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1
University of Illinois
Finance 431 April 20, 2006
CATS ARE DOGS
PwC
2
Agenda
PwC

• What is a Catastrophe
• Managing Catastrophe Risk
• Property Catastrophe Reinsurance
• Hurricane Katrina
• Rating Agencies and Catastrophes
• Final Points

3
Catastrophe Exposure in the United States
What is a Catastrophe
PwC

• Types of Catastrophes Traditional
• Hurricanes / Typhoons
• Earthquakes
• Floods
• Tornados
• Man-made (fires, explosions)
• Types of Catastrophes Alternative
• Terrorist Acts
• Asteroids
• Tsunami
• Power Outages

4
The Costs of Catastrophes
What is a Catastrophe
PwC

• 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.

5
The Rising Costs of Catastrophes
What is a Catastrophe
PwC

• 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.

6
Financing the Costs of Catastrophes
What is a Catastrophe
PwC

• 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/reinsuran
  ce companies (or cat bonds) to make an adequate
  return.

7
Managing Catastrophe Risk
Managing Catastrophe Risk
PwC

• 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.

• Insurance companies have several ways of managing
  catastrophe risk. These include
• Exposure Reduction
• Government Subsidies
• Reinsurance

8
Ways Insurance Companies Manage Catastrophe Risk
Managing Catastrophe Risk
PwC

• 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 buildings 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.

9
Ways Insurance Companies Manage Catastrophe Risk
Managing Catastrophe Risk
PwC

• 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

10
Ways Insurance Companies Manage Catastrophe Risk
Managing Catastrophe Risk
PwC

• 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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Introduction to Property Catastrophe Reinsurance
Treaties
Property Catastrophe Reinsurance
PwC

• 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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More Treaty Terms
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Programs
Property Catastrophe Reinsurance
PwC
140M
Reinsurer B

• 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 B is taking an 80 share of the layer
  40x100.
• The primary insurer is responsible for any losses
  in gray or above 140 Million.

100M
Reinsurer A
20M
0
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Property Catastrophe Reinsurance Programs -
Coinsurance
Property Catastrophe Reinsurance
PwC
140M
Reinsurer B

• 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.

100M
Reinsurer A
20M
0
Coinsurance
15
Property Catastrophe Reinsurance Models
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Models
What is a Catastrophe
PwC

• These models have two main components. Peril
  scenario generators and damage functions.
• The peril scenario generators model hurricane
  path and wind-speed 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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Property Catastrophe Reinsurance Models
Property Catastrophe Reinsurance
PwC

• 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 structures
• Location
• Age
• Class
• Construction

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Property Catastrophe Reinsurance Model Output
Property Catastrophe Reinsurance
PwC

• An insurer would input 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.

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Property Catastrophe Reinsurance Model Output
Property Catastrophe Reinsurance
PwC

• 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
• On average a loss of at least 500 Million will
  occur every 250 years.
• On average a loss of at least 1.5 Billion will
  occur every 500 years.

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Property Catastrophe Reinsurance Model Output
Property Catastrophe Reinsurance
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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Property Catastrophe Reinsurance Reinsurers
Property Catastrophe Reinsurance
PwC

• 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.

22
Property Catastrophe Reinsurance Reinsurers
Property Catastrophe Reinsurance
PwC

• 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.

23
Property Catastrophe Reinsurance Reinsurers
Property Catastrophe Reinsurance
PwC

• In addition to retrocessional coverage,
  reinsurers also manage risk using
• ILWs
• Cat Bonds
• Cat Swaps
• Side cars

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Property Catastrophe Reinsurance ILWs
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Cat Bonds
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Cat Swaps
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Side cars
Property Catastrophe Reinsurance
PwC

• 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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Property Catastrophe Reinsurance Side cars
Property Catastrophe Reinsurance
PwC

• 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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Hurricane Katrina Changed the Industry
Hurricane Katrina
PwC

• Largest insured loss ever as the insurance costs
  are approaching 50 Billion.
• This does not include the governments 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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Rating Agencies Have a Significant Impact on
Property Catastrophe Insurance and Reinsurance
Rating Agencies
PwC

• The major rating agencies, AM Best and SP
  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

31
Rating Agencies Have a Significant Impact on
Property Catastrophe Insurance and Reinsurance
Rating Agencies
PwC

• 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.

32
Conclusions
Conclusion

• 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.

33
Follow-Up

• Should you need any assistance please contact me
  at
• James Matusiak
• PricewaterhouseCoopers
• One North Wacker
• Chicago, IL 60606
• james.matusiak_at_us.pwc.com