INVITED ARTICLE REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES: CURRENT STATE OF THE MARKET AND REGULATORY REFORMS

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1 C Risk Management and Insurance Review, 2007, Vol. 10, No. 2, INVITED ARTICLE REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES: CURRENT STATE OF THE MARKET AND REGULATORY REFORMS J. David Cummins ABSTRACT U.S. insurers are heavily dependent on global reinsurance markets to enable them to provide adequate primary market insurance coverage. This article reviews the response of the world s reinsurance industry to recent megacatastrophes and provides recommendations for regulatory reforms that would improve the efficiency of reinsurance markets. The article also considers the supply of insurance and reinsurance for terrorism and makes recommendations for joint public private responses to insuring terrorism losses. The analysis shows that reinsurance markets responded efficiently to recent catastrophe losses and that substantial amounts of new capital enter the reinsurance industry very quickly following major catastrophic events. Considerable progress has been made in improving risk and exposure management, capital allocation, and rate of return targeting. Insurance price regulation for catastrophe-prone lines of business is a major source of inefficiency in insurance and reinsurance markets. Deregulation of insurance prices would improve the efficiency of insurance markets, enabling markets to deal more effectively with mega-catastrophes. The current inadequacy of the private terrorism reinsurance market suggests that the federal government may need to remain involved in this market, at least for the next several years. INTRODUCTION The 2004 and 2005 hurricane seasons created unprecedented losses for U.S. property insurers. The insured losses from the largest 25 hurricanes on record in the United States are shown in Table 1. Six of the top 10 hurricanes in terms of insured losses occurred in 2004 and Total insured losses from the events were $67.9 billion, accounting for 46 percent of the total losses of the top 25 events. Because losses of this magnitude are not diversifiable based on the spread of risk in the United States alone, U.S. insurers are critically dependent on the global reinsurance market to provide coverage and pay claims. Although 2006 was a calm year in terms of catastrophic events, it is clear J. David Cummins works at Fox School of Business and Management, Temple University, 482 Ritter Annex, 1301 Cecil B. Moore Avenue, Philadelphia, PA 19122; phone: , ; fax: ; 179

2 180 RISK MANAGEMENT AND INSURANCE REVIEW TABLE 1 U.S. Hurricanes 25 Largest Insured Property Losses (Billions of 2005$) Insured Losses Rank Hurricane Year ($Billions) 1 Hurricane Katrina Hurricane Andrew Great New England Hurricane Hurricane Wilma Hurricane Charley Hurricane Hugo Hurricane Ivan Hurricane Rita Hurricane Frances Miami Hurricane Hurricane Georges Hurricane Betsy Hurricane Jeanne Hurricane Allison Hurricane Opal Great Atlantic Hurricane Hurricane Floyd Hurricane Iniki Hurricane Fran Hurricane Frederic Galveston, Texas Hurricane Hurricane Celia Hurricane Carol Hurricane Hazel Hurricane Alicia Note: Inflation adjustment 1908 to 2005 made using the Construction Cost Index (CCI) (McGraw- Hill) 1900 to 1907 based on CCI and overlapping CPI and McCusker inflation index ( ). Loss estimates vary. For example, the Florida Office of Insurance Regulation currently reports Hurricane Wilma s Estimated Gross Probable Losses at $10.9 billion. Sources: A.M. Best Co., Insurance Services Office (ISO), Swiss Re (2007). that escalating insurance exposures and the recurrence of mega-hurricanes and other events will continue to expand the demand for reinsurance capacity. The increasing frequency of mega-catastrophes and the global interdependence between U.S. insurers and world reinsurance markets raises two important questions: (1) How well did world reinsurance markets perform in sustaining the recent catastrophic losses

3 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 181 and how are these markets likely to respond in the future? (2) Are there significant impediments to the efficiency of world reinsurance markets that could be remedied through changes in regulatory rules? The objective of this article is to address these two issues by providing an analysis of the status of the global reinsurance market and by proposing regulatory changes that could enhance the efficiency of this market. In addition to natural catastrophes, the United States is also exposed to catastrophic losses due to terrorism. Indeed, the terrorist attack on the World Trade Center (WTC) on September 11, 2001, was the largest disaster in terms of insured losses prior to Hurricanes Katrina, Rita, and Wilma in World reinsurers substantially withdrew from the terrorism insurance market following WTC, and U.S. primary insurers followed suit by inserting terrorism risk exclusions in most commercial lines property casualty policies. Congress responded to the lack of coverage by passing the Terrorism Risk Insurance Act of 2002 (TRIA), which requires insurers to make available terrorism coverage and creates a federal reinsurance backstop that limits the losses of private insurers in the event of a major loss. There are significant questions about the availability of private insurance coverage if TRIA were eventually allowed to expire. Accordingly, this article also reviews the available evidence about the adequacy of private terrorism reinsurance and makes recommendations concerning public policy options regarding terrorism reinsurance. Because terrorism poses some significantly different challenges that coverage for natural catastrophes, the TRIA analysis is conducted separately from the discussion of natural catastrophe reinsurance. The article begins by examining the adequacy of markets for natural catastrophe reinsurance and discussing public policy reforms that could enhance the efficiency of natural catastrophe markets. The article then turns to a discussion of terrorism insurance and reinsurance. REINSURANCE FOR NATURAL CATASTROPHES As Table 1 demonstrates, the frequency and severity of natural catastrophes have increased significantly in recent years. Further information on catastrophes is provided in Figure 1, which shows the annual insured losses from natural and man-made catastrophes over the period The recent years 2004 and 2005 were the worst years in recent history in terms of catastrophe losses. Hurricane Katrina, which made landfall on September 8, 2005, is the most costly natural catastrophic event in history, with projected insured losses in the range of $66.3 billion (Swiss Re, 2007). The most costly prior natural catastrophe was Hurricane Andrew in 1992, which cost insurers $23.0 billion. The increasing costs of catastrophes have significantly stressed insurance markets. Insurance works best for high-frequency, low-severity events that are statistically independent and have probability distributions that are reasonably stationary over time. Catastrophic events, and particularly mega-catastrophes such as Katrina, violate to some degree most of the standard textbook conditions for insurability. These are low-frequency, high-severity events that violate statistical independence by affecting many insured exposures at one time. Although considerable progress has been made in modeling natural catastrophes, Katrina exposed the limitations of existing catastrophe models in predicting losses for both personal and commercial risks and has caused modelers to launch new efforts to revise their databases and predictive techniques. Thus, the

