EXPOSURE
The RMS Magazine with a unique perspective and clear mission “... to provide insight and analysis to help insurance and risk professionals innovate, adapt, and deliver.”
Insurance: The next 10 years
Mohsen Rahnama, Cihan Biyikoglu and Moe Khosravy of RMS look to 2029, consider the…
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Tag: Issue 5
When the Lights Went Out
September 05, 2018How poor infrastructure, grid blackouts and runaway business interruption has hampered Puerto Rico’s recovery in the aftermath of Hurricane Maria As the 2018 North Atlantic hurricane season continues, Puerto Rico has yet to recover from destructive events of the previous year. In September 2017, Category 4 Hurricane Maria devastated several Caribbean islands, including Puerto Rico, and left a trail of destruction in its path. For many, Maria was one of the worst natural catastrophes to hit a U.S. territory, causing an estimated US$65 billion to US$115 billion in damage and claiming as many as 4,500 to 5,000 lives. The damage wrought has further strained the island’s sluggish economy. Puerto Rico had over US$70 billion in public debt when Maria hit. Economic forecasts for 2018 to 2020, considering the impact of Hurricane Maria, suggest Puerto Rico’s GDP will decline by 7 to 8 percent in 2018 and likely remain in a negative range of 5 to 7 percent for the next few years. “Resilience is also about the financial capacity to come back and do the reconstruction work” Pooya Sarabandi RMS Power outages, business interruption (BI) and contingent BI (CBI) — including supply chain disruption — have hampered the economy’s recovery. “Resilience is also about the financial capacity to come back and do the reconstruction work,” explains Pooya Sarabandi, global head of data analy- tics at RMS. “You’re now into this chicken- and-egg situation where the Puerto Rican government already has a lot of public debt and doesn’t have reserves, and meanwhile the federal U.S. government is only willing to provide a certain level of funding.” Maria’s devastating impact on Puerto Rico demonstrates the lasting effect a major catastrophe can have when it affects a small, isolated region with a concentrated industry and lack of resilience in infrastructure and lifelines. Whereas manufacturers based on the U.S. mainland have contingencies to tap into — the workforce, raw materials and components, and infrastructure in other parts of the country during times of need — there is not the same opportunity to do this on an island, explains Sarabandi. Rolling Blackouts Following Maria’s landfall, residences and businesses experienced power outages throughout the island. Severe physical damage to electric power generation plants, transmission and distribution systems — including solar and wind power generation plants — plunged the island into a prolonged period of rolling blackouts. Around 80 percent of utility poles were damaged in the event, leaving most of the island without electricity. Two weeks after the storm, 90 percent of the island was still without power. A month on, roughly 85 percent of customers were not connected to the power grid. Three months later, this figure was reported to be about half of Puerto Ricans. And finally, after six months, about 15 percent of residents did not have electricity. “There’s no real damage on the grid itself,” says Victor Roldan, head of Caribbean and Latin America at RMS. “Most of the damage is on the distribution lines around the island. Where they had the better infrastructure in the capital, San Juan, they were able to get it back up and running in about two weeks. But there are still parts of the island without power due to bad distribution infrastructure. And that’s where the business interruption is mostly coming from. “There are reports that 50 percent of all Maria claims for Puerto Rico will be CBI related,” adds Roldan. “Insurers were very competitive, and CBI was included in commercial policies without much thought to the consequences. Policyholders probably paid a fifth of the premiums they should have, way out of kilter with the risk. The majority of CBI claims will be power related, the businesses didn’t experience physical damage, but the loss of power has hit them financially.” Damage to transportation infrastructure, including railways and roads, only delayed the pace of recovery. The Tren Urbano, the island’s only rail line that serves the San Juan metropolitan area (where roughly 60 percent of Puerto Ricans live), started limited service for the first time almost three months after Hurricane Maria struck. There were over 1,500 reported instances of damage to roads and bridges across the island. San Juan’s main airport, the busiest in the Caribbean, was