NEW YORK, May 13, 1996 — A study by Insurance Services Office, Inc. (ISO) released today analyzes potential catastrophe losses vastly greater than anything the industry has experienced, estimates the number of insurer insolvencies that could result, and considers the consequences of those potential losses.
The study, "Managing Catastrophe Risk," uses a computer model that includes data on thousands of simulated hurricanes and earthquakes. The study analyzes the impact of potential catastrophes on the financial strength of 80 insurer groups representing 28 percent of the industry's property insurance premium.
One of the major determinants of the frequency and extent of an insurer's catastrophe losses is the geographical distribution of a company's customers.
"The geographically concentrated insurers are exposed to a lower number of catastrophes, each with high severity, whereas the geographically diversified insurers are exposed to a higher number of catastrophes, each of low severity," the study says.
The study reports that a group of insurers with geographically concentrated books of business has one-third the probability of suffering catastrophic losses greater than 10 percent of surplus in any given year, compared with a group of insurers with more diversified portfolios. In addition, the geographically concentrated insurers' percentage of expected catastrophe losses in excess of 10 percent of surplus is two and one-half times greater than for the diversified group.
Overall, taking reinsurance into account, of the 80 insurer groups studied, 73 manage their exposures well enough that their chance of insolvency because of catastrophes is less than 1 percent in any given year. Still, many insurers could reduce the volatility of their catastrophe losses by geographically diversifying their risks, the study says.
For example, the study found that 13 of the 80 insurer groups could at least halve the expected percentage of their annual catastrophe losses that exceed 10 percent of surplus, if they mirrored the geographic distribution of catastrophe exposures for all 80 groups. Similarly, an additional 18 insurer groups could reduce by 25 to 50 points their expected percentage of annual catastrophe losses that exceed 10 percent of surplus.
The study notes that pooling is one means of achieving a more dispersed geographic distribution. Insurance pooling is the practice of sharing and distributing risk among primary insurers. Two or more insurers normally divide the premiums for a policy or set of policies in portions and then contribute to paying any losses on these policies in the same proportion.
According to the study, a megacatastrophe that costs the industry $50 billion, $100 billion, or more could result in insolvency for up to 36 percent of all insurers, depending on where the event occurs, and assuming current levels of reinsurance and its full collectability. Unfunded claims could be as much as $56 billion, the study says.
While state and national catastrophe pooling could provide some relief, the study concludes that pooling mechanisms are significantly more effective when the geographic spread of participating insurers is broader and the pool covers more perils. "A national multi-peril plan is more effective than the single-state or single-peril plans," it says.
The infrequency and high severity of catastrophes contribute to insufficient capital in the industry, according to the study. "Solutions to availability problems and to the shortage of surplus to manage catastrophe risk will require access to capital from outside the industry," says the study.