Vol. 13 No. 2 June 1996

Published exclusively for subscribers to RISK FINANCING

FINANCIAL INNOVATION INPROPERTY CATASTROPHE

REINSURANCE:THE CONVERGENCE OFINSURANCE AND CAPITAL

MARKETS

by-Graciela. Chichilnisky, Ph.D. 1Columbia University

The property catastrophe reinsurance industryfaces a major challenge . Since 1989, climaticvolatility has produced unprecedented insuredlosses of $43 billion, $18 billion of whichwere from Hurricane Andrew alone . A surgeof insurer defaults and dramatic changes incapacity and pricing have followed in theirwake.

Catastrophic risks must be addressed with in-novative financial approaches that bring theinsurance industry closer to the securities in-dustry. This article discusses the new financialinstruments that can be successfully used tohedge unknown catastrophe risks.

'The author acknowledges information provided by Pe-ter Vloedman, Columbia Business School .

Hurricane Andrew Changed It All

In August 1992, Hurricane Andrew caused anunprecedented level of destruction . With in-sured losses of more than $18 billion and to-tal losses greater than $25 billion, Andrewwas the most devastating natural catastropheever recorded . It has also led to a wave of fi-nancial catastrophe: the hurricane affected al-most every major insurance company in theUnited States . No matter how hard reinsurerstried to diversify their portfolios among differ-ent insurance companies, they sustained loss-es on virtually every account that they hadunderwritten .

Reinsurers Depart

The magnitude of these losses contributed tothe demise of numerous reinsurers . In theyear following Andrew, 38 non-U.S . and 8

INSIDE . . .

continued on page 2

Circles and Cycles, Phases andStages: Their Effect upon WorkersCompensation Financing Decisions .. . . . . . . . 7

J

Page 2 RISK FINANCING NEWSLETTER Vol. 13 No. 2

.. . Catastrophe Reinsurance cont. from p. 1

U.S . reinsurers, with familiar names such asContinental Re and New England Re, eitherwithdrew from the reinsurance business com-pletely or ceased underwriting catastrophe re-insurance . Moreover, in the late 1980s tomid-1993, more than 200 reinsurers left themarketplace, citing intense competition, re-serve strengthening due to asbestos and envi-ronmental losses, and prior natural catastro-phes (such as the 1990 European windstormsand Hurricane Hugo) as reasons for their de-parture.

Capacity Constraints

The departure of reinsurers caused catastro-phe reinsurance capacity to drop by more

Maureen C . McLendon, CPCU, ARMRobert A. Bregman, CPCU, CLU, ARMEditors

Jack P Gibson, CPCU, CLU, ARMTechnical Adviser

Risk Financing Newsletter is published exclusively forsubscribers to Risk Financing . Permission to reproduce allof part of this newsletter is granted by the publisher. pro-vided attribution to Risk Financing Newsletter, the author,the publisher, and the date are given.

Published by

International Risk Management Institute, Inc.®12222 Merit Drive, Suite 1660

Dallas, Texas 75251-2217

Copyright O 1996International Risk Management Institute, Inc.e

The publisher has made every effort to assure the accu-racy of the information in this newsletter. Opinions on f',--nancial, tax, fiscal, and legal matters are those of the ed-itors, authors, and others . Professional counsel should beconsulted before any action or decision based on thismaterial is taken.

than 30 percent between 1989 and 1993-over 20 percent of which occurred between1992 and 1993 and was due to HurricaneAndrew. In 1989, the average U.S . catastro-phe reinsurance program was -approximately$144.3 million . But by January 1993, imme-diately after Andrew, the average program ca-pacity had plummeted to $93.7 million. Insur-ance companies could not buy enoughcatastrophe reinsurance-no matter howmuch they were willing to pay. The worldwidecatastrophe reinsurance demand exceededthe supply. This is illustrated by Figure 1 .

