Are Insurers Doing Enough To Mitigate Catastrophe Losses?
The Travelers Companies (NYSE:TRV) and Hartford Financial (NYSE:HIG) announced weak second quarter 2016 results last month, with net income for both companies declining in double-digits year-over-year (y-o-y) on the back of higher level of catastrophe losses and a decline in net investment income. Wind and hailstorms in Texas, and the wildfire in Canada were the primary contributors to the these catastrophe losses. As a result, Travelers’ combined ratio (the ratio of claims to premiums earned) increased to 93.1% in the quarter compared to 90.8% a year ago, and Hartford’s consumer business reported an underlying combined ratio of 112.6%, worsening by 13.4 percentage points over the prior year quarter. This recent performance by insurers seems to suggest that they may not be doing enough to price catastrophe risks into their policies. In this note, we explore the rising risk of global warming and climate change, its potential impact on insurance companies and the challenges they currently face to mitigate catastrophe losses.
Rising Number Of Natural Disasters
The second quarter was not an atypical quarter in terms of catastrophic losses; in fact, catastrophic events such as heatwaves, wildfires, hailstorms, tornadoes and floods have increased in frequency over the last decade in the U.S., much like the rest of the world. According to the Insurance Information Institute, the average number of natural disasters occurring in the U.S. in the first six months of the year has increased drastically from about 33 events in the ten-year period of 1997-2006 to about 45 events in the following 10 year period. [1]
However, this has not necessarily resulted in higher losses for the property and casualty (P&C) insurance industry, as the severity of these natural disasters has been varied and the increase in premiums collected has often offset the slightly higher claims by consumers. As shown below, the combined ratio of the P&C insurance industry as a whole worsened from 97% in 2014 to 97.8% in 2015, but managed to remain below 100%, thus returning an overall after-tax net income of $56.6 billion. A ratio above 100% indicates underwriting losses, whereas below 100% means the company is making an underwriting profit.
Higher Catastrophe Losses Expected
Apart from better underwriting, one of the factors contributing to this profit was lower catastrophe losses. Although devastating catastrophes have increased in frequency over the last decade, insured losses in the U.S. have been far below the decade’s average in the last two years. Compared to average annual insured losses of over $24 billion in the ten-year period of 2006-2015, annual insured losses were only $15-16 billion in 2014 and 2015. Considering that premium rates are primarily based on statistical analysis of historical losses, insurance companies have benefited from lower insured catastrophe related losses in the last two years, even when consumers were paying for a higher risk of occurrence of such events. However, this trend seems to be changing against insurers in 2016.
In the first six months this year, insured losses have climbed to $11 billion and are heading towards the decade average of $24 billion, owing to the higher number of severe natural disasters striking the country. Since the beginning of 2016, the country has witnessed a severe snowstorm (Jonas) in the New York tri-state area, Philadelphia, Boston and Washington, flooding in West Virginia in June, which was the worst in over a century in that region, a heatwave in Arizona, floods in Texas, a heatwave in the New York tri-state area, Philadelphia, Boston and Washington, wildfires in California in July and August, and catastrophic flooding in south Louisiana in August. Therefore, we expect higher catastrophe losses and a higher combined ratio for the industry in the next few quarters.
Underwriting and Climate Change
Scientific evidence and consensus suggests that climate change is a contributor to the increasing frequency and severity of natural disasters across the world, so things are not likely to get better in the near term from a natural disaster standpoint. [2] The World Economic Forum’s annual Global Risks Report (2016) listed “failure of climate-change mitigation and adaptation” as the greatest risk facing the world over the next 10 years. [3]
However, the insurance industry has not been able to price this increasing risk adequately into premium rates. [4] There are, of course, technical difficulties in incorporating such a risk premium for underwriters and actuaries, because of the lack of adequate data and inconsistency in the occurrence of catastrophic events, as well as developing adequate algorithms to predict their occurrence in the future.
Warren Buffet, in his annual letter to Berkshire-Hathaway shareholders earlier this year, highlighted that climate change was indeed the elephant in the room but reassured his shareholders that it wasn’t going to impact their future earnings. This might be true for Berkshire-Hathaway, considering its diversified portfolio of investments in renewable energy and its focus on traditional insurance products to ensure stable underwriting income (and downplaying catastrophe coverage), but it is unlikely to be true for other insurers and reinsurers – who help insurance companies in managing risk including for catastrophic events. Increasing premium rates only after catastrophic events occur may not be enough for insurers to turn a profit consistently, considering the frequency of such events is likely to increase further going forward.
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Notes:- Number Of Natural Disasters In The United States, 1980–First Half 2016, Insurance Information Institute, July 2016 [↩]
- Historic Paris Agreement on Climate Change, UNFCCC, Dec 12 2015 [↩]
- WEF Global Risk Report 2016 [↩]
- Hot Topic: Climate Change and Insurance, CFO, March 23 2016 [↩]