Aggregate Cover

A catastrophe aggregate XS treaty is a reinsurance tool designed to help insurers manage the effects of multiple extreme weather events on their results.

Weather-related catastrophes in Canada are commonplace. In some years, they can spoil the results of insurance companies. The inherent variability in the weather is difficult to predict and impossible to control. This can be a problem for insurers’ operating results and profit projections. We can’t change the events, but we can manage the repercussions.

In the past few years, the industry has seen more than the long-term average number of natural catastrophes. Almost all of these catastrophe losses are weather-related. In meteorologi- cal terms, these weather events are thunderstorms or “severe convective storms,” which form as a result of interactions between regional air masses. Their origins and development patterns are quite different from hurricanes or “tropical cyclones” that originate in the tropical latitudes of the Atlantic and in the Caribbean. However, the effect of convective storms and hurricanes on the landscape and on insured property can be quite similar. Extreme wind speeds, tornadoes and heavy rain happen over large areas, with lightning and hail in localized spots. Unlike earthquake risk, which is a major issue in B.C. and the Ontario/Quebec border region, weather events can happen anywhere in the country. The really spectacular stuff, though, is on the Prairies. Severe convective storms in large cells and “supercells” can travel across the entire expanse of the Prairie provinces and last several days. After the storms have passed, insurers are left to help clean up in the aftermath. Damage to buildings and vehicles can be severe.

If the storm “footprint” covers a broad area, it is likely an insurer’s catastrophe XS treaties will be triggered. The common “per-event” catastrophe XS program is intended to cover the losses that are too large for the insurer to retain com- fortably. But if the storm footprint is smaller, the insurer may have a string of claims that do not add up to the attachment point of their reinsurance program. That is not a problem, because the insurer has already decided that it can handle the loss without serious repercussions to its business plans. But what happens when there are too many of these smaller events? Retentions start to add up. At the end of the fiscal period, their impact might be significant. Does your multi-year catastrophe loss cost, net of your catastrophe XS program, look like this? (Please see See Table 1 below). A catastrophe aggregate XS cover is an effective solution to exactly this problem.

DEFINING CATASTROPHE AGGREGATE XS

Catastrophe aggregate excess of loss reinsurance protects insurance companies against a specified level of accumulation of their net loss position due to catastrophes during the period of the contract. Note that:

• coverage is for the company’s net position, after all other reinsurance, including the company’s regular catastrophe XS program, and

• coverage is for multiple events occurring within a specified time period.

HOW CATASTROPHE AGGREGATES WORK

A hypothetical insurance company writes property and auto business across Canada. It has a catastrophe XS program protecting them from individual catastrophic losses. With the help of some modeling software, the company has determined that its largest possible catastrophic loss is unlikely to exceed $100 million. It therefore structures its catastrophe XS program to protect them up to a limit of $100 million. It has also decided that its capitalization and risk tolerance can withstand a $10-million loss from a catastrophe. So, their net retention before the catastrophe XS program attaches is set at $10 million each loss occurrence. In treaty underwriter shorthand, this is shown as follows: Cat XS: $90M xs $10M, any one event.

The insurer retains catastrophe losses that do not add up to $10 million for any one event. Reinsurers pay for larger catastrophic events once the primary insurer has paid out claims totaling their $10-million catastrophe XS program retention for that event or occurrence.

Table 2 (above) shows a fictional year of large and small catastrophe losses. It also demonstrates how the main catastrophe xs program alters the insurer’s net loss position. Table 2 assumes total cat event losses for the year are $38.4 million before reinsurance..

WITHOUT A CATASTROPHE AGGREGATE XS COVER

In the Table 2 scenario above, the insurer retains $33.4 million and cedes $5 million to its catastrophe XS reinsurers. If the individual loss does not exceed $10 million, the cat XS program is not triggered. Here is the calculation in shorthand:

Insurer Net Cat Loss (2010): $38.4M gross less $5M ceded to Cat XS = $33.4M net

Our hypothetical insurer may or may not be able to absorb $33.4 million of unanticipated losses comfortably, depending on its size and expected profit margins.

ADDING A CATASTROPHE AGGREGATE XS COVER

Let’s say that to guard against being overwhelmed by numerous small losses, our hypothetical company has in place a catastrophe aggregate XS treaty. The treaty protects them from multiple net losses of $40 million in a year above a net aggregate retention of $20 million. In reinsurer parlance: Catastrophe Aggregate XS:

Limit: $40M aggregate annual net loss XS of Retention:$20M aggregate annual net loss.

To make it clear that the “net losses” are only due to catastrophes, there is usually a condition that the loss has to exceed a certain size. This is a threshold (or “franchise”) that defines which losses are included. It generally does not act as a deductible. For our example, the threshold is set at $1 million. Multiple policy claims caused by a single event are added together and when they reach the $1 million threshold, the entire amount is included in the aggregation list. Events where the claim totals do not reach $1 million are not aggregated.

Using the same set of losses as in Table 2, Table 3 shows how the aggregate XS applies.

In the Table 3 scenario, the insurer retains $20 million, cedes $5 million to the catastrophe XS reinsurers, and $13.4 million to the aggregate XS reinsurers. In shorthand, this reads:

Sum of Cat Losses (2010): $38.4M gross less $5M ceded to Cat XS less $13.4M ceded to Agg XS = $20M net.

DOES A CATASTROPHE AGGREGATE XS FIT YOUR COMPANY’S NEEDS?

How do you assess whether buying a catastrophe aggregate cover makes sense for your company? You need to answer the question: “Do I anticipate an unacceptable financial impact from an accumulation of retained catastrophe losses?” To answer this question, you need to know:

1) Your annual expected cat loss cost (net of Risk XS and Cat XS)

For example, cat losses variability of $10M to $100M, average of $20M.

2) Your (ROE)/profitability expectations

For example, a target profit (at average expected cat losses) of $50M ($70M less $20M average annual cat losses).

A quick comparison

Impact of a “good” cat year:

$70M minus $10-million worth of annual cat losses = $60M profit.

Impact of a “bad” cat year:

$70M minus $100-million worth of annual cat losses = $30M loss.

Based on the above, the corporate decision would be: Is a financial year loss of $30M “acceptable,” or would it be better to buy a multi-year smoothing mechanism?

CONCLUSION

A catastrophe aggregate XS cover represents long-term protection. It should be considered as a multi-year strategy to reduce annual patterns of volatility in weather-related losses. The limits and attachment points are determined according to each company’s specific needs, but the framework is easy to establish. The recoveries are simple annual calculations. Reinsurance pricing is based on long-term experience and exposure assessments and could be much more “bottom-line friendly” than simply accepting the unpredictability of the weather.