closed for several weeks. A Concentration of Risk Roughly half of Puerto Rico’s economy is based on manufacturing activities, with around US$50 billion in GDP coming from industries such as pharmaceutical, medical devices, chemical, food, beverages and tobacco. Hurricane Maria had a significant impact on manufacturing output in Puerto Rico, particularly on the pharmaceutical and medical devices industries, which is responsible for 30 percent of the island’s GDP. According to Anthony Phillips, chairman of Willis Re Latin America and Caribbean, the final outcome of the BI loss remains unknown but has exceeded expectations due to the length of time in getting power reinstalled. “It’s hard to model the BI loss when you depend on the efficiency of the power companies,” he says. “We used the models and whilst personal lines appeared to come in within expectations, commercial lines has exceeded them. This is mainly due to BI and the inability of the Puerto Rico Electric Power Authority (PREPA) to get things up and running.” Home to more than 80 pharmaceutical manufacturing facilities, many of which are operated by large multinational companies, Puerto Rico’s pharmaceutical hub was a significant aggregation of risk from a supply chain and insurance perspective. Although only a few of the larger pharmaceutical plants were directly damaged by the storm, operations across the sector were suspended or reduced, in some cases for weeks or even months, due to power outages, lack of access and logistics. “The perception of the Business Interruption insurers anticipated, versus the reality, was a complete mismatch” Mohsen Rahnama RMS “The perception of the BI insurers anticipated, versus the reality, was a complete mismatch,” says Mohsen Rahnama, chief risk modeling officer at RMS. “All the big names in pharmaceuticals have operations in Puerto Rico because it’s more cost- effective for production. And they’re all global companies and have backup processes in place and cover for business interruption. However, if there is no diesel on the island for their generators, and if materials cannot get to the island, then there are implications across the entire chain of supply.” While most of the plants were equipped with backup power generation units, manu- facturers struggled due to long-term lack of connection to the island’s only power grid. The continuous functioning of on-site generators was not only key to resuming production lines, power was also essential for refrigeration and storage of the pharmaceuticals. Five months on, 85 medicines in the U.S. were classified by the Food and Drug Administration (FDA) as “in shortage.” There are several reasons why Puerto Rico’s recovery stalled. Its isolation from the U.S. mainland and poor infrastructure were both key factors, highlighted by comparing the island’s recovery to recovery operations following U.S. mainland storms, such as Hurricane Harvey in Texas last year and 2012’s Superstorm Sandy. Not only did Sandy impact a larger area when it hit New York and New Jersey, it also caused severe damage to all transmission and distribution systems in its path. However, recovery and restoration took weeks, not months. It is essential to incorporate the vulnerabilities created by an aggregation of risk, inadequate infrastructure and lack of contingency options into catastrophe and pricing models, thinks Roldan. “There is only one power company and the power company is facing bankruptcy,” he says. “It hasn’t invested in infrastructure in years. Maria wasn’t even the worst-case scenario because it was not a direct hit to San Juan. So, insurers need to be prepared and underwriting business interruption risks in a more sophisticated manner and not succumbing to market pressures.” CBI Impact on Hospitality and Tourism Large-magnitude, high-consequence events have a lasting impact on local populations. Businesses can face increased levels of disruption and loss of revenue due to unavailability of customers, employees or both. These resourcing issues need to be properly considered in the scenario-planning stage, particularly for sectors such as hospitality and tourism. Puerto Rico’s hospitality and tourism sectors are a significant source of its GDP. While 69 percent of hotels and 61 percent of casinos were operational six weeks after Maria struck, according to the Puerto Rico Tourism Company, other factors continued to deter visitors. It was not until the end of February 2018, five months after the event, that roughly 80 percent of Puerto Rico’s hotels and restaurants were back in business with tourists returning to the island. This suggests a considerable loss of income due to indirect business interruption in the hospitality and tourism industry.