FIGURE 1PROPERTY CATASTROPHE REINSURANCE

CAPACITY: A HISTORICAL COMPARISON OFPLACEMENT SHORTFALL PERCENTAGE

Shortfall

0.0%

-10 .0%

-20 .0%

-30.0%

-40.096

Placement Shortfall* Percentage

1988 1890 lost 1802 1993 1894

Composite of 14 programs placed by GuyCarpenter 8c Co., Inc .

'Shortfall is the difference between the amount ofcoverage desired and the amount of coverageavailable in the market .

Prices Rise

Between 1989 and 1994, the contraction ofcapacity caused reinsurance prices to rise al-

continued on page 3

[Vol . 13 No. 2 RISK FINANCING NEWSLETTER Page 3

. .. Catastrophe Reinsurance cont. from p. 2

most 70 percent: from 12.4 percent rate online to 20.7 percent rate on line, much of itas a result of Andrew. (Rate on line is theprice charged per dollar of coverage pur-chased.) This is illustrated in Figure 2.

Rate onLine

30.0%

25.0%

20.0%

15 .0%

10 .0%

5 .0%

0 .0%

FIGURE 2PROPERTY CATASTROPHE REINSURANCE

CAPACITY : A HISTORICAL COMPARISON OFPROGRAM RATE ON LINE

Program Rate on Line*

1689 1680 1881 1882 1683 1984

Composite of 14 programs placed by GuyCarpenter & Co., Inc.'Rate on line is the price charged per dollar ofcoverage purchased .

Bermuda Emerges

The decrease in catastrophe reinsurance sup-ply following Andrew led to changes in themarketplace. With the continuing doubts overthe future existence of Lloyd's of London andthe need for capacity, Bermuda has become amajor force in the property catastrophe reinsur-ance market . In a period of 1 1/2 years, $4billion of capital was infused into Bermudacompanies formed for the purpose of writing

property catastrophe business . These new enti-ties included Centre Cat, Global Capital Re, In-ternational Property Catastrophe Re, La SalleRe, Mid Ocean Re, Renaissance Re, Partner Re,-and Tempest -Re. Interestingly, investors inthose companies comprised major players inthe securities industry, such as Morgan Stan-ley, Goldman Sachs, J .P Morgan, and WarburgPincus . This combination indicates the interestof the securities industry in the high margin re-insurance business. It anticipates the combineduse of insurance and security instruments as ameans of hedging property catastrophe risks.

The Effect upon Worldwide Capacity

The emergence of the Bermuda market is re-sponsible for more than 80 percent of the 35percent increase in worldwide reinsurance ca-pacity from 1993 to 1994. Bermuda hasgone from comprising less than 1 percent ofthe catastrophe reinsurance market to 25 per-cent in 5 years. -In contrast, U.K . capacitydropped about 60 percent during the sameperiod . In 1994, the Bermuda companies av-eraged a combined operating profit ratio of40 percent, which translated into an average15 percent return on equity ; an excellent re-turn in a year that witnessed almost $19 bil-lion i n worldwide catastrophe losses . Thesechanges in reinsurance market share are de-picted in Figure 3.

Problems in PredictingCatastrophic Risks

The practical problem for the reinsurance in-dustry is that catastrophic risks have reachedrecord values . Currently, reinsurers face twodifficulties in underwriting such coverage : vol-atile climatic conditions and the inapplicabilityof the law of large numbers in predicting ca-tastrophe losses .

continued on page 4

Page 4 RISK FINANCING NEWSLETTER Vol. 13 No. 2

. . . Catastrophe Reinsurance cont. from p. 3

U.K.58.0%

FIGURE 3"-

PROPERTY CATASTROPHE REINSURANCE CAPACITY :A HISTORICAL COMPARISON OF MARKET SHARE BY REGION

1989

Market Share by Region

Composite of 14 programs placed by Guy Carpenter &-Co., Inc .Charts provided by Guy Carpenter & Co.

Europe10.0%

others1.0%

1995

Climatic Conditions

In recent years, the increase in weather volatil-ity has heightened the difficulty in predictingcatastrophic property losses, rendering stan-dard actuarial tables unreliable . Such climatevolatility is often associated with global cli-mate change. This is blamed by some on theemission of greenhouse gases into the planet'satmosphere by Organization for Economic Co-operation and Development (OECD) countries,the group of the world's most industrialized na-tions . If so, volatility is only going to increase .The problem is not likely to go away.