4 182 RISK MANAGEMENT AND INSURANCE REVIEW FIGURE 1 Worldwide Insured Catastrophe Losses (2006 Monetary Units) Source: Swiss Re (2007). hurricanes were truly paradigm shifting events for insurance markets, equivalent in their impact to Hurricane Andrew and the WTC terrorist attack. This section of the article begins with a brief discussion of the role of reinsurance in permitting primary insurers to break the insurability log-jam and provide coverage for large catastrophic events. The discussion then turns to the response of insurance and reinsurance markets to recent mega-catastrophes and their likely response to future mega-catastrophes. The section concludes with a discussion of appropriate public policy responses that could enhance the efficiency of insurance markets with respect to catastrophic events. The Role of Reinsurance The role of the insurer is to diversify risk. Insurance companies assume the risks of consumers and business firms and diversify the risk by insuring large numbers of policyholders. Insurance works best if the losses of individual policyholders are statistically independent, meaning that losses do not occur simultaneously and from the same cause to large numbers of policyholders. With statistical independence, the losses from a large pool of risks become highly predictable, allowing insurers to provide coverage without having to hold large amounts of costly equity capital relative to the quantity of insurance being underwritten. Insurance markets with large numbers of statistically independent risks, with moderate loss amounts per claim, can be characterized as locally insurable (Cummins and Weiss, 2000). Examples of insurance markets where risks are

5 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 183 locally insurable include automobile collision insurance and homeowners insurance for noncatastrophic events such as ordinary fires. Losses from mega-catastrophes do not satisfy the conditions of statistical independent and hence are not locally insurable. The problem is that a single event can cause losses to many insured exposures simultaneously, violating the fundamental underlying principles of diversification. However, risks that are locally dependent may be globally independent, e.g., the risk of tornadoes in the American Midwest versus Australia. This provides the economic motivation for reinsurance markets and suggests that reinsurance for mega-catastrophes is of necessity a global market. As shown below, global reinsurance markets appear to be adequate to respond even to catastrophic losses as large as Katrina. Risks that are globally diversifiable through reinsurance can be characterized as globally insurable. The violation of the conditions for insurability can create situations where risks are neither locally nor globally insurable. Events that are potentially extremely large relative to the size of insurance and reinsurance markets fall into this category. However, if other conditions are satisfied, such risks may be globally diversifiable through capital markets. Consider the example of events with low frequency and very high severity, where the covariances among the individual risks making up a portfolio are also relatively high. Examples of such risks are hurricanes that cause even more damage than Katrina and earthquakes striking geographical regions with high concentrations of property values such as the fabled big one in California. Modelers have estimated that a $100 billion event in Florida or California has a probability of occurrence in the range of approximately one in 100 (i.e., a return period of 100 years). The capacity of the insurance and reinsurance industries may be inadequate to insure such events. However, events of this magnitude are small relative to the market capitalization of securities markets. Thus, by introducing securitized financial instruments representing insurance risk, catastrophic events in the $100 billion range are diversifiable across the financial markets, even though they may not be diversifiable in global insurance and reinsurance markets. The final category of risks consists of events that are either so severe that they are large even compared to the capitalization of securities markets or are not modelable with sufficient accuracy to permit investors to make reasonable decisions with regard to investing in securities linked to these risks. For example, it has been estimated that a severe earthquake in Tokyo could cause losses in the range of $2.1 to $3.3 trillion, constituting from 44 to 70 percent of the GDP of Japan (Risk Management Solutions, 1995). Losses from mega-terrorist events also very likely fall into this category, both because they are large and because they are difficult to model. Losses from such events can be characterized as cataclysmic or globally undiversifiable. Such losses may have to be borne by society at large through some form of governmental response. There is a fine line between loss events that are globally insurable and those that are globally diversifiable, and also a fine line between globally diversifiable and undiversifiable events. Losses that were once considered uninsurable, such as Katrina, actually turn out to be insurable in global markets, as shown below. And, losses that were once considered unmodelable, such as large natural catastrophes, have moved into the realm of modelability due to advances in computing, data processing, and modeling technologies. Thus, it is not advisable to automatically rule out a primary role for private markets

