The insurance industry admittedly may not be as glamorous as high-tech, investment banking, advertising, or Hollywood. After all, consider that the most influential publication on what’s happening in property & casualty insurance is titled IBNR Weekly (where IBNR means incurred but not reported, an insurance term of art for long-term bulk capital reserves). We therefore have no shame in titling this comment ‘California Wildfire Losses, Net or Gross?’ The purpose of this note is to peel back onion layers and explain why alarmist messages about the health of the insurance industry betray ignorance of the dynamics of a complex industry.
There is abundant noise declaring that the California insurance market is existentially threatened or collapsing. The venerable New York Times held forth on ‘The Possible Collapse of the U.S. Home Insurance System,’ Insurance Business America titled its piece apocalyptically ‘End of days? Is the insurance industry about to collapse?” And the Senate Banking Committee recently held a hearing and wrote a report on ‘Next to Fall: the Climate-Driven Insurance Crisis is Here and Getting Worse.’ Unfortunately, the general public’s perception of the health of the insurance industry is too often shaped by such alarmist proclamations. The reality is that the financial position of the insurance industry is shaped by factors such as:
- Reinsurance recoverables
- Insurer retention levels
- Cessions to affiliated and non-affiliated reinsurers
- Reinsurance reinstatements
- How many events took place
- Net versus gross
Diving into the above six drivers of insurance company health may not be as stimulating as a New York Times best-selling romance novel, but they are the factors that analysts and regulators use to determine whether the insurance industry and individual insurers, especially California’s, are standing or collapsing.
Reinsurance Recoverables
Insurance companies practice risk management to protect their balance sheet. They protect their balance sheet by calculating the upper limit on how much they can reasonably pay out in losses before their capital base is materially impacted. They determine their probable maximum loss (PML) on the basis of past losses and expected losses. Above that they lay off risk to reinsurers so that even if actual losses are higher than the PML, the maximum possible loss (MPL) is calculated. It considers what is the worst that could possibly happen. If the primary insurance industry is the economy’s financial first responder, the reinsurance industry is the shock absorber for insurers.
The reinsurance industry is global. Half of the industry’s $500 billion of capital is held by continental Europe’s big four – Munich Re, Swiss Re, Hannover Re and SCOR Re. Most of the rest is held by Bermuda reinsurers, spread across dozens of Lloyd’s syndicates, U.S. reinsurers (especially Berkshire Hathaway’s National Indemnity Company) and the Far East (Japan, Korea, China). Primary insurance companies spread their risk globally. In exchange for payments to reinsurers, insurers lay off risk, or cede it, to reinsurance companies. A large insurance company, such as Farmers, literally spreads its risk to 128 reinsurers all over the world. This achieves spread and diversification of risk. Reinsurance companies also practice risk management, by taking only a small piece of the risk ceded to them by primary insurers so as not to be overexposed to any one enormous catastrophe loss.
There is also reinsurance for reinsurance companies. This is known as retrocessional reinsurance, where a reinsurance company, the retrocedent, cedes risk to a retrocessionaire. Retrocessionaires include hedge funds such as D.E. Shaw, and several Lloyd’s syndicates.
The combined effect of insurance companies ceding much of their risk to reinsurers and reinsurers ceding to the retrocession market strengthens the protective walls of insurer balance sheets. So when one hears that the California wildfires may amount to $28 billion in insured losses, the reality is that much of that is borne by the reinsurance industry. The $28 billion is the gross amount; the amount that insurance companies pay is net, after recovering the loss amounts borne by reinsurers.
In addition to protection of insurers by reinsurance companies, which is termed “traditional” reinsurance, there is also capital provided by “alternative” reinsurance providers, mainly in the form of debt instruments in the form of insurance-linked securities, a/k/a catastrophe bonds, or cat bonds. Cat bonds are financed by third-party investors who view catastrophe risk as a diversification play, as the occurrence of catastrophes is uncorrelated with the capital markets.
Insurer Retention and Reinstatements
The amount an insurer has established as the most it will pay before reinsurance kicks in is the “attachment point.” Reinsurance payments are triggered when the loss pierces the insurer’s attachment point. If the losses are large enough, the insurer blows through its retention, above which the risk is borne by reinsurers on its panel (the list of its reinsurance counterparties). If the loss is so large as to exceed the limit of reinsurance, there may be a reinstatement, which is like reloading a pistol. The primary insurer gets a second helping of reinsurance coverage in exchange for the insurer paying a premium for the restored layer of cover.
Affiliated or Non-Affiliated Reinsurers
Large national insurance groups operate with complex pooling arrangements. For example, Mid-Century Insurance Company is a company within the Farmers group. Close to half, 44.5 percent of its business is California risk, and 50 percent is homeowners. It cedes $2.5 billion to Farmers Insurance Exchange, an inter-company pool. It also cedes to over 100 non-affiliated reinsurers, including insurers in Europe, Bermuda, London and the U.S.
One Event or Two
In the wake of the 9/11 terrorist attacks on the World Trade Center, there was substantial litigation regarding whether the destruction of the two towers was one event or two events. This was important because insurance limits may apply “per occurrence” or “in the aggregate.” Similarly, there may be debate regarding whether the California wildfires were one event or more than one. This will be an important distinction. For example, Mercury General’s catastrophe reinsurance treaty allows the combining of loss events that occur within a 150-mile radius to be treated as a single occurrence.
Analysts are tending to the view that the California wildfires will not dent reinsurers’ results this year. This is due in large part to higher reinsurance attachment points than a few years ago when the Camp Fire caused enormous losses. With the exception of very few insurers that are California-focused, the largest insurers of California homeowners’ insurance are the large nationals. To be sure, unlike Florida with its thinly-capitalized highly leveraged insurers, nine of the top ten California homeowners’ insurers– State Farm, Farmers, CSAA, Liberty Mutual, Allstate, Auto Club, Travelers, American Family, Chubb — are jumbo nationals that benefit from affiliated intercompany pooling arrangements as well as dozens of non-affiliated reinsurance counterparties.
If all this sounds complicated, it’s because it is. But having a passing understanding of the complex market is important to avoid having to paraphrase Mark Twain, who corrected a newspaper that published the writer’s obituary when he was still alive with “the reports of my death are highly exaggerated.”
Topics
Catastrophe
Natural Disasters
California
Profit Loss
Wildfire