As climate becomes more volatile, actuarialtables have become unreliable, creating therisk of using the wrong table for predictivepurposes. For example, one table could pre-

dict five hurricanes over a 5-year period, withaverage strength and associated loss of $3billion each. Another, equally reliable, tablecould predict 10 hurricanes during the sameperiod, having losses of about $2 billion each.

Although one can take an average of the twosource's opinions in creating a new actuarialtable, this does not work in actual practice . Ifboth scenarios are equally plausible, for exam-ple, then taking the average guarantees that,most of the time, the exposure to risks will ei-ther be overinsured or underinsured. Bothlead to costly risks . The former leads to finan-cial losses since insurance is expensive. Un-derinsurance is even more costly ; underinsur-ance leads to financial risks of default . In

continued on page 5

[-Vol. 13 No. 2 RISK FINANCING NEWSLETTER Page 5

.. . Catastrophe Reinsurance cont. from p. 4

either case, to the physical catastrophe onemay add financial catastrophe. This happenedto many reinsurers on the eve of Andrew. Italso happened with Lloyd's of London, whereunderestimation of climate losses has led tocontinuing doubts about its future existence.

Inapplicability of the Law of Large Numbers

The second problem associated with predict-ing the incidence of catastrophic property lossis that insurance does not work very well un-der these circumstances. The law of largenumbers requires that risks be "independent,"behaving, for example, as car accidents or firehazards . These conditions produce reliable ac-tuarial tables, which form the scientific foun-dation for pricing in the insurance industry.However, when large-scale catastrophic prop-erty losses occur, risks are no longer indepen-dent because a hurricane affecting one insur-er will also affect every other insurer writingcoverage in the same geographical area .

In effect, catastrophic property losses arehighly correlated risks-as opposed to beingindependent risks . And since large-scale prop-erty catastrophes impact a significant_ part ofthe insurer population both in physical and infinancial terms, the law of large numbersdoes not operate under these circumstances,making it impossible for reinsurers to diversifyrisks . What can be done?

Catastrophe Bundles:A Tool for Hedging Risks

In response to this problem, the insurance in-dustry has begun to adopt innovative solutions.Reinsurers can deal with the correlated risksposed by property catastrophes using a 'catas-trophe bundle,"2 introduced at the program on

2See A.M. Bests's Review, March 1996, p. 45 .

Information and Resources at Columbia Univer-sity (copyright 1995). A catastrophe bundle isa two-part contract which combines a catastro-phe future with a mutual reinsurance portfolio.Catastrophe bundles permit reinsurers to pro-vide full, customized coverage to an insurerwithout having it assume unreasonable risk.

Catastrophe Futures

The first component of a catastrophe bundletreats the actuarial table as the risk. i.e ., therisk of using the wrong actual table for predict-ing the frequency of property catastrophes . Se-curities similar to those suggested in 1992 arenow traded on both the Chicago Board ofTrade (CBOT) under the name _ "CAT" (catastro-phe) futures as well as in private sales. A CATfuture entitles the reinsurer to an agreed dollaramount that increases as the frequency of ca-tastrophe claims in a given region increases.Since the value of CAT contracts rises as lossesincrease, reinsurers decrease their exposures bybuying such instruments . On the other side ofthe equation, speculators can trade CAT con-tracts to make a profit, in effect providing themwith a means of betting on the weather.

The Mutual Reinsurance Portfolio

In addition to the protection provided by catas-trophe futures if catastrophe frequency rises,reinsurers also require additional protection ifthe severity of catastrophes exceeds their pre-dictions . This, in turn, is afforded by the sec-ond part of a catastrophe bundle : a mutual re-insurance portfolio. The mutual reinsuranceportfolio provides shares in a CAT pool and isdesigned to cover deviations from the averageseverity exposure posed by catastrophes .

