But innovative ideas could bring long-term solutions

Coastal properties in Texas and Louisiana may be ‘markets in peril’

Hurricanes Katrina, Rita and Wilma in 2005 left more than physical devastation. The storms left an indelible mark on the entire process of insurance in the regions affected by the hurricanes, particularly in Texas and Louisiana. As a consequence, insurance companies, reinsurers, modeling agencies, state regulators and industry analysts are reevaluating the nature of risk and the financial requirements to deal with it effectively.

The nature of the beast

It is estimated that more than 55 percent of the U.S. population lives within 50 miles of the coastline. Coastal areas are up to five times more densely populated than other areas, but as events have shown, they are also more catastrophe-prone. As the build up of property in these high-risk areas increases, many insurance companies have tried to reduce their exposure to catastrophic risk and the associated reinsurance costs by reducing voluntary writings in coastal areas.

This has resulted in a crisis in insurance availability. Responding to this situation, there has been significant growth in the state residual market mechanisms, or coastal wind pools, to pick up the slack. These pools are now facing greater than anticipated exposures in line with the harsher realities predicted by newly updated catastrophe models. They are levying more frequent — and larger — involuntary assessments against those insurers who remain in operation in order to maintain adequate funding levels. Ironically, the risks covered by the pools consist almost entirely of the older construction and near-ocean property that the insurance companies were trying to eliminate from their own portfolios!

Trouble in Texas

One of the most significant pools in terms of size and potential for loss is the Texas Windstorm Insurance Association (TWIA). The aggregate in force exposure of the TWIA is expected to be in excess of $60 billion by the end of 2007. This figure is likely to be substantially higher than most companies anticipated when they were purchasing or contemplating purchasing their reinsurance protections.

For example, Galveston County alone represents 70 percent of wind pool exposure. Assuming a 15 percent PML (probable maximum loss) on aggregate values for a direct hit on Galveston, a ground up loss could top $6.8 billion and the resulting assessment would be a challenging sum for any assessed company.

It is likely that most insurance companies do not realize the full potential of a TWIA assessment. This is especially true for insurance companies that focus on other areas of the country, but also write property business in Texas.

Losses in Louisiana

In Louisiana, exposures within the state pool are also rising dramatically. It is anticipated that Louisiana Citizens Property Insurance Corporation will have $23 billion of liability in force, spread over some 150,000 policies by the end of 2007. But with primary rates softening, both commercial and state insurers are struggling to afford the level of reinsurance protection the models suggest is necessary and which the rating agencies are insisting on.

Louisiana’s reinsurance program currently provides 90 percent of $400 million in excess of a $100 million retention.

Market solutions

A variety of market-based approaches seem to be making progress in the effort to stabilize property markets in coastal areas. They include:

More precise modeling. Catastrophe management has been an integral part of an insurance company’s analysis of risk, but now some companies’ very survival is seriously impacted by their ability to evaluate and mitigate catastrophe risk. This is an opportunity for reinsurers to work much more closely with their clients to refine near term loss expectations as well as overall aggregate accumulations.

Rather than simply accepting the output from models, reinsurers are now being far more proactive, helping insurers to become much more granular in their zip code analysis for example, by taking increased account of age and construction type of properties within particular zip codes, and thereby becoming more precise about the nature and extent of the risks they are writing.

However, all the models in the world cannot solve the underlying problem that many properties are old, in the wrong place, and extremely costly to insure and reinsure. All they can do is point out precisely where these properties are, and the impact of their presence on the insurer’s or state pool’s portfolio.

Blending of markets to write business in Louisiana. Post Katrina, a significant number of risks including many of quality construction and good loss experience were relegated to the Louisiana Citizens insurance facility. The migration of these risks was a direct result of the markets’ decision to dramatically reduce writings in catastrophe prone areas particularly in and around New Orleans.

Historically, even in pre-Katrina Louisiana, some of the more volatile business was written in the excess and surplus market while some was written in more traditional facultative markets. This historic “blending” has given rise to a different way of examining and writing business in Louisiana.

Working together, the treaty and facultative markets gave rise to the idea of extracting the wind and hail component from the mainframe policy exposure. This allows more companies to write business previously written in Louisiana Citizens. Once the wind and hail exposure has been carved out, the remaining policy experience, which historically has been excellent, can again be shared by a large group of traditional writers.

This combination of treaty and facultative is providing a solution to what was a seemingly intractable problem — enabling all those involved to play to their strengths.

London market taking on wind and hail. Wind and hail risks are much better suited to the London market, which is dominated by specialist players that thrive on high risk, high return business and can write it an acceptable rate. Such carriers would not normally entertain the “low risk” homeowners’ book with its attritional drag of small claims which require an army of domestic administrators to process efficiently. The London market is ideally suited to take on the very risks that the Louisiana insurance sector would avoid.

Top-up coverage in Texas. In Texas the solution has been somewhat different. Major catastrophe reinsurers in London and Bermuda agree that for specifically targeted coverage in Texas, the cost could be made attractive when compared, for example, to what companies currently spend on their top layers.

They have been assessing a number of retention and coverage options to provide dedicated top-up coverage that responds to involuntary assessments and which inures to the benefit of the mainframe catastrophe program. By targeting the coverage very precisely, they have been able to make costs affordable and at the same time provide the certainty that rating agencies and regulators require that PMLs are within the companies’ ability to manage.

These products are in their infancy but take-up has been rapid and it seems reasonable to assume that they will be successful in solving some of the state’s problems.

Continuing efforts to expand capacity

The moral to draw from the experience in Texas and Louisiana would seem to be that in a competitive market, solutions will be found to seemingly intractable problems. Creativity and innovation are the driving forces which enable business to be written and appropriate profits made. Pools are part of the answer, but they are not a long-term solution.