Reinsurance a benefit to policyholders, not just insurers: Report

A new report from the Federal Reserve Bank of Chicago underlines the necessity of reinsurance for insurers and policyholders across both high, and low risk catastrophe-prone regions of the U.S.

With the 2016 Atlantic hurricane season officially underway, insurers and reinsurers will be closely watching storm forecasts in the coming weeks and months, wondering if another season passes without a major U.S. landfalling hurricane.

In a recent Chicago Fed Letter, Florentine M. Eloundou, associate economist, and Alejandro Drexler, policy economist at the Federal Reserve Bank of Chicago, have highlighted the important role reinsurance protection plays for insurers in high-risk catastrophe regions of the U.S., and also areas of the country that face a slimmer chance of a natural disaster occurrence.

The study seeks to highlight that insurers in areas of the country that are at a higher risk of catastrophe activity, which includes South Atlantic and West South Central divisions, utilise a greater portion of reinsurance that the rest of the U.S.

This is unsurprising as according to data from the National Hurricane Center and the Insurance Information Institute, 13 of the 15 costliest U.S. natural disasters in the U.S., by damages, have impacted parts of the South Atlantic or West South Central division.

Furthermore, 12 of the 15 events were U.S. hurricanes, which the West South Central and South Atlantic divisions are very susceptible to.

As a result of the high concentration of damages occurring in these regions, Eloundou and Drexler reveal that unsurprisingly, insurers in these regions transfer a greater portion of risk to reinsurers.

In fact, from 2005 to 2015 insurers in the South Atlantic and West South Central divisions transferred roughly 32% and 33% of premiums to reinsurance companies, respectively. In contrast, the Pacific and Mountain regions transferred approximately 8% and 9% of exposures to reinsurers during the ten-year period, respectively.

Interestingly, two of the 15 costliest natural disasters to occur in the U.S. that weren’t hurricanes came from earthquake events in the Pacific division, which includes California, a region vulnerable to earthquakes.

However, as highlighted by the report, given the regions high exposure to earthquake activity it’s perhaps surprising that Pacific division insurers transferred just 8% of insurance premiums to reinsurers from 2005 to 2015.

“However, only 10% – 17% of California residents have earthquake insurance, which means earthquakes can be costly to people, but not so costly to insurers,” says the report.

While reinsurance protection provides value to insurers, enabling them to mitigate the adverse financial impacts of a large volume of claims following a natural disaster event, the benefits to policyholders is also apparent.

In California, should a large, costly earthquake take place, a lack of insurance penetration could ultimately result in costs to the government, and therefore taxpayers.

Owing to the region’s vulnerability to earthquakes and resulting high premiums for policyholders, the California Earthquake Authority (CEA), a publicly managed residential earthquake insurer was established.

Furthermore, the CEA utilises insurance-linked securities (ILS) structures such as catastrophe bonds to enable cheaper rates for consumers, ultimately supporting greater earthquake insurance take-up and highlighting the important role that capital markets sources of risk capital now play.

However, in spite of this, earthquake insurance penetration remains relatively low when compared to other catastrophe-prone regions of the U.S., meaning that when the next large earthquake happens in California the portion of economic losses covered by insurance could be significantly lower than required.

Data from the report shows that in the highest risk areas of the U.S. losses after the use of reinsurance are far lower and flatter than before reinsurance use, highlighting “that reinsurance is effective in smoothing the impact of catastrophes for insurers,” says the report.

However, despite insurers utilising less reinsurance in areas that are at lower risk of catastrophes, insurers still use reinsurance to support their balance sheets.

“This suggest that reinsurance has a role in risk management beyond its role of smoothing catastrophe losses,” says the report.

Ultimately, the study reveals that insurers in regions at higher risk of experiencing a natural disaster utilise a greater portion of reinsurance than areas less vulnerable, in the U.S. It also highlights the vital role that reinsurance capital plays, including ILS and catastrophe bonds, in making operating as an insurer in these regions possible.

However, it only takes one large event in a region that has relatively low insurance penetration for the costs to be too great for insurers to cope with, as owing to a lack of premium revenue the need for reinsurance might not be seen as so important.

This could result in the costs falling on the governments and citizens themselves, highlighting the substantial benefit reinsurance provides both insurers and policyholders, in high and low risk areas of the U.S.