Stability and Capacity of Property Liability Insurance Markets. Neil Doherty Cartagena, Colombia May PDF Free Download

Stability and Capacity of Property Liability Insurance Markets Neil Doherty Cartagena, Colombia May 2007

1.4 1.3 1.2 1.1 1 0.9 0.8 0.7 0.6 Market Stability: Combined Ratio in Colombia Life P&C 1975 1976 1977 1978 1979 198 0 198 1 198 2 198 3 198 4 198 5 198 6 198 7 198 8 198 9 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6

Message of Talk SHORT(ISH) RUN shocks are self correcting (probably) Occasionally fatal, usually disruptive, Can they be managed? LONG RUN Instability is of limited and declining importance (Maybe) REAL STORY is worldwide changes in capacity level & structure and how this filters down to individual country Story is mostly about CATASTROPHE RISK QUESTION for Colombia is how she can take advantage of these developments

Roadmap Classic model of stability Is the insurance cycle real or illusory? Capacity Constraint Model and Insurance Cycles International transmission through Reinsurance & Asset Shocks Changing insurance capacity International factors Expansion and rebalancing of World Risk Pool Development of Secondary Market Catastrophe Pooling Caribbean Risk Pool; World Bank Re? Domestic factors Micro Insurance Public Private Partnership; Turkish TCIP Regulation (good or bad) not negative examples, FLA What can your company do about capacity and the cycle? capital management

The insurance cycle: Real or Illusion? The insurance cycle refers to the periodic fluctuation in insurance prices and capacity Price as spread between losses and premiums underwriting profit or combined ratio What is NORMAL level of underwriting profit?. Suppose insurance premiums are set to recover the discounted value of losses and expense P = E( L) + 1+ r X or P E( L) X P = r But notice that the second equation simply says that with breakeven pricing the underwriting profit will simply be the negative of the interest rate We should expect some variation in UWP; this follows negatively the interest rate. This is NOT a real cycle it is simply the impact of the time value of money

The insurance cycle: Real or Illusion? Is there a REAL cycle? Empirical work suggests that prices (UWP) responds to interest rates shocks to assets shocks to liabilities changes in leverage inflow of new capital Moreover, there may be delayed responses

Classic model of stability: MARKET EQUILIBRIUM BEFORE A SHOCK PRICE DEMAND SUPPLY QUANTITY Potential market capacity Actual market supply Note: the potential market capacity is determined by insurer capital

CAPACITY CONSTRAINT MODEL: SHORT RUN IMPACT OF LIABILITY SHOCKS PRICE P* DEMAND SUPPLY Catastrophic claim reduces supply and increases demand and ENHANCES hard market. P Shocks cause MORE disruption QUANTITY Insurers pay claims or suffer loss. This creates stress on capital and they are forced to reduce supply. Possible increase in demand. MARKET HARDENS WITH LARGE PRICE INCREASE

CAPACITY CONSTRAINT MODEL: SHORT RUN IMPACT OF ASSET SHOCKS PRICE DEMAND DEMAND SUPPLY SUPPLY Asset Shocks reduces supply and depress demand and DAMPEN hard market. P* P Shocks cause LESS price instability but more quantity instability QUANTITY

CAPACITY CONSTRAINT MODEL: LONGER RUN IMPACT NEW CAPITAL ATTRACTED BY HARD MARKET PRICE DEMAND SUPPLY SUPPLY P QUANTITY Thus insurers have series of markets disruptions caused by asset or liability shocks These cause temporary hard market Market is self correcting hard market attracts new capital restore equilibrium

Capital Responses U.S. Illustrations 9/11 Terrorist Attacks Loss of $38 billion Capital Raised by December 31 2001 =$24.8 billion Capital Raised by September 2002 =$53.2 billion Hurricane Katrina in September 2005 Loss of $45 billion Capital Raised by September 2006 =$27 billion Significant part of this was securitization Cat Bonds, Sidecars, Industry Loss Warranties, etc

TYPES OF NEW CAPITAL New Capital Equity and Debt Multi-line Insurers Cat Reinsurance Start-ups Contingent Capital Finite Reinsurance Catastrophe Put Options CatEPuts Function Capital Relief Multi-line Treaty Reinsurance Automobile & Life Insurance Securitizations Cat Reinsurance Facultative Reinsurance Cat Bonds, Sidecars & ILW s Portfolio Capital Single line Pure Play Capital Focus

EXPANDED STABILITY MODEL Supply Considerations Capital shocks liability side Basic Capacity Constraint Model Capital Shocks asset side Large Liability Shocks concentrate on reinsurance market Large Asset shocks can be domestic or international Demand Considerations Demand will fluctuate depending on price and income elasticities Demand will grow with economic growth Domestic Induced Instability International Induced Instability

