Weathering the Storm (December 01, 2007)

Florida insurer Vanguard Fire and Casualty Company was ordered into receivership on Jan. 19, 2007. In March, it was put into liquidation. The insurer had incurred significant losses due to the series of hurricanes in 2004-05. Indeed, 34 insurance companies have become insolvent in the United States since 1992 due to natural catastrophes.

Natural hazards have the potential to cause insolvencies for Canadian insurers. Canadian property and casualty (P&C) insurance companies have paid out Cdn$4.4 billion (after adjusting for inflation) in disaster-related losses since 2000.

Disaster severity in Canada over the decade since 1997 has increased by 2.5 times over the previous decade (again accounting for inflation), from an average of Cdn$54 million per event to Cdn$136 million per event. In addition to increasing severity, frequency is also increasing. A Cdn$300-million insured loss disaster prior to 1997 happened once every 10 years. Since 1997 such an event has occurred five times. A Cdn$500-million event has occurred on average every three years since 1997, but not once between 1987 and 1997.

In the parlance of the common culture, Cdn$300 million has become the new Cdn$100 million for disaster losses in Canada.

Catastrophe losses in recent years have prompted a discussion within the industry and among insurance regulators about the property and casualty industry’s capacity to handle catastrophe risk. From a solvency perspective, “the industry” is of less interest than the capacity of individual insurers — with varying degrees of financial strength — to avoid wind-up and liquidation. Despite the failure of four companies following the effects of seven hurricanes in the United States over a period of two years, catastrophe losses had only a limited impact on solvency there.

LEARNING FROM THE PAST

During the mid-1980s to the mid-1990s, a pattern of failure emerged. Insurers exposed to catastrophic risks — risks they did not fully appreciate or for which they had not reserved — were becoming insolvent. In many ways, it resembled the problem of urban conflagrations in the 19th century such as the Great Fire of Montreal in 1852, the Great Chicago Fire of 1871 and the Great Fire of Toronto in 1904. A large number of risks on an insurer’s books would be correlated; if a catastrophe affected enough of those risks, a single event could destroy the company.

In many ways, Hurricane Andrew was a watershed for insurers. The event raised awareness of the scale of losses that a hurricane could create — particularly given that it missed the large urban area of Miami — and showed that insurance firms could be brought to financial insolvency by such events. At that time, insurers arguably knew a lot more about fire than weather-related risks. The increase in disaster-related losses in the 1980s and 1990s generated a flurry of research on insurance and disaster mitigation. Among the six prominent peer review research journals on insurance issues, the number of disaster-related articles increased significantly. In Canada, the 1998 Ice Storm further reinforced the lesson for Canadian insurers. The P&C industry in 1998 founded the Institute for Catastrophic Loss Reduction (ICLR) and partnered with the University of Western Ontario, focusing on multi-disciplinary disaster prevention research. Today insurers know a lot more about managing disaster-related risks.

Hurricane Andrew hit the Florida coast in 1992, causing Cdn$21.9 billion in insured losses (in today’s dollars) and 790,000 claims. As a result, 11 property and casualty insurance companies became insolvent. Florida’s guarantee fund provided protection on more than 25,000 claims.

A computer simulation in the late 1990s, presented at the annual meeting of the American Meteorological Society, suggested hurricane losses could be in the order of Cdn$66.7 billion to Cdn$127.6 billion, placing numerous insurers and reinsurers in danger of insolvency. Nearly a decade later, Hurricanes Katrina, Rita and Wilma (KRW) made landfall, generating more than Cdn$69 billion in insured losses. Despite the magnitude of the losses (representing three times that of Hurricane Andrew), only six insurance companies failed.

ACTIVE HAZARD RISK MANAGEMENT

Insurers now incorporate catastrophe risk in their risk management policies. Risk is better spread across product lines and geographic markets. Insurers have also developed risk models, better utilized the reinsurance market and raised rates in high-risk areas. Insurers have also been encouraging risk management among policyholders, by offering better terms and conditions and pricing to insureds who take steps to mitigate disaster-related risks.

The result of active hazard risk management has been that disaster-related insolvencies of P&C insurance companies have declined even as insured losses from disasters have increased.