6 184 RISK MANAGEMENT AND INSURANCE REVIEW in solving problems of diversification and financing of catastrophic risk, even for the largest and most unpredictable events. The Global Market for Reinsurance The market for reinsurance is truly a global market. Only by diversifying losses across the world, is it possible for the insurance industry to provide coverage and pay losses in areas such as Florida and California, which have high exposure to catastrophic risk and large concentrations of property values. The United States is by far the leading market in terms of both the demand for reinsurance and the amount of loss payments funded by reinsurers. In fact, the United States accounted for 87 percent of worldwide insured catastrophe losses in 2005 (Swiss Re, 2006) and 61 percent in 2006 (Swiss Re, 2007). Thus, U.S. insurance markets are heavily dependent upon both domestic and foreign reinsurers. The world s 35 leading reinsurers are shown in Table 2, with rankings based on 2005 gross premiums written. The rankings have been reasonably stable for the past three years, but Swiss Re is likely to become the world s largest reinsurer because of its acquisition of GE s reinsurance operation in June Reinsurers from 12 different countries are represented on the top 35 list, and the country with the largest number of companies on the list is Bermuda. Bermuda rose to prominence as a reinsurance market following Hurricane Andrew in 1992 and has continued to increase in importance since that time. The reason is that Bermuda is close to the United States, has developed a sophisticated infrastructure for the operation of financial institutions, has very limited regulation of insurance companies, and levies no income taxes. Hence, Bermuda s prominence is primarily due to restrictive regulatory and tax regimes in other jurisdictions such as the United States. The world s non-life-insurance premiums are broken down by country of reinsurance supplier (i.e., country of domicile of the reinsurer receiving the premiums) in Figure 2. Germany and the United States each account for more than 20 percent of world premium volume, and the other leading countries include Switzerland, Bermuda, the United Kingdom, and Japan. Because Figure 2 is based on the world s total non-life-insurance premiums, regardless of country of origin of the ceding insurer, it does not fully reveal the importance of foreign reinsurance to U.S. insurers. In particular, the overall numbers tend to understate the importance of Bermuda as a source of reinsurance for U.S. insurers, as discussed in more detail below. The reliance of U.S. insurers on foreign reinsurance is elucidated in Table 3. In U.S. insurance regulation, the term foreign, which in general usage means non-u.s., is used to refer to insurance companies domiciled in other states of the United States, whereas insurers and reinsurers domiciled in other countries are called alien insurers. For clarity, and to be consistent with the source of the data for Table 3, the term alien is adopted in this discussion. Table 3 shows the number of alien jurisdictions with which U.S. insurers transacted reinsurance business from 2001 through U.S. insurers did business with reinsurers domiciled in approximately 100 countries in each year and purchased reinsurance from more than 2,000 different alien reinsurers in each year. Total ceded reinsurance premiums, to both affiliated and unaffiliated alien insurers, grew steadily over the period

7 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 185 TABLE 2 Top 35 Global Reinsurance Groups Ranked by Consolidated Gross Premium Written in 2005 US$ (Millions) Gross Net Shareholder Ranking Group Name Country Premiums Premiums Funds 1 Munich Re Germany 26,482 22,606 28,652 2 Swiss Re Group Switzerland 23,151 21,229 17,430 3 Berkshire Hathaway Group U.S. 12,486 11,646 68,484 4 Hannover Re Germany 11,452 NA 3,740 5 Lloyd s of London U.K. 9,053 6,568 18,915 6 GE Global Ins Hldgs a U.S. 8,565 6,697 8,251 7 XL Capital Bermuda 5,686 5,013 8,472 8 London Reins Group U.K. 4,243 3, RGA Reins Co U.S. 4,222 3,867 2, Everest Re Group Bermuda 4,109 3,972 4, Transatlantic Hldgs Inc Group U.S. 3,888 3,466 2, Partner Re Group Bermuda 3,665 3,616 3, Korean Reins Co b Korea 2,975 2, Scor Group France 2,851 2,692 2, Odyssey Re Group (Fairfax) U.S. 2,627 2,302 1, Scottish Re c U.K. 2,553 NA 1, Aegon d Netherlands 2,112 1,156 NA 18 Converium Group Switzerland 1,994 1,816 1, White Mountains Re Bermuda 1,981 1,304 3, ACE Bermuda 1,847 1,794 11, RenaissanceRe Bermuda 1,809 1,543 2, Platinum Underwriters Group Bermuda 1,765 1,717 1, Arch Reins Ltd. Bermuda 1,751 1,657 2, Axa Re Group e France 1,729 1,719 40, Endurance Specialty Ins Ltd. Bermuda 1,669 1,619 1, Mapfre Spain 1,584 1, Assicurazioni Generali SpA Italy 1,575 NA 20, QBE Australia 1,546 1,191 3, Caisse Centrale de Reassur France 1,537 1,476 1, Axis Capital Holdings Limited Bermuda 1,519 1,491 3, Aspen Insurance Bermuda 1,443 1,129 2, Toa Reins Group b Japan 1,346 1,299 1, Chubb/Harbor Point f Bermuda 1, , Alea Group g Bermuda 998 1, Montpelier Bermuda ,222 Note: A.M. Best s Top 35 Ranking may differ from other published rankings in that: (1) the ranked entities are global in scope, not just U.S. based; (2) the ranked entities are insurance groups or unaffiliated single insurance companies; and (3) the ranking is based on 2005 consolidated gross premiums written (GAAP or non-u.s. accounting equivalent) for reinsurance only. a GE Insurance Solutions acquired by Swiss Re in June b Year end is March 31, c Acquired ING life reinsurance. d A.M. Best estimate based on statutory filings. e Axa includes expenses for both life and non-life segments. f Harbor Point acquired Chubb Re book of business in December g Operations materially curtailed in NA, Information not applicable or not available at time of publication. Source: A.M. Best Co.

