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Gavin Bradshaw
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August 23, 2022
Can the Florida Insurance Market Withstand a US$100 Billion Repeat of Hurricane Andrew?

Hurricane Andrew’s landfall in Florida in 1992 changed the face of property catastrophe insurance and kick-started many new initiatives, including the development of hurricane risk modeling. However, with significant exposure growth, the impact of social inflation, and climate change complications, the insurance market could struggle to respond to a repeat of Andrew. The wide-ranging impact of Hurricane Andrew on the Florida insurance market is a familiar story within the risk management world. However, 30 years on from August 24, 1992, when Andrew made landfall in Dade County, Florida, memories appear to be getting shorter, as the insurance industry once more seems to be in danger of underestimating its exposure to a Category 5 storm hitting the state. Image from the GOES-7 satellite shows Hurricane Andrew at its peak intensity on August 23, 1992, before making landfall near Homestead, Florida. Image source: NOAAWhen Hurricane Andrew came ashore as the first named tropical storm of the 1992 North Atlantic hurricane season, it followed a seven-year hiatus in major hurricane activity in Florida. Industry predictions at the time were that it would cost insurers around US$4 billion to US$5 billion, but Andrew ended up costing the insurance industry US$15 billion (in 1992 values) for Florida claims, and it caused the deaths of 44 people in the state. Following Hurricane Andrew, more than 650,000 claims were filed, leaving eight insurers becoming insolvent and a further three driven into insolvency the following year. Fast forward to today, and RMS® predictions for a repeat of Andrew would see the insured loss for wind and surge in the range of US$80 billion (GR) and US$90 billion (GU), in which other non-modeled losses and social inflation could lead to a US$100 billion event. Aftermath of Andrew The losses from Hurricane Andrew vindicated the need for catastrophe modeling solutions including the use of multiple simulated storms beyond those previously experienced in history. Catastrophe models enabled the new Bermuda reinsurance market: eight new reinsurers were established without the need for their own historical experience. In time, catastrophe models would enable the creation of insurance-linked securities such as catastrophe bonds, to tap into capital markets for alternatives to reinsurance. Without Hurricane Andrew, it might have taken much longer for this revolution to happen. The crisis caused by Andrew certainly precipitated some rapid and innovative changes to help manage a much larger hurricane risk cost than previously recognized, allowing the market to prepare for the hyperactive Florida hurricane seasons of 2004 and 2005. However, the following years were unusually quiet for intense storms landfalling in Florida, encouraging actions that further raised insurers’ hurricane risk costs. Among these was the 25 percent roof replacement rule in 2007, which mandated that if 25 percent or more of a roof is ‘repaired, replaced or recovered’ in any 12-month period, then the entire roofing system or roof section must be brought up to the latest building code. “Until the hurricanes returned with a vengeance in 2017,” says Peter Datin, senior director of modeling at RMS, “the significant additional cost imposed on insurers due to this code update was not clear.” Development of Hurricane Modeling Before Hurricane Andrew, exposure mapping by the insurance industry involved tracking premiums at a fairly coarse ‘Cresta Zone’ resolution. Post-Andrew, as modelers provided insurers with the ability to model exposures at a finer scale, insurers recognized how higher resolution data could provide a more accurate assessment of risk. RMS released its first hurricane model in 1993. Since then, there have been many updates and innovations, from basin-wide stochastic tracks, coupled ocean-atmosphere storm surge modeling, and significant enhancements in damage assessment modeling. After Hurricane Katrina in 2005, Robert Muir-Wood, chief research officer at RMS, coined the term ‘post-event loss amplification’ (PLA) to cover all processes that can raise losses after a major catastrophe, such as demand surge and claims inflation. Auguste Boissonnade, vice president of model development at RMS, who designed the first RMS hurricane model, worked on how to quantify these different factors in generating the overall insurance loss after cat events. Hurricane Katrina floodingFor the most extreme catastrophes, when damage requires the long-term evacuation of large parts of a city, the definition of a “super catastrophe” (or “super-cat”) event applies, where secondary consequences can be a significant component of the original damage. The flooding of New Orleans after Hurricane Katrina was such a super-cat.   “With the hurricane catastrophes of 2004 and 2005 came the realization that cat loss models needed to allow for undervaluation of insured exposures as well as the secondary impact of economic, social, and political factors that could amplify the losses,” Boissonnade says. After major hurricanes, RMS vulnerability modelers review lessons that can be learned from the events and the resulting claims data. “Through claims analyses, it has been possible to quantify the degree to which changes in wind design codes have reduced damage and losses to buildings and incorporate those learnings into cat models,” added Datin. Current Market Dynamics The average cost of an annual homeowner’s policy in Florida is expected to soar to US$4,231 this year, almost three times the U.S. annual average, according to the Insurance Information Institute. Five Florida market insurers have already gone insolvent so far in 2022, faced with rising claims costs and increased costs for reinsurance. Meanwhile, the number of policies written by Citizens, a post-Andrew creation, has risen to over a million, as insurers have either gone insolvent, withdrawn capacity from the market, or had their ratings downgraded, making it harder for insureds to secure coverage that will meet their mortgage lenders’ approval. In July 2022, rating agency Demotech wrote to 17 insurers warning them they could be downgraded from A (exceptional) to S (substantial) or M (moderate), potentially impacting millions of policyholders whose mortgage providers demand home insurance from the strongest-rated carriers. Florida legislators then looked to circumvent the use of Demotech ratings with a new stopgap measure, where Citizens take on a reinsurance role to pay claims for insolvent insurers. At the same time, insurers are struggling to secure reinsurance capacity, and Citizens only managed to get a third of its desired reinsurance cover, making it harder for carriers to deploy sufficient capacity to meet the demand for hurricane coverage. There has also been a huge increase in the volume of catastrophe claims in recent years, driven by social inflation and undervaluation of exposures. Likely Impact of Andrew Now “Our prediction that a repeat of Andrew today could cause as much as US$100 billion in insured losses is based in large part on changes in exposure and population since 1992, coupled with updated predictions of the impact of wind and storm surge, with significant anticipated post-event loss amplification. Together these components reveal a more complete picture of potential economic and insured losses,” says Mohsen Rahnama, chief risk modeling officer at RMS. Combined wind and surge losses for a repeat of Hurricane Andrew are estimated at US$87 billion. Post-event loss amplification, whether it is from a slow recovery, supply chain issues from COVID-19, or current inflationary trends, could take the ultimate loss closer to US$100 billion. The impact of storm surge, particularly with the climate change-related rise in sea levels, is also more pronounced now compared to estimates at the time of Andrew.   South Florida property developmentAdded to this is the significant demographic shift in Florida. As of this year, the population of Florida is estimated at over 22 million – a 61 percent increase from the number of people in 1992. Building counts in Andrew’s wind and surge footprints have increased by 40 percent to 1.9 million and by 32 percent to 55,000 respectively. Economic exposure has also increased by 77 percent in the wind footprint and 67 percent in the surge footprint. And in Miami-Dade County, the number of high-rise buildings that are over 15 stories has tripled since 1992, many of which are now potentially in Andrew’s surge footprint. “While the wind was the main driver of loss in 1992, the number of new, high-valued buildings near the coast suggests that storm surge losses may play an increasing