The Future for Flood Protection
September 05, 2018With innovation in the flood market increasing, EXPOSURE explores whether high-definition (HD) flood models are one of the keys to closing the protection gap In August 2017, Hurricane Harvey brought the highest level of rainfall associated with a tropical cyclone in the U.S. since records began, causing catastrophic flooding in some of the most populated areas of the Texas coast, including Houston. The percentage of losses attributed to inland flood versus wind damage was significant, altering the historical view that precipitation resulting from a tropical storm or hurricane is an attritional loss and highlighting the need for stochastic modeling. Total economic losses resulting from Harvey were around US$85 billion and insured losses were US$30 billion, revealing a significant protection gap, particularly where inland flood damage was concerned. Around 200,000 homes were inundated by the floods, and yet 80 percent of homes in the Houston area were uninsured. Hurricane Harvey Impacts – Aftermath An innovative catastrophe bond has suggested one way this protection gap could be reduced in the future, particularly as a private flood insurance market develops in the U.S. FloodSmart Re, which was announced at the end of July 2018, secured US$500 million of reinsurance protection on behalf of FEMA’s National Flood Insurance Program (NFIP). Reinsurer Hannover Re was acting as the ceding reinsurer for the transaction, sitting between the NFIP and its Bermuda-based special purpose insurer. “It’s a landmark transaction — the first time in history that the U.S. federal government is sponsoring a catastrophe bond,” says John Seo, co-founder and managing principal at Fermat Capital. “It’s just tremendous and I couldn’t be more excited. Events like Harvey are going to accelerate the development of the flood market in terms of risk transfer to the insurance-linked securities (ILS) market. “You have to have more efficient risk pooling and risk sharing mechanisms,” he adds. “There’s over US$200 trillion dollars of capital in the world, so there’s obviously enough to efficiently absorb event risk. So, it’s about, how do you get it out into that larger capital base in an efficient way?” While the bond only provides cover for flooding arising from named storms, either due to storm surge or rainfall, it is a “good test case for the ILS market’s appetite for flood risks,” according to ILS blog Artemis. While “it is not a broad flood coverage, it will likely help to make it more palatable to cat bond investors given their comfort with modeling the probability of named storms, tropical storms and hurricanes.” According to Cory Anger, global head of ILS origination and structuring at GC Securities, the ILS market is certainly showing an appetite for flood risk — including inland flood risk — with several catastrophe bonds completed during 2017 for European flood risk (Generali’s Lion II), Japanese flood risk (MSI and ADI’s Akibare Series 2018-1 Notes) and U.S. flood risk. “Both public and private sector entities see value from utilizing capital markets’ capacity to manage flood risk,” she says. “We think there are other geographic regions that would be interested in ILS capacity that haven’t yet tapped the ILS markets. Given the recent success of FEMA/NFIP’s FloodSmart Re Series 2018-1 Notes, we expect FEMA/NFIP to continue to utilize ILS capacity (along with traditional reinsurance capital) to support future U.S. flood risk transfer opportunities.” The ILS sector has grown significantly over the past 15 years, with deals becoming more complex and innovative over time. Many market commentators feel the market was put to the test following the major natural catastrophe losses in 2017. Not only did bonds pay out where they were triggered, fresh capital re-entered, demonstrating investors’ confidence in the sector and its products. “I’m hearing people starting to coin the phrase that 2018 is the ‘great reload,’” says Seo. “This is something I have been saying for quite some years: That the traditional hard-soft, soft-hard market cycle is over. It’s not that you can’t have an event so large that it doesn’t impact the market, but when it comes to capital markets, high yields are actually a siren call for capital. “I don’t think anyone doubts that had 2017 occurred in the absence of the ILS market it would have been a completely different story, and we would have had a traditional hard market scenario in 2018,” he adds. FloodSmart Re has clearly demonstrated the strong investor interest in such transactions. According to Anger, GC Securities acted as the structuring agent for the transaction and was one of two book runners. More than 35 capital markets investors provided fully collateralized protection to FEMA/NFIP on the landmark catastrophe bond. “The appetite for new perils is generally strong, so there’s always strong interest when new risks are brought to market,” says Ben Brookes, managing director of capital and resilience solutions at RMS. He thinks improvements in the underlying data quality along with high-definition flood models make it more likely that inland