8 186 RISK MANAGEMENT AND INSURANCE REVIEW FIGURE 2 Global Reinsurers: Net Premiums Written by Country, 2005 Source: Standard & Poor s (2006). TABLE 3 Dependence of U.S. Insurers on Alien Reinsurance No. Alien No. Alien Ceded Net Policyholders Recoverables/ Year Jurisdictions Reinsurers Premiums Recoverables Surplus Surplus ,287 37,317 80, , % ,290 46,169 93, , % ,344 53, , , % ,330 53, , , % ,321 62, , , % Note: Monetary statistics are in millions of U.S. dollars, not adjusted for price level changes. Number of alien reinsurers assuming reinsurance from U.S. insurers. Source: Data on alien reinsurance from Reinsurance Association of America (2006); data on policyholders surplus from A.M. Best Company (2005, 2006e). and reached $62 billion by Putting this number in perspective, total net written premiums for U.S. property-casualty insurers were $433.5 billion in As the premium totals would suggest, U.S. insurers are also heavily dependent on alien reinsurers for their financial strength. As shown in Table 3, U.S. insurers showed $123.9 billion in recoverables from alien reinsurers in 2005, equal to 28.6 percent of total policyholders surplus. 1 The relative importance of alien reinsurers and U.S. professional reinsurers as sources of supply for reinsurance coverage for U.S. insurers is shown in Figure 3. The figure shows 1 Recoverables represent funds owed by alien reinsurers to U.S. insurers, consisting primarily of loss payments owed under reinsurance contacts. Policyholders surplus is the property casualty insurance industry s terminology for equity capital.

9 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 187 FIGURE 3 Reinsurance Premiums Ceded: U.S. Professional Reinsurers Versus Alien Reinsurers Source: Reinsurance Association of America (2006). FIGURE 4 Premiums Ceded to Alien Reinsurers by Jurisdiction in 2005 Source: Reinsurance Association of America (2006). the percentage of total reinsurance premiums ceded by U.S. insurers to U.S. professional reinsurers and alien reinsurers from 1997 to The percentage of reinsurance ceded to alien reinsurers increased significantly during this period, from 38.4 percent in 1997 to 51.8 percent in Figure 4 shows that Bermuda and off-shore Caribbean jurisdictions accounted for 52 percent of reinsurance cessions by U.S. insurance companies in 2005, and Germany, Switzerland, and the United Kingdom accounted for another 41 percent. To provide a more detailed analysis of the dependence of U.S. insurers on alien reinsurers, I conducted a special study in cooperation with the Reinsurance Association of America

10 188 RISK MANAGEMENT AND INSURANCE REVIEW (RAA). The study utilizes the Schedule F database constructed by the RAA. The data in the RAA s Schedule F database are taken from the annual regulatory statements filed by U.S. insurers with the National Association of Insurance Commissioners (NAIC). The RAA has revised the raw data reported by insurers to correct errors and systematize the reporting of company names and other information contained in the database. The result is a version of Schedule F that is much more accurate than the raw NAIC data taken by themselves. Schedule F reports reinsurance purchasing by U.S.-licensed insurers from both domestic and alien reinsurers. The primary data items reported are premiums assumed and ceded and reinsurance recoverables. The data are provided by company. Although only U.S.- licensed insurers are required to file Schedule F, U.S. companies are required to report transactions with non-u.s.-licensed (alien) insurers. Accordingly, Schedule F provides a complete picture of the reinsurance purchasing of U.S.-licensed insurers and reinsurers. Schedule F does not report data by line of insurance. To provide an approximate indication of the importance of reinsurers from Bermuda and other alien jurisdictions by line of insurance, a special study was designed. Specifically, an analysis was conducted of reinsurance purchasing by the top 50 reinsurance cedants in each of 12 lines of business. 2 Although the premium cessions reported in Schedule F are the company s overall premiums and not premiums by line, by focusing on the leading cedants in each line of business, it is possible to obtain a better idea of the importance of alien reinsurance to insurers focusing on each line in the sense that they are purchasing a relatively large amount of reinsurance. To determine the top 50 cedants for each line of business included in the study, data were obtained from the Part 2B Premiums Written page of the NAIC annual statement. This page gives cessions to affiliated and unaffiliated insurers by line of business but does not break down sessions by the name of the assuming 2 (re)insurer. For the top 50 cedants in each line, data on overall premium cessions were obtained from Schedule F. The lines of business included in the study are homeowners, aircraft, commercial multiple peril, ocean marine, medical malpractice, allied lines and earthquake (combined), workers compensation, other liability, private passenger auto liability, commercial auto liability, auto physical damage, and nonproportional reinsurance. The study focuses on reinsurance premiums ceded to unaffiliated (re)insurers because affiliated cessions often are conducted for reasons other than risk hedging and diversification. 3 The results of the study are summarized in Tables 4 and 5, which show the results for six representative lines of insurance. Tables 4 and 5 show the top 20 jurisdictions supplying reinsurance for the top 50 cedants in each line of business. Bermuda is the leading supplier of reinsurance by far in all six lines of business shown in the tables. 4 The proportion 2 The synonym for the term ceding company is not spelled consistently in the reinsurance literature. Two spellings, cedant and cedent, are frequently used. This article adopts the spelling from the glossary maintained by Lloyd s of London, i.e., cedant, defined by Lloyd s as a syndicate or company that transfers a risk exposure under a reinsurance contract. See 3 Similar conclusions were obtained when the analysis was conducted using reinsurance receivables rather than premiums. 4 Bermuda is also the leading insurer in the six additional lines of business included in the study but not shown in the tables.