role in a repeat of this event,” says Rahnama. In constant-dollar terms, economic exposure has grown substantially within both Andrew’s wind and surge footprints, based on an analysis of the total built floor area (see Figure 1). On top of this, cost inflation since 1992 has been substantial, with replacement costs in Florida estimated to have increased between two times and 2.5 times since 1992, based on historical construction cost indices. Figure 1: Exposure growth in Hurricane Andrew’s footprint (in constant dollars). Source: RMSOne key uncertainty in estimating the losses from a repeat of Hurricane Andrew concerns the impact of claims litigation. “Irma in 2017 was the first significant hurricane to make landfall since the 25 percent roof replacement rule was expanded in 2017 to all buildings across Florida, and it contributed to a significant increase in claims frequency and severity, as roof damage sustained during the storm attracted many roofing contractors, who handed over their exaggerated claims to be pursued by attorneys,” recalls Datin. An estimated US$15 billion has been paid to claimants by insurers in Florida since 2013, driven by assignment of benefits (AOB) cases, where litigation has capitalized on the 25 percent roof replacement rule, with a significant portion of the cost being driven by attorney’s fees on both sides. However, a new law passed by the Florida legislature in May 2022 changed the 25 percent roof replacement rule to exempt roofs “built, repaired, or replaced in compliance with the 2007 Florida Building Code, or any subsequent editions of the Florida Building Code.” “This means that only the damaged portion of the roof on newly built or upgraded roofs needs to be repaired after a damaging wind event instead of the entire roof or roofing system. Most importantly for insurers, the right of the contractor or assignee to obtain compensation for attorney fees – that drives up the cost of claims even further – has been removed,” adds Datin. Muir-Wood adds: “There is further hope for insurers following a recent appeal court ruling in Florida which could provide the blueprint for insurers to successfully argue against contractors in such lawsuits. Here we have at least one factor that is now being brought under control, which has significantly raised the insurance costs of hurricane losses. However, insurers will be watching closely to see if there is any reduction in social inflation because of recent legislative measures.” Can the US$100 Billion Repeat of Andrew be Prevented? Should another Category 5 hurricane make landfall in southeast Florida today, not only will the insured loss be more considerable, but the insurance industry will face major challenges that could severely impact its ability to withstand the event. What can the risk management industry do to mitigate losses? Risk modeling has advanced dramatically. “Insurers need to collect detailed data on their exposures and values and then employ high-resolution modeling alongside all those factors that can affect the ultimate loss, whether from post-event loss amplification or from more resilient construction standards,” says Muir-Wood. The spirit of the industry working together with regulators, similar to post-Andrew, needs to be resurrected. “To help insurance carriers to remain competitive, regulators and legislators have been working with the industry to prevent claims litigation from getting out of control and potentially threatening the viability of hurricane insurance in Florida,” adds Boissonnade. “And legislators also need to keep a close eye on how claims respond to the changes to the 25 percent roof replacement rule, and in measures that reduce the need for litigation, so as to reduce vexatious claims,” he adds. Datin acknowledges the role that risk modelers can play, “The catastrophe modeling community has already helped drive positive change in Florida by demonstrating the impacts of building codes and the effects of AOB-driven claims inflation on modeled risk.” In addition, says Rahnama: “It’s crucial that modeling for hurricane risk takes greater account of the effects of climate change on global warming and sea level rise, and the impact those will ultimately on wind and storm surge in the event of another hurricane like Andrew. Let’s not sleepwalk into another Andrew-type scenario. The insights are there, and the warning signs have flashed – we just need to learn from history.”