The impact of insured catastrophe losses in Canada has been on average approximately half of that in the United States. Although insured losses from natural disasters in Canada have displayed an upward trend during the past decade, they remain relatively low compared to total industry claims costs. However, the large catastrophe losses incurred in 1998 and 2005 both fortuitously occurred in strong earnings environments, permitting the industry to absorb the losses without involuntary exit. Had the 1998 Ice Storm occurred in 2001, when industry earnings were weak, the Insurance Bureau of Canada estimates that up to two companies may have been at risk of insolvency. Natural disasters have also contributed to a small number of companies exiting the market through voluntary run-off.

Overall, of the 35 insolvent Canadian P&C insurance companies analyzed in PACICC’s study on why insurers fail in Canada, only one company exited the market due to disaster-related losses.

OPERATING ENVIRONMENT

Even as fewer insurers are failing as a result of disasters, the industry’s operating environment following a disaster has changed. Given the increasing number of people living in higher-risk areas, and the increased frequency of disasters, insurers are facing a different claims environment today than they were a decade or more ago. In addition, policyholders have different service expectations of their insurers than in the past. Also, today’s insurers face more demanding political and reporting pressures.

In response, insurance companies have greatly improved their knowledge of underwriting in disaster-prone areas and have increased capacity to provide claims service to policyholders affected by disasters. Many large weather events can be tracked and insurance companies prepare to have adjusters and claims staff enter the disaster-affected area as soon as it is safe to do so. This greatly improves claim response times and allows policyholders to get back to normal as fast as possible.

The contrast between Hurricanes Andrew and KRW in Florida clearly highlights the importance of claims response times. Six months after Hurricane Andrew, claims adjusters, relying on paper documents (which in many cases had also suffered damage), were still in the process of identifying claims and the extent of company exposure. Following KRW, after six months, an estimated 90% of claims in Florida were closed and paid. Insurer response, remote location connection technology and electronic documentation greatly facilitated the handling of claims.

For both regulators and guarantee funds, this use of information technology also accelerates the assessment of whether a company is financially distressed. The lag involved in analyzing a company’s claim situation and its subsequent financial position is greatly reduced. Identifying whether a company was insolvent took up to two years after Hurricane Andrew. Following KRW, in contrast, it took six months to close 94% of claims and identify that the Poe group of insurance companies was financially distressed and would need to be placed into rec eivership.

LESSONS FOR GUARANTEE FUNDS

Reviewing U.S. experience in responding to a catastrophe and to potential insolvency highlights a number of lessons for a guarantee fund like PACICC. First, preparedness is key. Florida’s insurance guarantee fund was highly successful in its handling of the Poe insurance group liquidation due to its operational preparedness. PACICC has identified several key factors that have allowed guarantee funds in other jurisdictions to respond effectively following a disaster. These include:

Operational preparedness

* maintaining a small professional staff that is able to respond quickly and flexibly to changing circumstances;

* being operationally prepared on short notice to review and contribute to the drafting of a winding-up order;

* liquidators may have challenges in finding qualified claims staff, since the rapid identification of insolvency means that insurers providing service to their own policyholders are also using claims personnel. Guarantee funds need to develop contingency plans and may have to provide some support to liquidators in the early stages of a liquidation; and

* maintaining a capacity for addressing policyholder and claimant inquiries helps support consumer confidence and minimizes negative media attention.

Financial preparedness

* having the capacity to estimate and assess member companies in a timely manner for the necessary resources to refund unearned premiums first, allowing consumers to quickly find new coverage, and then pay policyholder claims;

* maintaining the capacity to estimate the impact of PACICC’s assessments on member companies, which may already be under financial strain from the disaster.

SUMMARY

The upward historical trend in catastrophe losses and the increase in insurers’ potential losses have led regulators, insurers and rating agencies to pay increasing attention to how insurers manage their catastrophe risk. The Canadian catastrophe loss environment, while less severe than that of the United States, appears to be increasing. Fortunately, as a result of improved risk management, as well as the good fortune of having the two largest catastrophe loss years occur in years of strong profitability, the Canadian P&C industry has been able to weather catastrophic loss events with few insurer insolvencies.

But such luck may not continue. PACICC is therefore paying attention to how P&C insurance guarantee funds manage insolvency resulting from disaster losses. By conducting research and strengthening its operational preparedness, PACICC’s goal is to reduce the burden borne by member insurers, both in terms of reputational loss to the industry and in liquidation costs.