problem is that in the case of catastrophe insurance, the annual pattern of losses is highly non-smooth and dynamic, premium strategies based on a few years of experience will lead to loss ratios in some years, which is far from the estimates. The problem is mainly a capital market problem rather than an insurance problem. Financial innovations like Cat Bonds and sidecars are developed by a number of investment bankers, which provide capital to an insurance company in advance of a catastrophe. These innovations to provide capital to the private markets are nothing but the modern version of bottomry.?In addition, there is always an expectation that state and national catastrophe program should provide some supplementary support and relief.?The pooling mechanism is in place in many countries, as it will achieve broader geographical spread.

Implications to the insurance industry

The aftermath of the hurricanes and other catastrophes result in the hardening of the insurance and reinsurance market resulting in the increased price and the cost of insurance and reinsurance. The hard market naturally attracts more entrepreneurs and additional capital to take advantage of the increasing prices.

The major loss events like hurricane Ian have put many reinsurance companies under strain to meet their liabilities and the credit rating of many reinsurers are under scrutiny and watch list. The climate change is considered as the major reason for an increasing number of catastrophic events y-o-y. In the last two or three years, the whole world witnessed the Covid-19 pandemic. Any pandemic ends, but the climate change is a continuing phenomenon and has become a systemic risk and hence there is no end to it.

With the increasing frequency and severity of such catastrophes the cover for Catastrophe perils under pro-rata reinsurance arrangement is constricted by event limit or cession limit imposed on the cover. The insurers and reinsurers would implement and expect to have better control and tracking of accumulation of risks in each region and will have to monitor their catastrophe aggregates more closely and accurately. The insurance companies realize the need for buying more vertical catastrophe cover than what was bought in the earlier years, whenever a Catastrophe loss of high magnitude happens. Insurers should only chew what they can swallow. It is always a tug of war between increasing the top line and protecting the bottom line.