NIGEL ALLEN
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September 06, 2019
A Climate Model Challenge

Insurance-linked securities (ILS) investors want to know more about how climate change impacts investment decisions, according to Paul Wilson, head of non-life analytics at Securis Investment Partners, an ILS asset manager We make investments that are typically annual to two-to-three years in duration, so we need to understand the implications of climate change on those timescales,” explains Paul Wilson, head of non-life analytics at Securis Investment Partners. “We reevaluate investments as part of any renewal process, and it’s right to ask if any opportunity is still attractive given what we know about how our climate is changing. “The fundamental question that we’re trying to address is, ‘Have I priced the risk of this investment correctly for the next year?’” he continues. “And therefore, we need to know if the catastrophe models we are using accurately account for the impact climate change may be having. Or are they overly reliant on historical data and, as such, are not actually representing the true current risk levels for today’s climate?” Expertise in climate change is a requirement for how Securis is thinking about risk. “We have investors who are asking questions about climate change, and we have a responsibility to be able to demonstrate to them that we are taking the implications into consideration in our investment decisions.” “We have investors who are asking questions about climate change, and we have a responsibility to demonstrate to them that we are taking the implications into consideration in our investment decisions Paul Wilson Securis Investment Partners The rate at which a changing climate may influence natural catastrophes will present both a challenge and opportunity to the wider industry as well as to catastrophe modeling companies, thinks Wilson. The results coming out of climate change attribution studies are going to have to start informing the decisions around risk. For example, according to attribution studies, climate change tripled the chances of Hurricane Harvey’s record rainfall.  “Climate change is a big challenge for the catastrophe modeling community,” he says. “It’s going to put a greater burden on catastrophe modelers to ensure that their models are up to date. The frequency and nature of model updates will have to change. Models we are using today may become out of date in just a few years’ time. That’s interesting when you think about the number of perils and regions where climate change could have a significant impact. “All of those climate-related models could be impacted by climate change, so we have to question the impact that is having today,” he adds. “If the model you are using to price the risk has been calibrated to the last 50 years, but you believe the last 10 or last 20 years are more representative because of the implication of climate change, then how do you adjust your model according to that? That’s the question we should all be looking to address.”

