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					       Finance 431:
Property-Liability Insurance
       Lecture 20:
       Catastrophes
      Insurance Definition of a
            Catastrophe
A loss that affects more than one insured and
causes a loss that is in aggregate in excess of a
specified level. The current commonly used
level is $25 million.
For someone living in Champaign-
Urbana, what is the most likely type of
catastrophic loss?
A)   Fire
B)   Earthquake
C)   Hail
D)   Hurricane
E)   Tornado
RMS Catastrophic Risk Map
             Catastrophes
Insurable vs. Non-Insurable Catastrophes
History of Insured Losses from Catastrophes
Reasons for Growth in Catastrophe Exposure
How Insurers Deal with Catastrophe Exposure
What Is Being Done to Help Industry Cope
  with Catastrophes
      Insurable vs. Non-Insurable
             Catastrophes
Ideal Criteria for an Insurable Exposure
1   Large Number of Similar Exposure Units
2   Fortuitous Losses
3   Catastrophe Unlikely
4   Definite Losses
5   Determinable Probability Distribution
6   Economic Feasibility
    What Makes a Loss Uninsurable?
1   Large Number of Similar Exposure Units
    If losses are concentrated in a particular area
       Earthquakes, Floods
2   Fortuitous Losses
    If location and timing of losses can be predicted
       Flooding downstream after upstream area affected
3   Catastrophe Unlikely
    If potential loss could hurt financial condition of
    industry
       Tornadoes or riots can be covered
       War or nuclear disaster cannot be covered
                      History of Insured Losses from Catastrophes

                                                                             Catastrophe Losses, 1949-1997
                                                                                                In nominal terms

                      18,000,000,000                                                                                                                                                            Quake
                                                                                                                                                                                            Andrew
                      16,000,000,000

                      14,000,000,000
Billions of Dollars




                      12,000,000,000

                      10,000,000,000
                                                                                                                                                                              Hugo, Quake
                       8,000,000,000

                       6,000,000,000

                       4,000,000,000                                                                                                                            Elena, Gloria
                                                                                                                                          Frederic, David
                       2,000,000,000                                                           Betsy                        Winds
                                       Winds Carol, Hazel                                                       Celia
                                  0
                                       1949

                                              1951

                                                     1953

                                                            1955

                                                                   1957

                                                                          1959

                                                                                 1961

                                                                                        1963

                                                                                                1965

                                                                                                       1967

                                                                                                              1969

                                                                                                                     1971

                                                                                                                            1973

                                                                                                                                   1975

                                                                                                                                           1977

                                                                                                                                                  1979

                                                                                                                                                         1981

                                                                                                                                                                1983

                                                                                                                                                                       1985

                                                                                                                                                                              1987

                                                                                                                                                                                     1989

                                                                                                                                                                                            1991

                                                                                                                                                                                                   1993

                                                                                                                                                                                                          1995

                                                                                                                                                                                                                 1997
              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.
  History of Insured Losses from
           Catastrophes
Significant change in size of catastrophes occurred
  starting in 1989
The ten largest insured losses have all occurred since
  1989
Recent estimates of possible losses
  New Madrid Fault Earthquake $116 billion
  California Earthquake $77 billion
  Florida Hurricane $76 billion
  Northeast Hurricane $21 billion
          Reasons for Growth in
          Catastrophe Exposure
Weather Pattern Change
  1949-1989 Period of Unusually Good Weather (?)
  Recent Return to the Long Term Norm
Population Growth in At Risk Areas for Hurricanes
  Southeastern seacoast
Lowered Building Standards
  Lulled by Reduced Storm Activity
  Overwhelmed by Population Growth
Mandates to Cover Earthquakes
Impact of Catastrophe on Repair/Rebuilding Costs
      How Insurers Deal with
       Catastrophe Exposure
Reinsurance
Managing Exposures
  Sophisticated catastrophe modeling
  Limiting concentration of exposures
     Monitoring by zip code
  Higher deductibles
Premium Increases
Withdrawals from Some Markets
         Property Catastrophe
         Reinsurance Programs
              $140M
                      Property Catastrophe Reinsurance
Reinsurer B           Treaties are typically part of a
                      program. This program would be
              $100M   stated as follows:
                      •Reinsurer A is taking an 80% share of
                      the layer 80x20. This translates into
Reinsurer A           Reinsurer A is reimbursing the primary
                      carrier for losses in excess of $20 Million
                      per occurrence up to a limit of $80
              $20M    Million.
                      •Reinsurer B is taking an 80% share of
                      the layer 40x100.
               $0     •The primary insurer is responsible for
                      any losses in gray or above $140 Million.
   Property Catastrophe Reinsurance
       Programs - Coinsurance
              $140M   Primary insurers are usually not
                      able to cede 100% of the loss. The
Reinsurer B
                      portion they retain in called
              $100M   coinsurance.
                      Coinsurance is required to avoid the
                      two following forms of adverse
Reinsurer A           selection.
                      – Writing large amounts of catastrophe
                        exposed risk because they have
              $20M
                        reinsured the risk away.
                      – Not controlling losses during the
               $0       claim settlement process after the
                        event has occurred.
                      Coinsurance
    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.
Property Catastrophe Reinsurance –
             Models
                         •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.
    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
                                            Property Catastrophe Reinsurance –
                                                      Model Output
                                                                                                                            •An insurer would input
                           12.00%
                                                                                                                            information on his book
                           10.00%                                                                                           of business into the
                           8.00%
                                                                                                                            model.
Proability of Exceedance




                           6.00%                                                                                            •The output would
                           4.00%
                                                                                                                            include expected value
                           2.00%
                                                                                                                            estimates and an
                                                                                                                            exceedance curve similar
                           0.00%
                                    $0   $5,000,000   $10,000,000   $15,000,000
                                                                      Loss
                                                                                  $20,000,000   $25,000,000   $30,000,000
                                                                                                                            to the one of the left.
                                                                                                                            •Using management
                                                                                                                            judgment and risk
                                                                                                                            tolerances the insurer can
                                                                                                                            begin to manage its risk.
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.
    Property Catastrophe Reinsurance –
              Model Output
Rates on a property catastrophe treaty are typically quoted
using the term “Rate On Line”.

   RATE                     TREATY PREMIUM
    ON =
   LINE                         TREATY LIMIT


                   Roughly equal to the probability of
                              payment.
  What Is Being Done to Help
Industry Cope with Catastrophes
California Earthquake Authority
Florida Hurricane Catastrophe Fund
Hazard Mitigation Grant Program (Floods)
Homeowners Insurance Availability Act
  Initially introduced in 1997
  Not enacted yet
  Would provide catastrophe reinsurance
Tax Deferred Catastrophe Reserves
  Proposals under consideration in Congress
              Next Lecture
Securitization of catastrophe risk

				
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