PML’s leave re/insurers over-exposed to losses, ILS can help: Karen Clark

As U.S. property values and catastrophe risks increase, the insurance-linked securities (ILS) sector can help to mitigate the “false sense of security” PML’s offer the global insurance and reinsurance market, according to Karen Clark & Company.

Catastrophe risk modelling and management firm, Karen Clark & Company (KCC) has released a new report, titled “Increasing Concentrations of Property Values and Catastrophe Risk in the US,” examining the potential impact of rising property values and how innovative insurance and reinsurance methods and insurance-linked securities (ILS) can minimise this.

“Because the traditional market has been relying on PMLs which provide only limited information on loss potential, there appears to be an over-capacity problem,” explains KKC founder, Karen Clark.

The company explains that re/insurers’ use of Exceedence Probability Curves (EP) to manage their catastrophe risks, which provides them with 100 and 1 in 250 year PML’s (Probable Maximum Losses), could be leaving them dangerously exposed should a large catastrophe occur in a concentrated area.

KCC explains; “Because of increasingly concentrated property values in several major metropolitan areas, the losses insurers suffer from the 100 year event will greatly exceed their estimated 100 year PML’s.”

In the U.S. alone building values now go beyond $40 trillion and that doesn’t include contents and time exposures, with these elements included the figure grows to more than $90 trillion.

And as migration to coastal regions continues to rise, along with asset values and residential, commercial and industrial property values, the likelihood of a mega-loss catastrophe increases also.

Highlighting this, KKC notes that out of the total $90 trillion exposed U.S. properties roughly $16 trillion is in the first tier of Gulf and Atlantic coastal counties, a $1.5 trillion rise from 2012.

“In reality, insurers are building up exposure concentrations faster than they realize, and the chances of solvency-impairing losses are increasing.  Insurers would benefit from more coverage provided through innovative ILS transactions,” advised Clark.

The KCC report goes into some detail about how re/insurers use PMLs, coming to the conclusion that, as mentioned before, they “can give a false sense of security and can mask exposure concentrations leading to solvency-impairing events.”

“Because the model-generated EP curves developed through simulations of random event characteristics, exposure concentrations can be missed entirely,” the firm explains.

This means that despite recent, record-low forecasts for the 2015 Atlantic hurricane season, should a large, single event occur in a metropolitan city the resulting losses would likely be far greater than companies’ estimated PMLs, which in the worse case scenario could prove fatal.

To tackle this, KCC discusses the benefits of using a different approach that defines the probability of an event based on the actual hazard, as opposed to the loss amount.

This is called the Characteristic Event (CE) approach, in which “events are meticulously and judiciously created using all of the scientific knowledge about the events in specific regions,” notes KCC.

Adding; “Once the events are created, they are “floated” to estimate the losses at specific locations.”

Clark stated; “The new Characteristic Event (CE) analysis provides clarity on where and how big those peak exposures are, and this technique can be used to structure transactions well suited to the ILS market.”

Alternative risk transfer solutions such as sidecars, catastrophe bonds, insurance-linked securities (ILS) and so on, are perfect tools for protecting against large loss events.

And as the global reinsurance market sits awash with traditional and alternative capital, it would be put to good work deployed through innovative, ILS structures aimed at protecting the growing value of the U.S. property sector.

Clark advised; “As property values become more concentrated in vulnerable areas, less and less peak catastrophe risk is being covered, on a proportionate basis, by the traditional reinsurance market.”

“Newer, open models, like RiskInsight®, provide more transparent information and efficient analyses that have the potential to greatly expand the ILS market to the benefit of insurers and investors.”