flood could be included as a peril in future catastrophe bond issuances on behalf of private insurers, on an indemnity basis. “In the early days of the cat bond market, new perils would typically be issued with parametric triggers, because investors were skeptical that sufficient data quality was achieved or that the indemnity risks were adequately captured by cat models. But that changed as investor comfort grew, and a lot of capital entered the market and you saw all these deals becoming indemnity. Increased comfort with risk modeling was a big part of that.” The innovative Blue Wings catastrophe bond, which covered insurer Allianz for severe U.K. flood risk (and some U.S. and Canadian quake) and was completed in 2007, is a good example. The parametric bond used an index to calculate flood depths at over 50 locations across the U.K., was ahead of its time and is the only U.K. flood catastrophe bond that has come to market. According to Anger, as models have become more robust for flood risk — whether due to tropical cyclone (storm surge and excess precipitation) or inland flooding (other than from tropical cyclone) — the investor base has been open to trigger selection (e.g., indemnity or parametric). “In general, insurers are preferring indemnity-triggered solutions,” she adds, “which the ILS market has concurrently been open to. Additionally, for this peril, the ILS community has been open to per occurrence and annual aggregate structures, which gives flexibility to sponsors to incorporate ILS capital in their risk transfer programs.” As the private market develops, cat bond sponsors from the insurance market would be more likely to bundle inland flood risk in with other perils, thinks Charlotte Acton, director of capital and resilience solutions at RMS. “A degree of hurricane-induced inland flood risk is already present on a non-modeled basis within some transactions in the market,” she says. “And Harvey illustrates the value in comprehensive modeling of flooding associated with named storms. “So, for a broader portfolio, in most cases, inland flood would be one piece of the picture as it will be exposed to multiple perils. However, a stand-alone inland flood bond is possible for a public sector or corporate sponsor that has specific exposure to flood risk.” With inland flood, as with all other perils, sophisticated models help to make markets. “A fund would look at the risk in and of itself in the deal, but of course they’d also want to understand the price and returns perspective as well,” says Brookes. “Models play into that quite heavily. You can’t price a bond well, and understand the returns of a bond, unless you understand the risk of it.” As the ILS market makes increasing use of indemnity protection through ultimate net loss (UNL) triggers, sophisticated HD flood modeling will be essential in order to transfer the peril to the capital markets. This allows clear parameters to be set around different hours clauses and deductible structures, for instance, in addition to modeling all causes of flood and the influence of local defenses. “It’s a landmark transaction — the first time in history that the U.S. Federal Government is sponsoring a catastrophe bond” John SEO Fermat capital Jillian Williams, chief underwriting officer at Leadenhall Capital Partners, notes that ILS is increasingly bundling together multiple perils in an effort to gain diversification. “Diversification is important for any investment strategy, as you are always trying to minimize the risk of losing large amounts in one go,” she says. “Cat bonds (144A’s) currently have defined perils, but collateralized reinsurance and private cat bonds can cover all perils. Complexities and flow of information to all parties will be a challenge for cat bonds to move from defined perils to UNL all perils. “Any new peril or structure in a cat bond will generate many questions, even if they don’t have a major impact on the potential losses,” she continues. “Investors will want to know why the issuers want to include these new perils and structures and how the associated risk is calculated. For UNL, all flood (not just sea surge) would be included in the cat bond, so the definition of the peril, its complexities, variables and its correlation to other perils will need to be evaluated and represented in the flood models used.” She thinks the potential to transfer more flood to the capital markets is there, but that the complexity of the peril are challenges that need to be overcome, particularly in the U.S. “Flood coverage is already starting to move into the capital markets, but there are many issues that need to be worked through before it can be moved to a 144A transaction in a UNL format for many territories,” says Williams. “Just one of the complexities is that flood risk may be covered by government pools. “To move flood perils from government pools to private insurers is like any evolution, it can take time, particularly if existing coverage is subsidized,” she adds. “For private insurers, the complexity is not just about flood modeling but also about ensuring risk-adequate pricing and navigating through government legislation.”
