Hurricane Sandy highlights basis risk for non-traditional reinsurance products: S&P

The ongoing struggle to estimate losses from hurricane Sandy continues to cause consternation among insurers and reinsurers. The complex and unprecedented nature of the storm means assessment has been difficult, particularly claims resulting from business interruption, infrastructure damage and flood claims. It’s hard to assess how much of an impact they will have on the insurance and reinsurance markets, but despite this S&P said Sandy will have limited credit impact on re/insurers.

In a report published yesterday, Standard & Poor’s said that hurricane Sandy could “Upend some previous beliefs regarding catastrophe losses.” According to S&P there have been delays due to non-standard policy language, misunderstandings over coverage limits, assumptions about losses have been proved to be wrong as estimates grow and that basis risk on non-traditional reinsurance products (such as catastrophe bonds and industry loss warranties or ILWs) may have been underestimated. S&P hints that these issues may become factors that the re/insurance industry seeks to better understand or change.

That final issue is important. Basis risk is the risk that the pay out from a product may not be commensurate with the policyholders actual loss experience. It’s an issue regularly discussed with respect to catastrophe bonds, insurance-linked securities, industry loss warranties (ILWs) and other non-traditional reinsurance products, particularly where the trigger is based on a reported industry loss total, an index or parametric factors.

There seem to be two schools of thought regarding basis risk. There are those who consistently want to minimise it and shy away from any non-traditional reinsurance products as a result of this. Then there are those in the market who embrace it and realise that, in order to obtain the cover structured in the way they want, an element of basis risk is unavoidable. Some would say that basis risk is only really negative if you haven’t thought through your overall reinsurance or risk transfer program structure properly. The careful selection of elements of a risk transfer program means that you can minimise or compensate for basis risk in one instrument with cover from another. However, basis risk is a factor in many insurance and reinsurance products and it isn’t going away. Even indemnity claims face basis risk of sorts as the moral hazard issue of accurate claims reporting, by policyholders themselves but also by insurers and reinsurers, can result in a gap between actual loss and loss payment.

In their report, S&P said that many of the non-traditional reinsurance products, such as ILWs and cat bonds, pay out based on industry losses reaching a predefined trigger point. Independent third-parties are responsible for reporting the industry loss figures which become the arbiter of whether a trigger has been breached or not. S&P highlights that with Sandy, the $20 billion mark is a crucial industry loss figure as it is around the mid-point of some modellers estimates and is a key trigger for ILWs.

S&P discusses Property Claims Services (PCS) who are the most commonly used source for an industry loss trigger. The PCS methodology is long-established but S&P notes that it does not include all losses as it may exclude some losses from policies underwritten directly by non-U.S. insurers. Losses from Sandy which originate from flood and commercial claims will in some cases have been underwritten by international insurers meaning they may not all be included in the PCS loss estimate.

Now this should be well understood as anyone using a PCS trigger within their coverage should have made it their goal to fully understand the way PCS accumulate loss numbers and should have designed their risk transfer programs triggers to account for some difference between the PCS loss estimate and the total industry loss. That way you mitigate the effects of basis risk, however you can never totally eliminate it from an industry loss based transaction. Industry loss triggers play a vital role for many insurers and reinsurers, providing cover that can cut across their reinsurance program at specific layers of industry impact.

S&P notes that if actual insured losses come close to the $20 billion mark, then the international losses could be the difference between being able to claim on an ILW and not being able to claim. However, as long as you have diligently assessed the triggers you use and reconciled yourself with the fact that there will be some basis risk, then you should be prepared for the possibility that an industry loss may fall just short of your trigger point. This is a fact of these instruments and applies to the use of any type of index trigger such as industry loss, modelled industry loss or parametric index.

This is basis risk. The difference between one source of loss and the beneficiary of the covers own loss. S&P said that “Basis risk is often considered in terms of how the idiosyncrasies of each beneficiary’s insured exposure differ from the industry’s.”In the case of Sandy S&P said that how the insurance industry’s losses differ from the PCS figure may be viewed as a more important source of basis risk and that if this difference has been underappreciated then some insurers risk management practices could change.

If there is any change we suspect it will be in spending more time assessing how an industry loss, or index trigger, instrument fits within an insurers reinsurance program to make sure it minimises this basis risk. We could also see rates rise for the lower level industry loss triggers as insurers seek to strengthen the cover these instruments provide.

Whatever the final loss estimates come in at there will always be differences between the different risk modellers, PCS and other sources of industry loss estimate such as Sigma. What is key is to ensure that you understand and appreciate the process that is undertaken to calculate an industry loss total and that you are happy with that and reconcile yourself with the fact that this does contain some basis risks and reconcile your reinsurance program with the trigger you have chosen.

Basis risk is not going away, it is inherent in much of what the insurance and reinsurance industry does. These industry loss triggers, and other index type or parametric triggers, play an extremely valuable role in enabling reinsurance cover to be bought at levels of risk that suit the buyer and also in regions of the world where they can be appropriate. These triggers and indices also allow for much quicker settlement of claims than your typical indemnity type contract which is extremely important to the beneficiaries of the covers. We suspect that there may be some assessment of how certain re/insurers use these types of triggers but we don’t believe that the industry loss trigger is going anywhere soon.

It will be interesting to follow the reaction of the industry to the final loss figures when they are announced.

The report from S&P also looks at auto claims and suggests that they believe that the auto loss toll from hurricane Sandy could reach as much as $3 billion which would be 15% of a $20 billion loss total, a very high proportion compared to other storm events. The largest auto insurers in the region are GEICO Corp., Allstate Corp., State Farm Property/Casualty Insurance Group, Liberty Mutual Group Inc., and Progressive Corp.

S&P stick by their original statement that industry losses would need to be closer to $50 billion for Sandy to have a material impact on the sector and Sandy continues to be viewed as an earnings event for 2012. Under existing estimates S&P don’t expect any ratings impact to re/insurers.