3See, for example, G. Chichilnisky and'G. Heal, "GlobalEnvironmental Risks,' Economic Perspectives, October1993, and G. Chichilnisky, "How To Hedge UnknownRisks, A.M. Best's Review, March 1996.

continued on page 6

. . . Catastrophe Reinsurance cont. from p. 5

This combination of catastrophe futures and amutual reinsurance portfolio can be meshedto provide reinsurers with a very effectivemeans of hedging property catastrophe risks,ultimately producing an optimal allocation ofrisk bearing between reinsurers seeking tohedge their risks, and speculators who seek aprofit from the transaction . The mathematicalformulas required to implement a catastrophebundle can be provided by consultants at theProgram on Information and Resources at Co-lumbia University and are customized accord-ing to each reinsuress individual situation . Al-though other hedging instruments arepossible, catastrophe bundles are straightfor-ward and relatively easy to execute and trade .

Negative Correlations

In contrast to insurance, catastrophe bundlesare not based solely on either the law of largenumbers or on the pooling of risk. Rather, theyinvolve the use of negative correlations (in thecase of catastrophe futures), together with riskpooling (as respects the mutual reinsuranceportfolio). The principle of negative correlationsis one with which the securities industry is fa-miliar but the insurance industry is not . For ex-ample, when there is an earthquake, thosewho are affected are affected differently. Thehomeowner loses from the earthquake but theconstruction industry gains . Thus, by buyingenough shares in the construction industry,one can hedge the risk of losing one's home.The point is that it does not matter who suf-fers the risk. Everyone does. There is no riskpooling when using negative correlations .Rather, negative correlations allow reinsurers tohedge risks by buying catastrophe futures .

Catastrophe-Linked Bonds

Banfield Ellinger, a London-based reinsurancebroker, has recently pioneered a product simi-

The Future of the Industry

continued on page 7

Page 6 RISK FINANCING NEWSLETTER Vol. 13 No. 2

lar to catastrophe bundles . It joined with AIGCombined Risks (AIGCR), the investment bank-ing arm of American International Group, toplace a portfolio of catastrophe-linked bondswith a U.K. manager. The fund manager is in-vesting about $10 million with an offshorespecial vehicle which will sell a loss warrantyreinsurance contract to reinsurance companies .The policy is triggered if catastrophic insurancelosses in one of five geographical areas-theUnited States, Japan, Australia, the Caribbean,and Western Europe-exceed a level stipulatedin the contract . Losses are measured againstthe industry loss indexes of Property ClaimsServices . M. Matthew Harding, the chairmanof Banfield, calls this a "groundbreaking prod-uct which accesses a new source of capitalfor the reinsurance industry."4

Solving the problem of hedging unknown cata-strophic risks requires a blend of skills fromthe securities and insurance industries . By tap-ping capital markets, reinsurers will be betterable to deal with correlated, catastrophic risks .The size of the derivative securities markets isa great plus : with about $3 billion traded perday, this market avoids the major difficulty of"thin" markets in which prices turn against thereinsurer after a catastrophe, precisely whencapital is needed most. Because the deriva-tives market is both large and liquid, when anumber of reinsurers go to the market to bor-row after a catastrophe, it will not turn againstthem, thus affording reinsurers a source offunds even when demand is high. The FieldsInstitute of Mathematical Sciences conducteda workshop in June in Toronto, during whichindustry players and scientific researchers

4See R. Lapper, 'Catastrophe insurance loss bonds pio-neered,' Financial Times, Thursday, May 2, 1996, p. 26 .

Vol. 13 No. 2 RISK FINANCING NEWSLETTER Page 7 1. . . Catastrophe Reinsurance cont. from p. 6

would flesh out solutions to these problems us-ing the new instruments proposed .here.

In practical terms, what is required to suc-cessfully hedge property catastrophe risks isthe skill to produce and sell a simple productwhich is transparent, credible, and can bepriced fairly and traded easily. Experience hasshown that this can be achieved .

