Don’t get caught out by exposure concentrations this hurricane season

by Artemis on June 3, 2014

Risk modelling can underestimate the losses that an insurance or reinsurance company, or an insurance-linked security (ILS) or catastrophe bond investor, could face from a major hurricane as they do not always fully capture exposure concentrations.

In a paper published yesterday, independent catastrophe risk management and modelling firm Karen Clark & Company (KCC) discusses the importance of understanding your exposure concentrations and how its unique Characteristic Event (CE) loss estimates, which it launched its RiskInsight platform with back in 2012, can help.

The paper looks at the 100 year hurricane event, so the most intense hurricane that can be expected in a particular region with about a one percent chance, the 1% probability event. The characteristics of an event of such magnitude change along the coastline, where a landfall occurs can have a huge bearing on the potential for an outsized industry loss.

For the individual insurer or reinsurer, or ILS investor or indeed single catastrophe bond deal, the location of a landfalling hurricane can make the difference between a manageable loss and a solvency impairing, or total loss of principal in the case of a cat bond, with concentrations of exposure a huge factor in the eventual loss tally.

The paper from Karen Clark & Co. looks at a new risk metric, the 100 year Characteristic Event (CE), and how this can be used to scientifically identify and manage exposure concentrations in order to reduce the chances of surprise losses. The Characteristic Event’s address a company’s “informal” risk tolerance by highlighting where a company can have a larger loss and also where a company could suffer a larger share of the market loss than expected.

For most companies a 100 year Characteristic Event loss will be much greater than a 100 year probable maximum loss (PML), says the report. This shows the importance of understanding where exposure is concentrated and just what type of event and location of landfall is required to cause these worst case scenario losses.

The study concludes that PML’s do not do a good enough job of helping companies understand where unexpected losses may occur or, where the hot spots are, where they could suffer outsized losses when compared to their peers or the industry as a whole.

For insurers and reinsurers avoiding these outsized losses is vital, as shareholders will be the first to question why your loss is greater than your peers or larger than your market share suggests it would be.

For catastrophe bond sponsors and ILS investment managers managers, understanding where counterparties and cedents hot spots are is essential to avoid the dreaded unexpected loss, that loss where an event occurs that was not expected in the modelling and which can result in investor confidence declining or disappearing completely.

As the ILS and catastrophe bond market continues to grow understanding where exposure concentrations lie is increasingly important. Investors want to feel assured that everything has been done to understand the risks that their capital is being invested in, so any unexpected or outsized losses will raise questions.

Karen Clark, CEO of Karen Clark & Company, believes that Characteristic Event metrics are the right way to assess and monitor solvency and informal risk tolerances for insurers and reinsurers. They are also just as applicable to the catastrophe bond and ILS space.

Karen Clark told Artemis; “The Characteristic Event (CE) analysis gives ILS investors additional valuable information – it vividly illustrates the exposure and loss potential of an issuer and clearly shows the correlations between issuers.”

This is a very good point. The potential for correlated exposure concentrations to impact a portfolio of catastrophe bonds is clear, particularly with so much of the outstanding cat bond market exposed to U.S. wind and Florida hurricanes. With some investment managers having 60% or greater exposure to U.S. and Florida wind the potential for a worst case scenario to negatively impact a number of cat bonds in a portfolio is clear.

Karen Clark believes that the CE metric would provide significant value to ILS and cat bond investors; “If investors got this one chart for each transaction, they would have a wealth of information for building a robust diversified portfolio of securities.”

As all investors in ILS and reinsurance are aware, the tools for building diversified portfolios of cat bonds are still evolving, so any additional insight into exposure concentrations would be a valuable addition to the ILS investors analytics toolbox.

Karen Clark continued; “The CE analysis can be conducted for different return periods – for higher layer transactions ILS investors may want to look at the 250 year hurricane loss potential, for lower layers, the 50 year hurricane may be more relevant. Investors can be more confident in the CE analysis than the vendor model expected loss estimates because the CEs are fully transparent.”

The paper is available via the Karen Clark & Company website. It makes interesting and timely reading with hurricane season now upon us and clearly demonstrates the importance of understanding where and how any outsized or unexpected losses could occur.

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