11 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 189 TABLE 4 Reinsurance Premiums Ceded to Unaffiliated Alien Reinsurers by U.S. Insurers by Jurisdiction in 2005 Homeowners Commercial Multiple Peril Ocean Marine Jurisdiction Amount Percent Jurisdiction Amount Percent Jurisdiction Amount Percent Bermuda 4,889, Bermuda 4,986, Bermuda 5,325, U.K. 2,017, U.K. 2,368, U.K. 2,836, Cayman 1,194, Germany 1,495, Germany 1,764, Germany 1,008, Cayman Islands 1,401, Cayman Islands 1,624, Switz 416, Switzerland 466, Switzerland 710, France 330, Barbados 348, Barbados 427, Sweden 280, France 310, Ireland 291, Ireland 271, Ireland 289, Sweden 291, Barbados 229, Sweden 280, France 287, Japan 180, Japan 189, Japan 197, Turks & Caicos 165, Luxembourg 141, Luxembourg 142, Luxembourg 136, Canada 121, Canada 106, Canada 115, Isle of Man 89, Isle of Man 100, British Virgin Isl 103, Channel Isles 79, Channel Isles 89, Isle of Man 89, Turks & Caicos 53, Turks & Caicos 57, Channel Isles 63, British Virgin Isl 26, Italy 24, Island of Nevis 27, Italy 24, Korea 21, Belgium 18, Belgium 18, British Virgin Isl 18, Australia 14, Australia 15, Australia 15, Gibraltar 13, Korea 13, Gibraltar 13, Total: Top 20 11,567, Total: Top 20 12,721, Total: Top 20 14,347, Overall total 11,643, Overall Total 12,814, Overall Total 14,431, Source: The Reinsurance Association of America s Schedule F database.

12 190 RISK MANAGEMENT AND INSURANCE REVIEW TABLE 5 Reinsurance Premiums Ceded to Unaffiliated Alien Reinsurers by U.S. Insurers by Jurisdiction in 2005 Allied Lines and Earthquake Other Liability Nonproportional Reinsurance Jurisdiction Amount Percent Jurisdiction Amount Percent Jurisdiction Amount Percent Bermuda 5,404, Bermuda 5,374, Bermuda 4,414, U.K. 2,655, U.K. 2,634, U.K. 2,144, Germany 1,782, Germany 1,785, Germany 1,369, Cayman Islands 1,578, Cayman Islands 1,556, Cayman Islands 916, Switzerland 508, Switzerland 774, Switzerland 633, Barbados 373, Barbados 436, Barbados 410, France 306, France 305, Sweden 282, Sweden 292, Ireland 303, France 244, Ireland 237, Sweden 284, Ireland 227, Japan 186, Japan 188, Japan 189, Turks & Caicos 185, Luxembourg 142, Turks & Caicos 100, Canada 181, Canada 102, Isle of Man 98, Luxembourg 141, Isle of Man 98, Channel Isles 90, Isle of Man 100, Channel Isles 90, Luxembourg 85, British Virgin Isl 90, Turks & Caicos 86, Canada 44, Channel Isles 89, British Virgin Isl 25, Italy 24, Island of Nevis 31, Italy 24, British Virgin Isl 20, Italy 24, Belgium 18, Australia 14, Australia 1 5, Australia 15, Gibraltar 13, Gibraltar 13, Island of Nevis 14, Hong Kong 13, Total: Top 20 14,199, Total: Top 20 14,263, Total: Top 20 11,339, Overall total 14,293, Overall Total 14,350, Overall Total 11,404, Source: The Reinsurance Association of America s Schedule F database.