A Risk-Driven Business
September 05, 2018Following Tower Insurance’s switch to risk-based pricing in New Zealand, EXPOSURE examines how recent market developments may herald a more fundamental industry shift The ramifications of the Christchurch earthquakes of 2010-11 continue to reverberate through the New Zealand insurance market. The country’s Earthquake Commission (EQC), which provides government-backed natural disaster insurance, is forecast to have paid around NZ$11 billion (US$7.3 billion) by the time it settles its final claim. The devastating losses exposed significant shortfalls in the country’s insurance market. These included major deficiencies in insurer data, gaps in portfolio management and expansive policy wordings that left carriers exposed to numerous unexpected losses. Since then, much has changed. Policy terms have been tightened, restrictions have been introduced on coverage and concerted efforts have been made to bolster databases. On July 1, 2019, the EQC increased the cap limit on the government-mandated residential cover it provides to all householders from NZ$100,000 (US$66,000) (a figure set in 1993) to NZ$150,000. A significant increase, but well below the average house price in New Zealand as of December 2017, which stood at NZ$669,565, and an average rebuild cost of NZ$350,000. It has also removed contents coverage. More recently, however, one development has taken place that has the potential to have a much more profound impact on the market. Risk-Based Pricing In March 2018, New Zealand insurer Tower Insurance announced a move to risk-based pricing for home insurance. It aims to ensure premium levels are commensurate with individual property risk profiles, with those in highly exposed areas experiencing a price rise on the earthquake component of their coverage. Describing the shift as a “fairer and more equitable way of pricing risk,” Tower CEO Richard Harding says this was the “right thing to do” both for the “long-term benefit of New Zealand” and for customers, with risk-based pricing “the fairest way to distribute the costs we face as an insurer.” The move has generated much media coverage, with stories highlighting instances of triple-digit percentage hikes in earthquake-prone regions such as Wellington. Yet, what has generated significantly fewer column inches has been the marginal declines available to the vast majority of households in the less seismically active regions, as the high-risk earthquake burden on their premium is reduced. A key factor in Tower’s decision was the increasing quality and granularity of the underwriting data at its disposal. “Tower has always focused on the quality of its data and has invested heavily in ensuring it has the highest-resolution information available,” says Michael Drayton, senior risk modeler for RMS, based in New Zealand. “The earthquakes generated the most extensive liquefaction in a built-up area seen in a developed country” Michael Drayton RMS In fact, in the aftermath of the Christchurch earthquakes, RMS worked with Tower as RMS rebuilt its New Zealand High-Definition (HD) Earthquake Model due to the caliber of their data. Prior to the earthquake, claims data was in very short supply given that there had been few previous events with large-scale impacts on highly built-up areas. “On the vulnerability side,” Drayton explains, “we had virtually no local claims data to build our damage functions. Our previous model had used comparisons of building performance in other earthquake-exposed regions. After Christchurch, we suddenly had access to billions of dollars of claims information.” RMS sourced data from numerous parties, including EQC and Tower, as well as geoscience research firm GNS Science, as it reconstructed the model from this swell of data. “RMS had a model that had served the market well for many years,” he explains. “On the hazard side, the fundamentals remained the same — the highest hazard is along the plate boundary, which runs offshore along the east coast of North Island traversing over to the western edge of South Island. But we had now gathered new information on fault lines, activity rates, magnitudes and subduction zones. We also updated our ground motion prediction equations.” One of the most high-profile model developments was the advanced liquefaction module. “The 2010-11 earthquakes generated probably the most extensive liquefaction in a built-up area seen in a developed country. With the new information, we were now able to capture the risk at much higher gradients and in much greater resolution,” says Drayton. This data surge enabled RMS to construct its New Zealand Earthquake HD Model on a variable resolution grid set at a far more localized level. In turn, this has helped give Tower sufficient confidence in the granularity and accuracy of its data at the property level to adopt risk-based pricing. The Ripple Effects As homeowners received their renewal notices, the reality of risk-based pricing started to sink in. Tower is the third-largest insurer for domestic household, contents and private motor cover in New Zealand and faces stiff competition. Over 70 percent of the market is in the hands of two players, with IAG holding around 47 percent and Suncorp approximately 25 percent. News reports also suggested movement from the larger players. AMI and State, both owned by IAG, announced that three-quarters of its policyholders — those at heightened risk of earthquake, landslide or flood — will see an average annual premium increase of NZ$91 (US$60); the remaining quarter at lower risk will see decreases averaging NZ$54 per year. A handful of households could see increases or decreases of up to NZ$1,000. According to the news website Stuff, IAG has not changed premiums for its NZI policyholders, with NZI selling house insurance policies through brokers. “One interesting dynamic is that a small number of start-ups are now entering the market with the same risk-based pricing stance taken by Tower,” Drayton points out. “These are companies with new purpose-built IT systems that are small and nimble and able to target