Roadmap Classic model of stability Is the insurance cycle real or illusory? Capacity Constraint Model and Insurance Cycles International transmission of cycle through Reinsurance & Asset Shocks Changing insurance capacity International factors Expansion and rebalancing of World Risk Pool Development of Secondary Market Catastrophe Pooling Caribbean Risk Pool; World Bank Re? Domestic factors Micro Insurance Public Private Partnership; Turkish TCIP Regulation (good or bad) not negative examples, FLA What can your company do about capacity and the cycle? capital management

Asset Shocks Liability Shocks Domestic Impact Interest Rates Equity Returns GDP (demand side) Stretch Domestic Primary Capacity International Transmission Co-movement of: Interest Rates Equity Returns Impact in Both Developed and Developing Economies Stretch I/N reinsurance capacity Hard post-loss market in US, EUR, JAPAN; etc Probably minor impact on Third World Reinsurance Capacity

International Transmission of Cycles USA Catastrophe losses in one country may lead to shortage of reinsurance capacity in all countries. HOW IMPORTANT HURRICANE Reinsurance Market??????? HIT TO WORLD REINSURANCE CAPITAL Developed Country HARD MARKET Major competitors for limited reinsurance capacity Developing Country Minor Impact Not major users Diversification benefit to reinsurers

COLOMBIA COMBINED RATIO vs U.S UNDERWRITING PROFITS MODEST CORRELATION U.S. Underwriting profits 1.4 1.3 1.2 1.1 1 0.9 Columbia: Combined Ratio: (Incurred Losses+Commissions+ Gen. Expenditures)/ Earned Premiums 0.8 0.7 Life P&C 0.6 1975 1976 1977 1978 1979 198 0 198 1 198 2 198 3 198 4 198 5 198 6 198 7 198 8 198 9 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6

COLOMBIA COMBINED RATIO vs U.S COMBINED RATIO MODEST CORRELATION P&C 1.4 1.3 1.2 1.1 1 0.9 0.8 P&C 0.7 0.6 1975 1976 1977 1978 1979 198 0 198 1 198 2 198 3 198 4 198 5 198 6 198 7 198 8 198 9 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6

Expansion & Re-balancing of Risk Pool World Insurance Pool Pool dominated by Industrialized Countries 14% or world population 77% of world GDP 90% of Non Life Premiums 89% of Life Premiums Latin American share of Emerging Market 10% of population 20% of GDP 21% of non life premiums 9% of Life Premiums

Sigma # 5, 2004, Swiss Re

Colombia Sigma # 5, 2004, Swiss Re

Sigma # 5, 2004, Swiss Re Colombia

Expansion & Re-balancing of Risk Pool Catching the Wave Insurance is growth industry ride the S Curve As developing countries catch up, better spread of risk Particularly important is the growth of the mega economies; China and India This enables reinsurers to diversify their risk particularly catastrophe risk, more effectively Better spread of CAT RISK will lower the price of reinsurance Can Developing Countries Capture this benefit NOW? POSSIBLY, Mexico recently issued CAT BOND. Price was LOWER than other CAT bonds WHY Because it offered diversification to investors. All prior risk was concentrated mostly in USA

Expansion and rebalancing of World Risk Pool; Importance of catastrophe risk Catastrophe Insurance Industrialized countries 30% of people and business have Cat Ins Emerging economies 3% of people and business have Cat Ins Great majority of lives at risk in Third World Great VALUE of property at risk in Industrial Countries Almost all insured VALUE AT RISK is in few locations US JAPAN EUROPE AUSTRALASIA LITTLE DIVERSIFICATION OF WORLD INSURED CAT RISK PORTFOLIO

Great Natural Disasters 1950 2005 Economic and insured losses 160 bn US$ >178 bn US$ 120 US$ bn. 100 80 60 Economic losses (2004 values) Insured losses (2004 values) Trend of economic losses Trend of insured losses 40 20 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2005 MRNatCatSERVICE, Geo Risks Research, Munich Re

Expansion and rebalancing of World Risk Pool; Importance of catastrophe risk Catastrophe risk is major determinant of insurance capacity This risk requires very high capital input relative to expected cost Thus very large capital cost built into premium Catastrophe risk seems to be growing Existing cat insurance highly concentrated in US, Europe, Australasia and Japan China has major flood, earthquake & storm risk China has had 35% of earthquakes measuring over 7 on Richter scale Very little earthquake insurance Signs of some modest catching up in emerging economies Future stability of insurance markets depends largely on how much capital can be allocated to this risk Dedicated reinsurance capacity More primary capital in developed and newly developed markets Development of Secondary Market for catastrophe risk