13 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 191 of premiums ceded to unaffiliated alien reinsurers that go to Bermuda insurers ranges from 36.9% in ocean marine insurance to 42% in homeowners. The United Kingdom is the second leading jurisdiction in all six lines shown in the tables, and Germany is third in five of the six lines. The Cayman Islands is the third leading jurisdiction in one line and the fourth leading jurisdiction in four lines. Switzerland is the fifth leading jurisdiction in all six lines shown in the tables. Additional details not shown in the table reveal that approximately 250 U.S. insurance groups, representing more than 1,000 individual insurance companies, ceded reinsurance to unaffiliated alien reinsurers in Hence, the results imply that U.S. insurers are heavily dependent on non-u.s. reinsurers, with Bermuda, Caribbean jurisdictions, and three European countries accounting for a substantial share of the transactions. Any potential factors leading to the erosion of these international relationships would raise the price of insurance in the United States and lower the financial quality (solvency) of the U.S. insurance industry. Insurance and Reinsurance Market Response to Mega-Catastrophes Cycles and Crises. Insurance markets are subject to cycles and crises triggered by shifts in the frequency and severity of losses as well as investment shocks. The underwriting cycle refers to the tendency of property casualty insurance markets to go through alternating phases of hard and soft markets. In a hard market, the supply of coverage is restricted and prices rise, whereas in a soft market, coverage supply is plentiful and prices decline. The consensus in the economics literature is that cycles are driven by capital market and insurance market imperfections such that capital may not flow freely into and out of the industry in response to unusual loss events (Winter, 1994; Cummins and Danzon, 1997; Cummins and Doherty, 2002). Informational asymmetries between capital providers and insurer management about exposure levels and reserve adequacy can result in high costs of capital during hard markets, such that capital shortages can develop. Insurers are reluctant to pay out retained earnings during soft markets because of the difficulty of raising capital again when the market enters the next hard market phase, leading to excess capacity and downward pressure on prices. Hard markets are usually triggered by capital depletions resulting from underwriting or investment losses (Berger, Cummins, and Tennyson, 1992). The three most prominent hard market periods since 1980 resulted from the commercial liability insurance crisis of the 1980s, catastrophe losses from Hurricane Andrew in 1992 and the Northridge earthquake in 1994, and the WTC terrorist attack of The 1980s liability crisis was triggered by an unexpected increase in the frequency and severity of commercial liability claims accompanied by a sharp decline in interest rates in the early 1980s, and the catastrophe and terrorist crises were driven by catastrophic losses of unexpected magnitude. Each crisis not only depleted insurer capital but caused insurers to reevaluate probability of loss distributions and reassess their exposure management and pricing practices. The existence of cycles and crises implies that the response of insurance markets to large event losses is not necessarily fully efficient in the sense that prices are not predictable and supply shortages may develop periodically. However, in general, the market has functioned well in response to losses from mega-catastrophes, and evidence is presented below that the ability of the market to sustain catastrophic losses and to recover quickly from catastrophic events has improved significantly since the 1990s. Thus, the cycle may have moderated significantly, at least with respect to mega-catastrophes.

14 192 RISK MANAGEMENT AND INSURANCE REVIEW Market Response to Catastrophes: Pre Hurricane Andrew in 1992 and, to a lesser extent, the Northridge earthquake in 1994 were paradigm shifting events for insurance and reinsurance markets. The magnitude of losses from Andrew in particular took insurers by surprise, and they drastically underestimated the financial impact of the hurricane even after the event took place. There were 13 insurance company failures in 1992 and 1993 primarily attributable to Hurricane Andrew and three additional failures in Hawaii due to Hurricane Iniki, which also made landfall in 1992 (A.M. Best Company, 2006b). Catastrophe modeling firms responded to Hurricane Andrew by greatly enhancing the sophistication of their catastrophe modeling systems and making greater efforts to collect data on insurer loss exposures, especially in catastrophe-prone geographical areas. Insurance companies responded by developing improved loss estimation, underwriting, and risk management capabilities. The capital market responded by supplying significant amounts of new equity capital to restore insurance industry capacity, and several new companies were formed, most prominently in Bermuda. New capital also entered the industry following the WTC terrorist attacks in 2001, although most of the added capacity was not used to provide terrorism insurance coverage. Hence, even prior to the 2004 hurricane season, there was evidence that insurance and capital markets were responding appropriately to mega-catastrophes and developing the capability to handle such events more efficiently in the future. Market Response to Catastrophes: In general, insurance markets responded efficiently to the hurricane losses of 2004 and For the most part, the losses represented an earnings event rather than a capital event, meaning that earnings were reduced but capital was not significantly degraded. New capital entered the industry in several new start-up companies as well as capital issuances by established insurers. Prices of reinsurance increased for the 2006 renewals, as expected considering that the events caused insurers and modeling firms to revise upward their expectations of future hurricane losses. The 2006 price increases and capacity shortages primarily affected hurricane-prone regions of the United States (Benfield, 2006). Elsewhere in the world, price increases were more moderate, and severe coverage shortages did not develop (Guy Carpenter, 2007a). However, reinsurance prices began to soften in late 2006 and early 2007 (Benfield, 2007b). Thus, it seems that the underwriting cycle still exists, but perhaps has shortened and become somewhat more moderate than in the past. This section provides additional information on the market response following the storm losses. These two years are emphasized because they represented paradigm shifting loss experience, whereas 2006 losses were significantly lower (Figure 1). In contrast to prior years when insurers suffered significant catastrophe losses, 2004 and 2005 were relatively good years for U.S. property casualty insurers. The industry-wide combined ratio for 2004 was 98.1 percent, implying that insurers earned an underwriting profit overall for the first time since The industry-wide combined ratio for 2005 was percent, significantly less that the average combined ratio of the past 20 years (106.8). A combined ratio near 100 implies that insurers essentially broke even on underwriting, even though catastrophe losses boosted the overall combined ratio by 8 percentage points (A.M. Best Company, 2006c, 2006e). U.S. insurers earned operating profits of $40.5 billion in 2004 and $48.4 billion in By contrast, the U.S. insurance industry sustained operating losses of $2.7 billion in 1992 (Andrew) and $12.5 billion in 2001 (WTC).