From the insurance industry's point of view,management must ensure that the culture ofits firm encourages the innovation needed tohedge these risks. The future of the industrylies with those firms which implement such in-novation. The companies that adapt successful-ly will be the ones that survive. In 10 years,these organizations will draw the map of acompletely restructured reinsurance industry.

Graciela Chichilnisky is UNESCO Profes-sor of Economics and Mathematics at Co-lumbia University. She has taught at Har-vard, Essex, and Stanford universities andfrom 1985-1989 was chairman andchief executive officer of FITEL, an inter-national financial telecommunications cor-poration. She has been adviser to the Or-ganization of Economic Cooperation andDevelopment, the United Nations, andthe Organization of Petroleum ExportingCountries in international economics andenvironmental policy. She was a memberof the Presidential Cabinet of the CentralBank of Argentina, and she holds doctor-ates in mathematics and economics fromthe University of California at Berkeley.The author of five books and numerousarticles, Professor Chichilnisky is an activeconsultant to the global financial industry.She can be reached at (212) 854-7275,

~or E-mail: GC9®Co1umbia.EDU

CIRCLES AND CYCLES,PHASES AND STAGES:THEIR EFFECT UPON

WORKERS COMPENSATIONFINANCING DECISIONS

by Keith Kakacek, CPA, CPCU, ARMSelf-Insurance Resource. Inc.

Willie Nelson, in his famous ballad, describes`circles and cycles, phases and stages ." Thiswonderful analogy can apply to the workerscompensation risk financing decision process.Specifically, different approaches become al-ternatively more or less viable as the marketfor workers compensation moves through var-ious phases .

This article analyzes the way in which changesin the Texas workers compensation market dur-ing the past 10 years-triggered by reformswithin the Texas workers compensation sys-tem-have affected market conditions and there-fore require risk managers to continually reviewtheir approach to financing this exposure .

Although the article focuses upon Texas, theconcepts it discusses also have broader, nation-al ramifications. Many of the reforms imple-mented in Texas during the early 1990s wereadopted in other jurisdictions, as well . Such re-forms are likely to be adopted in virtually allstates by the end of the decade.

Reforming the Texas WorkersCompensation System

At a seminar more than a decade ago in1985, Self-Insurance Resource, Inc., forecast-ed the inevitable implosion of the Texas work-ers compensation system by 1990. The chartin Figure 1 at that time graphically demon-

continued on page 8

Page 8 RISK FINANCING NEWSLETTER Vol. 13 No. 2

.. . WC Financing Decisions cont. from p. 7

ad that the system, as was then constituted,could not withstand the onslaught of trial at-torneys -and a workforce that joined forces towillingly exploit the benefits available in anuncontested hog trough .

Amazingly, in investigation after investigation,legislators refused to heed horror stories pre-sented by Texas employers who witnessed first-hand their premium dollars being squanderedby a system that fostered no accountability onthe part of key players in that system . It wasonly after the Workers' Compensation AssignedRisk Pool sustained a billion-dollar shortfall anduntold billions of premium dollars were wastedthat the Texas Senate finally passed meaningfulreform legislation .

Rarely has a process yielded such a signifi-cant outcome as the 1988-1990 review andlegislative overhaul of workers compensationin Texas. By January 1, 1991, the new law

toTight arket

8

6

Available Market

4

FIGURE 1TEXAS WORKERS' COMPENSATION INSURANCE MARKET

2

competitive Market

01985 1986 1987 1988 1989

was in place. It dealt with all aspects of thesystem, including the following .

" Governance

" Claims handling" Administration

" Insurance market" Safety

" State assigned" Benefits

Governance

The governance of the system was totally re-vamped with the creation of the Texas Work-ers Compensation Commission. This body hastaken a much more active role than whatwas provided under the previous system. Spe-cifically, the Legislative Oversight Committeeand the Sunset Process have focused atten-tion on the need to prevent workers compen-sation from threatening the livelihood of theTexas populace . These two bodies arecharged with reviewing, monitoring, and de-termining the effectiveness of the systemcomponents.

----------------------------------------

risk pool

1990 1991 1992 1993 1994 1995

continued on page 9