Development of Secondary Market Secondary Insurance Markets Provide substitute for reinsurance and capital : notably cat risk securitization Allow insurers to market products without warehousing risk: life and auto securitization Catastrophe risk securitization Main vehicle CAT BONDS, others include Cat Put Options, Industry Loss Warranties and sidecars Rapid Growth of this market, CAPACITY IS: 1997, $633 million 2003, $1.7 billion 2005 $2 billion. Year after Katrina. $3.8 billion Much of this capacity devoted to US risk. Slowed recently due to Florida Regulatory Initiatives

Development of Secondary Market Is this secondary market accessible to Emerging Countries. Typically spread is about 3-7 times the expected loss Recent Mexican Bond had much lower spread (greater diversification benefit to investors) Nevertheless these are very expensive modeling costs cost of holding high level of capital setting up special purpose vehicle (investment bank fees) Note high layer reinsurance also very costly Question is how can financial markets be used at lower transaction cost? Key is in using providing effective mediation between domestic insurance market and capital/reinsurance markets - special role fo multi-lateral institutions

Catastrophe Pooling Caribbean Risk Pool; World Bank Re? Many of the innovations in expansion of capacity may be of limited impact on emerging economies Transaction cost of these instruments is very high. Percentage cost may be higher still on smaller transaction Some good news in that emerging economies can provide diversification of cat risk to investors and this lowers the capital cost Other innovations may be very important Public Private Partnerships ; e.g. Turkey s TCIP Use of International Organizations (Such as World Bank) to intermediate between domestic insurers and capital markets to provide catastrophe risk capital Caribbean Insurance Pool; World Bank Re (?)

Investors Balance costs of Bank and Private capital REINSURANCE OR SPV UNDIVERSIFIABLE RISK DEVELOPMENT BANK RE DIVERSIFIABLE RISK WORLD BANK+ DEVELOPMENT BANKS diversification country country country country country

Informal insurance and Micro Insurance Family and extended family networks often provide informal insurance for their members Provision for elderly Income support in unemployment Help for disasters and accidents Remittances from family working abroad as income support E.g. average income in India is $500. Average income of Indians working in U.S. is $64,000. Transfers from US to India = $24 billion Similar transfers from US to Central America The are very important but are limited in their ability to spread risk Families are usually too small for spreading the risk of low frequency or correlated events For example, natural disaster will often affect all or most of a family unit

Informal insurance and Micro Insurance Households, extended families and communities In emerging economies, the only form for security for a large part of the population comprises informal insurance arrangement within the family or community Family and extended family networks Community and mutual insurance Other micro insurance schemes

Community and mutual insurance Examples. Nigeria: people in agricultural villages insured for events such as flooding, wind damage, insect infestation, medical emergencies Senegal: India; fisherman form informal arrangements for rescue, repair of damaged boats, etc These type of arrangement can be transfers or short term, credit They tend to be effective when risks are small and frequent Because such risk can be spread in small pool Because participants see and receive benefits in return for the support they offer to others With infrequent events, those lucky enough not to suffer loss often begin to question the value and are likely to leave and ask for repayments People tend to see these arrangements, not as risk pools, but as reciprocal support. Thus they need to believe they will actually get a benefit. If they fail to receive benefit, they leave. This does limit the effectiveness of such arrangement. (see P Latteau, Journal of Development Economics, 33, 6, 764-796 (1997)

Micro Insurance and Micro Finance Micro finance: small low interest loans for low impact high frequency risks Micro insurance: for rural, and possibly urban, poor Challenges Educating people on nature of risk and benefit of insurance Moral hazard and adverse selection can be high may limit products Transaction cost high relative to benefits Micro insurance often grafted on to micro finance as method of securing the borrowers investments and repayment of loans Pillar example, Grameen Bank (Bangladesh); system of community secured, rural credit. Grafted on to this is now micro insurance Death of member Death of livestock Health insurance Challenges. To what extent can insurance companies move into this space?

A Example for Public Private Partnerships Earthquake Insurance One of the biggest threats to personal and economic security comes from natural disasters Because event hits many people at the same time, loss is not easily spread in insurance system Solutions often seek to exploit all 3 pillars Use of private insurance including international insurance Role for the government as facilitator, insurer of last resort ex post transfer Households still must bear considerable risk The challenge is to blend all three pillars to maximize the effectiveness of available resources

TCIP Turkey has major seismic risk. Previously very little Earthquake insurance. Following major quakes in late 1990 s early 2000 s, Turkish Government collaborated with World Bank to set up TCIP Mandatory program (but coverage 27% in Istanbul) address adverse selection Premiums risk related to address moral hazard Use insurance companies for distribution Pool backed up by reinsurance and contingent World Bank Debt

Stability and Capacity of Property Liability Insurance Markets. Neil Doherty Cartagena, Colombia May 2007