Legacy of Hurricane Katrina – Reinsurance capacity bubble: Moody’s

Saturday 29th August was the 10th anniversary of hurricane Katrina’s destructive landfall in Louisiana, which caused the inundation of New Orleans and resulted in the most costly natural catastrophe event in U.S. history, changing the reinsurance market in its wake.

The effects of hurricane Katrina were felt across Florida, the Panhandle and the Gulf Coast states, but most acutely in New Orleans where the human tragedy of a major natural catastrophe event unfolded that day.

The sad toll, in terms of human lives set back or lost altogether, is a constant reminder that the insurance and reinsurance industry is there for a reason, to help people recover, rebuild and refinance after the worst happens. It’s also a reminder that no matter how much insurance or reinsurance is in place, it is no replacement for building resilience against these disasters in advance and being as well prepared as possible.

But Katrina changed parts of the insurance and reinsurance market forever, in the same way that other major storms or catastrophe events, like superstorm Sandy or the Tohoku earthquake and tsunami, have also done. When such major disasters strike, the industry adjusts, to better protect itself and to offer better protection to its cedents and ultimately the insurance customer.

Rating agency Moody’s Investors Service Vice President Kevin Lee, explained the biggest legacy left behind by hurricane Katrina, as far as the insurance and reinsurance sector is concerned.

“Hurricane Katrina’s biggest legacy on the reinsurance industry is that it inspired back-to-back capacity bubbles,” Lee explained.

He continued; “In hindsight, too much reinsurance capacity poured into the industry right after Katrina to take advantage of the spike in prices.  Moreover, the healthy returns in cat risk subsequently attracted a separate wave of alternative capacity from outside the industry.”

And the influx of alternative capital from investors outside the industry, that was stimulated by the losses suffered due to Katrina and subsequent rise in prices, accelerated the structural change in reinsurance that we see the clear effects of today.

“These investors stumbled upon cat risk while searching for better returns in a low interest rate, post-financial crisis environment.  This glut of capacity is now taking its toll on the reinsurance industry,” Lee said.

Lee also believes that hurricane Katrina was the trigger that resulted in some lines of catastrophe business becoming commoditised, which made it easier for third-party capital and institutional investors to become capacity providers for those risks.

He said; “Katrina helped to commoditize catastrophe risk.  The catastrophe models were way off on Katrina.  But once the models were recalibrated to produce more realistic losses, they became more credible and people from outside the reinsurance industry like pension funds and other institutional investors got comfortable using these models to price cat risk.  That comfort level with the models underpins the rush of alternative capital that has flowed into cat risk.”

There is another issue here. Rather than pinning the pressure and commoditisation of risk on new sources of capital, it’s worth remembering that while efficient capital poured into the reinsurance market, the less efficient traditional capacity stayed put and subsequently grew as well. The growth of the traditional capital also continued post-Katrina, due to the hurricane drought and low catastrophe losses of recent years.

If, as more efficient and lower-cost ILS capital flowed into the reinsurance market, other more traditional forms of capital had exited the commoditised risk space, the level of pressure on pricing may not have been so great and excess capital less of an issue.

The traditional capital could have focused on new opportunities, realising that the capital markets were destined to take a major share of the property catastrophe space.

Today, we see that this has happened anyway, but only after a painful period for traditional players. Perhaps if they’d stepped aside (or refocused) post-Katrina, things would not have been so painful and the focus on creating new opportunities may have set them up better for the future?

It’s hard to say how things would have panned out had traditional capital exited the peak U.S. hurricane risk markets post-2005. The reality is that the rates-on-line available were far too attractive and at that time ILS and alternative capital was still building scale, so wasn’t yet the competitive force that we see today.

The truth is that the reinsurance market needs both traditional and alternative capital sources, in order to provide the best client service and product suite that it can. However there is a point at which players need to realise where they’re capital is best put to work and where they are at risk of writing business at levels that won’t support traditional ROE’s anymore.

Katrina stimulated a change in the reinsurance capital base and an acceleration of alternative capital, capital markets convergence and the use of insurance linked securities and catastrophe bonds.

One other area of the market that Katrina affected, again in terms of the industry’s capital, was reinsurers leverage options.

Kevin Lee explained; “Reinsurers can’t lever up their returns as much as they did before Katrina.  Prior to Katrina, some catastrophe reinsurers would run at a premium leverage ratio of 1-to-1 (premium-to-equity capital).  Today, those same reinsurers may be running at about half that leverage.  Part of this deleveraging reflects more realistic models after Katrina.  But a large part is due to more scrutiny from external constituents.”

Katrina left a lasting and indelible mark on the United States and the global reinsurance industry. As risk capital becomes more efficient and lower-cost, while the structures become increasingly responsive, the levels of in-force re/insurance protection are growing.

At the same time resilience measures are increasing and there is a growing consensus that exposure needs to be dealt with, wherever possible.

It is to be hoped that if the worst happens again and we see another Katrina scale disaster, the region affected may be better prepared, more resilient, better financially protected and ultimately able to recover more quickly.