niche sectors.” “It’s certainly a development to watch closely,” he continues, “as it raises the potential for larger players, if they are not able to respond effectively, being selected against. It will be interesting to see if the rate of these new entrants increases.” The move from IAG suggests risk-based pricing will extend beyond the earthquake component of cover to flood-related elements. “Flood is not a reinsurance peril for New Zealand, but it is an attritional one,” Drayton points out. “Then there is the issue of rising sea levels and the potential for coastal flooding, which is a major cause for concern. So, the risk-based pricing shift is feeding into climate change discussions too.” A Fundamental Shift Policyholders in risk-exposed areas such as Wellington were almost totally unaware of how much higher their insurance should be based on their property exposure, largely shielded away from the risk reality of earthquakes in recent years. The move to risk-based pricing will change that. “The market shifts we are seeing today pose a multitude of questions and few clear answers” Michael Drayton RMS Drayton agrees that recent developments are opening the eyes of homeowners. “There is a growing realization that New Zealand’s insurance market has operated very differently from other insurance markets and that that is now changing.” One major marketwide development in recent years has been the move from full replacement cover to fixed sums insured in household policies. “This has a lot of people worried they might not be covered,” he explains. “Whereas before, people simply assumed that in the event of a big loss the insurer would cover it all, now they’re slowly realizing it no longer works like that. This will require a lot of policyholder education and will take time.” At a more foundational level, current market dynamics also address the fundamental role of insurance, exposing the conflicted role of the insurer as both a facilitator of risk pooling and a profit-making enterprise. When investment returns outweighed underwriting profit, it appeared as if cross-subsidization wasn’t a big issue. However, current dynamics has meant the operating model is squarely focused on underwriting returns — to favor risk-based pricing. Cross-subsidization is the basis upon which EQC is built, but is it fair? Twenty cents in every NZ$100 (US$66) of home or contents fire insurance premium, up to a maximum of NZ$100,000 insured, is passed on to the EQC. While to date there has been limited government response to risk-based pricing, it is monitoring the situation closely given the broader implications. Looking globally, in an RMS blog, chief research officer Robert Muir-Wood also raises the question whether “flat-rated” schemes, like the French cat nat scheme, will survive now that it has become clear how to use risk models to calculate the wide differentials in the underlying cost of the risk. He asks whether “such schemes are established in the name of ‘solidarity’ or ignorance?” While there is no evidence yet, current developments raise the potential for certain risks to become uninsurable. Increasingly granular data combined with the drive for greater profitability may cause a downward spiral in a market built on a shared burden. Drayton adds: “Potential uninsurability has more to do with land-use planning and building consent regimes, and insurers shouldn’t be paying the price for poor planning decisions. Ironically, earthquake loading codes are very sophisticated and have evolved to recognize the fine gradations in earthquake risk provided by localized data. In fact, they are so refined that structural engineers remark that they are too nuanced and need to be simpler. But if you are building in a high-risk area, it’s not just designing for the hazard, it is also managing the potential financial risk.” He concludes: “The market shifts we are seeing today pose a multitude of questions and few clear answers. However, the only constant running through all these discussions is that they are all data driven.” Making the Move Key to understanding the rationale behind the shift to risk-based pricing is understanding the broader economic context of New Zealand, says Tower CEO Richard Harding. “The New Zealand economy is comparatively small,” he explains, “and we face a range of unique climatic and geological risks. If we don’t plan for and mitigate these risks, there is a chance that reinsurers will charge insurers more or restrict cover. “Before this happens, we need to educate the community, government, councils and regulators, and by moving toward risk-based pricing, we’re putting a signal into the market to drive social change through these organizations. “These signals will help demonstrate to councils and government that more needs to be done to plan for and mitigate natural disasters and climate change.” Harding feels that this risk-based pricing shift is a natural market evolution. “When you look at global trends, this is happening around the world. So, given that we face a number of large risks here in New Zealand, in some respects, it’s surprising it hasn’t happened sooner,” he says. While some parties have raised concerns that there may be a fall in insurance uptake in highly exposed regions, Harding does not believe this will be the case. “For the average home, insurance may be more expensive than it currently is, but it won’t be unattainable,” he states. Moving forward, he says that Tower is working to extend its risk-based pricing approach beyond the earthquake component of its cover, stating that the firm “is actively pursuing risk-based pricing for flood and other natural perils, and over the long term we would expect other insurers to follow in our footsteps.” In terms of the potential wider implications if this occurs, Harding says that such a development would compel government, councils and other organizations to change how they view risk in their planning processes. “I think it will start to drive customers to consider risk more holistically and take this into account when they build and buy homes,” he concludes.