15 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 193 What conclusions can be drawn from the strong performance of property casualty insurers in 2004 and 2005? One possible conclusion is that insurers were fortunate in the sense that the hurricane losses occurred in years that were otherwise favorable for insurance markets in terms of both underwriting and investment earnings. However, the performance of was attributable to more than just good luck. To a significant extent, it seems that insurers have learned how to manage both the underwriting cycle and their exposure to various types of risk much more effectively than in the past. Insurers have introduced and continued to refine sophisticated exposure management models. In addition, underwriting standards have been significantly tightened, and insurers have placed more emphasis on capital allocation and rate of return targeting in various lines of insurance. The result has been a significant increase in the industry s ability to sustain large loss shocks without major disruptions to insurance markets. Reflecting the improved risk management in the industry, only four U.S. insurance companies failed as a result of the storms, although one of them was the third largest homeowners insurer in Florida (A.M. Best Company, 2006a). In addition, four Bermuda reinsurers entered into runoff after ratings downgrades resulting from hurricane losses made it difficult for them to retain existing customers and attract new business. Nevertheless, the storms did not result in significant market disruptions due to insurer or reinsurer insolvencies (A.M. Best Company, 2006d). In general, reinsurance markets responded efficiently to the storm losses of As would be expected, losses of the magnitude experienced in had an impact on reinsurers operating results. However, the effects were not as disruptive as prior events such as Hurricane Andrew and the WTC terrorist attacks. Moreover, substantial new capital entered the industry, placing the industry in a strong position to finance future catastrophic events. U.S. reinsurers had combined ratios of in 2004 and in 2005, which included, respectively, catastrophe losses of 8.3 percentage points in 2004 and 34.6 percentage points in However, including investment income, U.S. reinsurers posted positive net income in both 2004 and 2005 (A.M. Best Company, 2006a). As shown in Figure 5, U.S. reinsurers weathered the storms without significant deterioration in key leverage ratios. The liabilities to surplus ratio declined in The ratio of reinsurance recoverables to surplus increased in 2005 but remained below its peak level attained in The combined ratio for the global reinsurance industry is plotted in Figure 6 for the period 1988 though As expected, the combined ratio peaks in 1992, 2001, and 2005, in response to Andrew, the WTC terrorist attacks, and the Katrina Wilma Rita hurricane season, respectively. The combined ratio also shows the cyclicality of the global reinsurance market. Figure 6 shows that global reinsurers were profitable in 2004 despite the high hurricane losses and were again profitable in Because underwriting profits were unusual prior to 2002, the experience since 2002 reveals that the industry has become more proficient at pricing reinsurance and managing exposure to loss. The Bermuda reinsurance industry bore the brunt of the 2004 and 2005 hurricane losses. Nevertheless, the industry was able to withstand the losses from both disaster years without major disruption. The Best s Bermuda composite combined ratio for 2004 was 94.9 percent, implying that the firms included in this index actually posted an

16 194 RISK MANAGEMENT AND INSURANCE REVIEW FIGURE 5 U.S. Reinsurers: Leverage Ratios FIGURE 6 Global Reinsurance Industry Combined Ratio: Source: Standard & Poor s (2005, 2006) and Guy Carpenter (2007a).

17 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 195 FIGURE 7 Major Reinsurers Combined Ratios for 2005 underwriting profit for However, the Bermuda composite combined ratio for 2005 was percent, implying an underwriting loss of about 20 percent of premiums. The Bermuda composite firms incurred a net operating loss of $3.3 billion in 2005, following a net operating gain of $5.5 billion in The United Kingdom and continental European reinsurers also responded well to the losses. Lloyd s of London and the London market reinsurers had combined ratios below 100 percent in 2004, and the combined ratios for Lloyd s and the London market companies were 112 and 119 percent, respectively, in These combined ratios were far below those experienced by Lloyd s and the London market firms in 2001, 136 and 177 percent, respectively. The improved performance for the U.K. firms reflects the adoption of improved risk and capital management techniques, including a risk-adjusted approach to capital. The combined ratios for the continental European reinsurers were mostly in the same range as those of the U.K. reinsurers (see Figure 7). Nevertheless, despite sustaining approximately $6 billion in U.S. hurricane losses, the major continental European reinsurers posted operating profits in 2005 (A.M. Best Company, 2006a). After Katrina, the reinsurance industry raised about $30 billion in new capital, including both new entrants and existing reinsurers (Benfield, 2007a,b). Conventional equity capital issues totaled about $9.5 billion for start-ups and $12.5 billion in seasoned equity issues. In addition, the industry raised about $5 billion in sidecars and another $5 billion by issuing CAT bonds. The capital raising tended to be centered in Bermuda. To illustrate, the capital raised by new entrants in Bermuda is shown in Table 6. The first section of the table shows conventional equity capital issuance by the newly formed Bermuda reinsurers. A total of $8.37 billion was raised by 11 new entrants. For purposes of comparison, Table 6 also