NIGEL ALLEN
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September 06, 2019
ILS: A Responsible Investment Approach

As environmental, social and governance principles become more prominent in guiding investment strategies, the ILS market must respond  In recent years, there has been a sharper focus by the investment community on responsible investment. One indicator of this has been the increased adoption of the Principles for Responsible Investment (PRI), as environmental, social and governance (ESG) concerns become a more prominent influencer of investment strategies. Investment houses are also seeking closer alignment between their ESG practices and the United Nations’ Sustainable Development Goals (SDGs). The 17 interconnected SDGs, set in 2015, are a call to action to end poverty, achieve peace and prosperity for all, and create a sustainable society by 2030. As investors target more demonstrable outcomes from their investment practices, is there a possible opportunity for the insurance-linked securities (ILS) market to grow, given the potential societal capital that insurance can generate? “Insurance certainly has all of the hallmarks of an ESG-compatible investment opportunity,” believes Charlotte Acton, director of capital and resilience solutions at RMS. “It has the potential to promote resilience through enabling broader access and uptake of appropriate affordable financial protection and reducing the protection gap; supporting faster and more efficient responses to disasters; and incentivizing mitigation and resilient building practices pre- and post-event.” RMS has been collaborating on numerous initiatives designed to further the role of insurance and insurance technologies in disaster and climate-change resilience. These include exploring ways to monetize the dividends of resilience to incentivize resilient building, using catastrophe models to quantify the benefits of resilience investments such as flood defenses, and earthquake retrofit programs for housing. The work has also involved designing innovative parametric structures to provide rapid post-disaster liquidity. “Investors will want a clear understanding of the exposure or assets that are being protected and whether they are ESG-friendly” Charlotte Acton RMS “ILS offers a clear route for investors to engage with insurance,” explains Acton, “broadening the capital pool that supports insurance is critical as it facilitates the expansion of insurance to new regions and allows the industry to absorb increasingly large losses from growing threats such as climate change.” Viewed as a force for social good, it can certainly be argued that insurance-linked securities supports a number of the U.N.’s SDGs, including reducing the human impact of disasters and creating more sustainable cities, increasing overall resilience levels and increasing access to financial services that enhance sustainable growth potential. While there is opportunity for ILS to play a large part in ESG, the specific role of ILS within PRI is still being determined. According to LGT Capital Partners ESG Report 2019, managers in the ILS space have, in general, yet to start “actively integrating ESG into their investment strategies,” adding that across the ILS asset class “there is still little agreement on how ESG considerations should be applied. However, there is movement in this area. For example, the Bermuda Stock Exchange, a primary exchange for ILS issuers, recently launched an ESG initiative in line with the World Federation of Exchanges’ Sustainability Principles, stating that ESG was a priority in 2019 “with the aim to empower sustainable and responsible growth for its member companies, listings and the wider community.” For ILS to become a key investment option for ESG-focused investors, it must be able to demonstrate its sustainability credentials clearly. “Investors will want a clear understanding of the exposure or assets that are being protected,” Acton explains, “and whether they are ESG-friendly. They will want to know whether the protection offered provides significant societal benefits. If the ILS market can factor ESG considerations into its approach more effectively, then there is no reason why it should not attract greater attention from responsible investors.”

