Reinsurers profit despite catastrophe
Insurance is defined as the equitable transfer of the risk of loss from one entity to another, in exchange for payment. In the short-term insurance space your client’s “personal lines” policy transfers the risk of loss of his / her personal possessions an
Insurance company profitability is a tug-of-war between premium received and claims paid. If they accept higher levels of risk without premium compensation they face long-term losses. And if their premiums are too high they risk losing business to the competition. That’s why insurers, both short and long-term, work with underwriters to fix premiums commensurate with your client’s risk profile. Underwriters collect data from potential policyholders and use computer programs and actuarial modelling to determine both the frequency and quantum of future claims against a policy will be. Higher risk individuals are then charged premiums appropriate to their risk. With the “how insurance works” discussion taken care of we need to consider another side of the risk equation. What happens when a natural disaster results in claims that exceed the insurer’s ability to pay?
Insurance for insurers
We can extend the insurance principles that apply to individuals and companies to insurers. Each year the insurer assesses its financial position and determines what quantum of loss they can fund from their balance sheet versus additional funding that may be required. They use historic claims data and a variety of modelling tools to determine the impact (to their book) of the so-called worst case scenario. They then enter into reinsurance agreements with one (or more) reinsurers. Companies such as Munich RE, Swiss Re and Hannover Re are among the largest global reinsurers at present.
What is reinsurance? The Reinsurance Association of America (RAA) defines reinsurance as insurance for insurance companies – a way for a primary insurer to protect against unforeseen or extraordinary losses. The association expands the definition as follows: “Reinsurance serves to limit liability on specific risks, to increase the individual insurer’s capacity, to share liability when losses overwhelm the primary insurer’s resources, and to help insurers stabilize their business in the face of the wide swings in profit and loss margins inherent in the insurance business.”
Over time, reinsurance has evolved into a global business. It makes sense that massive financial risks are diversified geographically. The United States is a case in point, with 46% of that country’s property and casualty reinsurance premiums placed in foreign markets. This global spread ensures that in the event of a US-based catastrophe its insurers enjoy greater capital and liquidity protection. We can get to grips with the reinsurance business by considering the insurance impact of the largest natural catastrophes through 2011. Swiss Re has pencilled in $108 billion in insured manmade and catastrophe losses for the period, making 20111 the second highest year on record (behind the $123 billion claimed in 2005). The group noted that last year would have been the costliest year ever (measured by insured losses) had Japan been comprehensively covered for insurance risk.
Trading through catastrophe to profit
It is important to distinguish between the “economic loss” and “insured loss” concept. We can use the Japanese earthquake / tsunami and nuclear reactor catastrophe which took place in March 2011 to define each of these phrases. In the wake of the massive tsunami, Japan suffered economic losses running into hundreds of billions of dollars. The economic loss includes all damage to structures and infrastructure as well as the subsequent loss in production – the cost of rebuilding and impact on GDP if you prefer. The insured loss, estimated by Swiss RE at just $35 billion, represents the total claims the insurance industry will have to carry.
The Japan catastrophe was singled out as the costliest (to insurers) catastrophe last year. Also high on the list was the January 2011 floods in Australia ($2.3 billion in insured losses), floods in Thailand (between $8 and $11 billion) and the New Zealand earthquake ($12 billion). Given the scale of catastrophe claims through 2011 you can be excused for wondering how the reinsurers stay afloat. Swiss RE issued a number of profit warnings during the year… But the latest indications are that the reinsurers have profited despite the turmoil!
Swiss Re announced recently that its net profit had more than doubled following an “unusually low number of catastrophes in Q3 2011. And on 13 February 2012 Hannover Re, the world’s third largest reinsurer with gross premium of around EUR 11 billion, reported that group net income would be in the order of EUR600 million for the 2011 financial year! And this improved result allowed for the net burden of losses from the flooding in Thailand, at a cost of EUR 196 million.
Editor’s thoughts: In the immediate aftermath of the Japanese earthquake many industry commentators suggested that insurers (South African insurers included) would have to pay over the odds to renew their reinsurance contracts for 2012. Do you think such increases can be justified given the recent profit announcements from the likes of Swiss Re and Hannover Re? Add your comment below, or send it to gareth@fanews.co.za
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