18 196 RISK MANAGEMENT AND INSURANCE REVIEW TABLE 6 New Capital in Bermuda: The Classes of 1993, 2001, and 2005 Capital Company/Instrument ($M) Lead Investors Class of 2005 Amlin Bermuda Ltd. 1,000 Merrill Lynch, Goldman Sachs Ariel Re 1,000 Blackstone, Texas Pacific, Thomas H. Lee Arrow Capital Re 500 Goldman Sachs CIG Re 450 Citadel Investment Group Flagstone Re 750 West End Capital Harbor Point 1,500 Stone Point, Chubb Hiscox Ins. Co. 500 Hiscox Plc Lancashire 1,000 Capital Z New Castle Re 500 Citadel Investment Omega Specialty 170 Omega Underwriting Holdings Plc Validus 1,000 Aquiline, Merrill Lynch, Goldman Sachs Total: Class of ,370 Sidecars Avalon Re 405 Oil Casualty Insurance Bay Point Re 250 Golden Tree Asset Management Blue Ocean 300 Montpelier Re and other investors CastlePoint Re 265 Tower Group Champlain Ltd. 90 Montpelier Re and other investors Concord Re 375 Lexington (AIG) Cyrus Re 500 Highfields Management and others Flatiron Re 600 Goldman subisidiary Kaith Re 414 Hannover Re Olympus Re/Helicon 330 Monte Fort Re 200 Lehman Panther Re 144 Hiscox Petrel Re 200 First Reserve Corporation Rockridge Re 91 West End Capital, Montpelier Shackleton Re 235 Endurance Specialty Insurance Sirocco Re 95 Lancashire Starbound Re 300 Merrill Lynch Timicuan Re 50 Renaissance Re Triumphe Re 121 Paris Re Total: Sidecars 4,965 Total sidecars & reinsurers 13,335 Continued.

19 REINSURANCE FOR NATURAL AND MAN-MADE CATASTROPHES IN THE UNITED STATES 197 TABLE 6 (Continued) Capital Company/Instrument ($M) Lead Investors Class of 2001 Allied World Assur Co Ltd. 1,500 AIG, Chubb, Goldman Sachs Arch Capital Group Ltd. 1,000 Warburg Pincus, Hellman & Friedman Aspen 200 Aspen Insurance Holdings Ltd. Axis Capital Holdings 1,700 MMC Capital DaVinci Rein Ltd. 400 RenaissanceRe, State Farm Endurance Speciality Ins Ltd. 1,200 Aon, Texas Pacific, Thomas H. Lee Montpelier Re Hldgs Ltd. 900 White Mountains, Cypress, Benfield Platinum 1,000 Initial Public Offering, St. Paul, RenaissanceRe Olympus Reins Co Ltd. 500 Leucadia National, Gilbert Global, Franklin Mutual Rosemont Re 145 Goshawk Insurance Holdings Total 8,545 Class of 1993 Centre Cat Ltd. 309 Centre Reinsurance Holdings, Morgan Stanley Global Capital Re 440 Goldman Sachs, Johnson & Higgins, Underwriters Re IPC (International Propety 300 AIG Catastrophe) LaSalle Re 371 Aon, CNA Insurance and Corporate Partners Mid-Ocean Re 770 Marsh & McLennan, JP Morgan Partner Re 1,000 Swiss Re, John Head and Partners Renaissance Re 308 USF&G, Warburg Pincus Tempest Re 500 General Re Compass Re 300 SCOR Starr Excess Liability 500 AIG, General Re, Primerica, Munich Re, Aon Total 4,798 Sources: A.M Best Company (2006b), Marsh (2006a), Covaleski (1994), Thiele (2006), and Benfield (2006d, 2007). shows the new Bermuda companies formed following Hurricane Andrew and the WTC terrorist attack. Startup companies raised $4.8 billion in new equity following Andrew and $8.5 billion following WTC attack. Hence, capital markets respond quickly to new capital needs of reinsurers. In addition to conventional new and seasoned equity, reinsurers also raised capital using innovative vehicles known as sidecars. Sidecars date back to at least 2002 but became

20 198 RISK MANAGEMENT AND INSURANCE REVIEW FIGURE 8 The Structure of a Typical Sidecar much more prominent following the 2005 hurricane season (A.M. Best Company, 2006a). Sidecars are special purpose vehicles formed by insurance and reinsurance companies to provide additional capacity to write reinsurance, usually for property catastrophes and marine risks. The capital raised using property catastrophe sidecars following Katrina is shown in Table 6. Sidecars are usually off-balance sheet, formed to write specific types of reinsurance such as property catastrophe quota share or excess of loss from a specified ceding reinsurer. Sidecars generally have limited lifetimes to capitalize on high prices in hard markets and quickly withdraw capacity in soft markets. The sidecars receive premiums for the reinsurance underwritten and are liable to pay claims under the terms of the reinsurance contracts. In addition to providing capacity, sidecars also enable the sponsoring reinsurer to move some of its risks off-balance sheet, thus improving leverage. The sidecar structure is diagrammed in Figure 8. The sidecar is formed by a ceding reinsurer, and all of its risk-bearing activities are typically confined to this specific reinsurer. The sidecar is usually owned by a holding company, and the holding company raises capital for the sidecar by issuing equity and debt, although often sidecars are exclusively equity financed. If debt securities are issued, a tiered structure can be used, similar to that of an asset-backed security, to appeal to lenders with differing appetites for risk. Private equity, hedge funds, insurers, and reinsurers provide the capital for the typical sidecar. The capital raised by the sidecar is held in a collateral trust for the benefit of the ceding reinsurer. The cedant then enters into a reinsurance contract with the sidecar, which often represents a quota share agreement. The transaction enables the reinsurer to expand its capacity to write additional reinsurance. The ceding reinsurer can earn profits on the transaction through a ceding commission and sometimes also a profit commission. In comparison with issuing debt or equity securities, the sidecar does not affect the issuing reinsurer s capital structure, and thus sidecars may reduce regulatory costs and enhance the issuer s financial rating. Nearly all sidecars to date have been established in Bermuda because of Bermuda s favorable regulatory and tax systems.

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