NIGEL ALLEN
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September 06, 2019
The Power of a Crisis

As Christchurch City Council continues to build back better, will its resilience investment pay dividends when it comes to citywide insurance cover? The Canterbury Earthquake Sequence is the largest insured event in New Zealand’s history. Between September 2010 and December 2011, four major earthquakes caused damage to approximately 168,000 residential buildings. The earthquakes spawned more than 770,000 claims for the country’s Earthquake Commission (EQC) alone, resulting in a payout of around NZ$10 billion (US$6.4 billion). The private sector absorbed almost twice that, with the Insurance Council of New Zealand putting the figure at NZ$21.4 billion (as of March 31, 2019). Christchurch Art Gallery. The city’s art gallery, for example, has been retrofitted to resist even the most severe earthquake activity. Nine years on from the initial tremors, there remain over 1,200 open property claims in the private market, while the outstanding figure for the EQC stood at some 2,600 claims in February 2018. “Dealing with the property claims was extremely challenging,” explains Raf Manji, chair of the Christchurch City Council’s Finance Committee, “not just in terms of contractual issues, but because the insurance was based on building-by-building cover. And when you’re dealing with damage to so many buildings, it is going to take a very long time to agree what that damage is.” Building Back Better The need to rebuild Christchurch presented the city with an opportunity.  “As American politician Rahm Emanuel once said, ‘Never let a crisis go to waste,’” says Lianne Dalziel, mayor of Christchurch. “The earthquakes provided a major opportunity to build back better and ensure we embed resilience into every aspect, from below ground up.” That commitment means that new construction, whether of above-ground assets or horizontal infrastructure, is being carried out to a level much higher than building codes dictate.  “With the information, we want more informed conversations with both traditional and alternative markets about how we transfer risk more effectively” Raf Manji Christchurch City Council “We’re building to an exceptionally high standard,” states Mike Gillooly, chief resilience officer for the city. This is a relatively new public position created following Christchurch’s inclusion in the first wave of the Rockefeller Foundation’s 100 Resilient Cities program. “The city’s art gallery, for example, has been retrofitted to resist even the most severe earthquake activity,” Gillooly continues. But this dedication to resilience goes beyond the immediate rebuild. The council is also making resilience a core component of its long-term strategic planning. The city’s 2021-2051 infrastructure strategy, which covers the council’s investments in water supply, wastewater, stormwater, transport, parks, facilities, solid waste and communication technology for the next 30 years, will have resilience as its overarching theme. “This is the first time we are proactively building risk and resilience into our long-term planning framework,” states Dalziel. “We are developing a much deeper appreciation of risk and have spent considerable time understanding our infrastructure. We are also working toward a much more sophisticated engagement with risk at the community level.” “It’s not only about strengthening our physical infrastructure,” she continues. “It’s also about strengthening our social infrastructure.”  “We are committed to promoting greater community well-being. We need to build up social capital by bringing people together to plan for an uncertain future. High levels of social capital accelerate recovery in the aftermath of a shock, while also creating greater inherent resilience to more slow-moving challenges, such as climate change and associated rising sea levels.” Dalziel is quick to stress the importance of insurance in all this. “There is a strong relationship between economic resilience and social resilience, and the role of insurance in facilitating both cannot be underestimated. The value of insurance does not simply equal the sum of claims paid — it’s as much about the financial and social well-being that it supports.”  Making Resilience Pay Recently insurers across New Zealand have been shifting their appetite and premiums in high-hazard regions to be more reflective of the country’s risk profile.  There has been a shift too in the council’s approach to insurance — a shift that is central to its resilience efforts, explains Manji. “Following the earthquakes, Lianne asked me to run for council. I was a former financial markets trader and she wanted someone onboard with a financial background. But when I joined, I was taken aback by the lack of risk understanding that I saw at the local government level.” One of his first steps was to set up an independently chaired audit and risk committee and introduce a new risk management framework — a model that has since been adopted by Auckland. “Through this new framework, we were able to establish a much more sophisticated view of risk,” he explains, “and we also launched a five-year program to document every single asset in place — both above and below ground. Having this granular level of exposure insight means we can assess our approach to mitigating, retaining and transferring risk from a much more data-informed position.” At present, Christchurch is conservatively insured. This is a very deliberate choice, however, and Manji is convinced of the benefits of this approach. “This excess capacity means we have headroom into which we can grow as we continue to construct new and reconstruct old assets. That’s a much stronger position to be in than having to return to the market seeking more limit when capacity may be limited. It also demonstrates a long-term commitment to the insurance market upon which you can have much more constructive, ongoing dialogue.” Data-Informed Dialogue Christchurch City Council has been making use of insurance capital for many years. It was the 2010-11 earthquakes, though, that spurred its focus on arming itself with increasingly higher-resolution data. “We’re now coming to the table each year with an ever more accurate picture of our exposure. Working with RMS, we’ve been able to significantly evolve our risk thinking based on a range of citywide loss scenarios, and to look at ways of creating a more effective balance between traditional and more innovative parametric-based solutions.” That desire for balance does not just apply to the source of Christchurch capital, but also what kinds of assets that capital covers. At present, while the council has secured coverage for 65 percent of the value of its above-ground structures, it has only managed to buy insurance to cover approximately 15 percent of its underground infrastructure. “The insurance market is not comfortable with providing cover for underground infrastructure because it tends not to be well understood or documented,” Manji continues.  “Unlike most cities, however, we know exactly what is underground and just how resilient it is. With that information, we want to have more informed conversations — with both the traditional market and alternative providers of risk capital — about how we transfer this risk more effectively. Parametric-based solutions, for example, give us the opportunity to look beyond typical building replacement covers and take a bigger-picture view of what we want to achieve from our investment in risk transfer. “And whereas an indemnity-based policy is designed primarily to return you to where you were prior to the loss, parametric payouts can be deployed for what ever purpose you want. That flexibility — along with the speed and certainty of payout — is incredibly valuable.” For Gillooly, it is about becoming an increasingly sophisticated user of risk capital and engaging in ever more mature dialogue with the markets. “If we can demonstrate through the data and analytics that we understand the exposure, that we’ve quantified the risk and we’re investing in effective risk reduction, then the market needs to acknowledge these efforts in the form of increased capacity, reduced premiums or both. Data, analytics and risk insights will continue to be the key focus of our annual discussions with the London market — and will allow us to explore parametric insurance-linked securities with confidence too.”

NIGEL ALLEN
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May 20, 2019
Clear Link Between Flood Losses and NAO

RMS research proves relationship between NAO and catastrophic flood events in Europe The correlation between the North Atlantic Oscillation (NAO) and European precipitation patterns is well known. However, a definitive link between phases of the NAO and catastrophic flood events and related losses had not previously been established — until now. A study by RMS published in Geophysical Research Letters has revealed a direct correlation between the NAO and the occurrence of catastrophic floods across Europe and associated economic losses. The analysis not only extrapolated a statistically significant relationship between the events, but critically showed that average flood losses during opposite NAO states can differ by up to 50 percent. A Change in Pressure The NAO’s impact on meteorological patterns is most pronounced in winter. Fluctuations in the atmospheric pressure between two semi-permanent centers of low and high pressure in the North Atlantic influence wind direction and strength as well as storm tracks. The two-pronged study combined extensive analysis of flood occurrence and peak water levels across Europe, coupled with extensive modeling of European flood events using the RMS Europe Inland Flood High-Definition (HD) Model. The data sets included HANZE-Events, a catalog of over 1,500 catastrophic European flood events between 1870 and 2016, and a recent database of the highest-recorded water levels based on data from over 4,200 weather stations. “The HD model generated a large set of potential catastrophic flood events and quantified the associated losses” “This analysis established a clear relationship between the occurrence of catastrophic flood events and the NAO phase,” explains Stefano Zanardo, principal modeler at RMS, “and confirmed that a positive NAO increased catastrophic flooding in Northern Europe, with a negative phase influencing flooding in Southern Europe. However, to ascertain the impact on actual flood losses we turned to the model.” Modeling the Loss The HD model generated a large set of potential catastrophic flood events and quantified the associated losses. It not only factored in precipitation, but also rainfall runoff, river routing and inundation processes. Critically, the precipitation incorporated the impact of a simulated monthly NAO index as a driver for monthly rainfall. “It showed that seasonal flood losses can increase or decrease by up to 50 percent between positive and negative NAOs, which is very significant,” states Zanardo. “What it also revealed were distinct regional patterns. For example, a positive state resulted in increased flood activity in the U.K. and Germany. These loss patterns provide a spatial correlation of flood risk not previously detected.” Currently, NAO seasonal forecasting is limited to a few months. However, as this window expands, the potential for carriers to factor oscillation phases into flood-related renewal and capital allocation strategies will grow. Further, greater insight into spatial correlation could support more effective portfolio management. “At this stage,” he concludes, “we have confirmed the link between the NAO and flood-related losses. How this evolves to influence carriers’ flood strategies is still to be seen, and a key factor will be advances in the NAO forecasting. What is clear is that oscillations such as the NAO must be included in model assumptions to truly understand flood risk.”

Helen Yates
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September 05, 2018
IFRS17: Under the Microscope

How new accounting standards could reduce demand for reinsurance as cedants are forced to look more closely at underperforming books of business They may not be coming into effect until January 1, 2021, but the new IFRS 17 accounting standards are already shaking up the insurance industry. And they are expected to have an impact on the January 1, 2019, renewals as insurers ready themselves for the new regime. Crucially, IFRS 17 will require insurers to recognize immediately the full loss on any unprofitable insurance business. “The standard states that reinsurance contracts must now be valued and accounted for separate to the underlying contracts, meaning that traditional ‘netting down’ (gross less reinsured) and approximate methods used for these calculations may no longer be valid,” explained PwC partner Alex Bertolotti in a blog post. “Even an individual reinsurance contract could be material in the context of the overall balance sheet, and so have the potential to create a significant mismatch between the value placed on reinsurance and the value placed on the underlying risks,” he continued. “This problem is not just an accounting issue, and could have significant strategic and operational implications as well as an impact on the transfer of risk, on tax, on capital and on Solvency II for European operations.” In fact, the requirements under IFRS 17 could lead to a drop in reinsurance purchasing, according to consultancy firm Hymans Robertson, as cedants are forced to question why they are deriving value from reinsurance rather than the underlying business on unprofitable accounts. “This may dampen demand for reinsurance that is used to manage the impact of loss making business,” it warned in a white paper. Cost of Compliance The new accounting standards will also be a costly compliance burden for many insurance companies. Ernst & Young estimates that firms with over US$25 billion in Gross Written Premium (GWP) could be spending over US$150 million preparing for IFRS 17. Under the new regime, insurers will need to account for their business performance at a more granular level. In order to achieve this, it is important to capture more detailed information on the underlying business at the point of underwriting, explained Corina Sutter, director of government and regulatory affairs at RMS. This can be achieved by deploying systems and tools that allow insurers to capture, manage and analyze such granular data in increasingly high volumes, she said. “It is key for those systems or tools to be well-integrated into any other critical data repositories, analytics systems and reporting tools. “From a modeling perspective, analyzing performance at contract level means precisely understanding the risk that is being taken on by insurance firms for each individual account,” continued Sutter. “So, for P&C lines, catastrophe risk modeling may be required at account level. Many firms already do this today in order to better inform their pricing decisions. IFRS 17 is a further push to do so. “It is key to use tools that not only allow the capture of the present risk, but also the risk associated with the future expected value of a contract,” she added. “Probabilistic modeling provides this capability as it evaluates risk over time.”

Helen Yates
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September 05, 2018
The Future for Flood Protection

With 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.”

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