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Insider In Full: Opinion: Latent risk – The cat market’s inconvenient truth

Whether the Texas Deep Freeze ends as a $12.5bn, $15bn or $20bn insured loss, it will be a medium-sized cat event that will...

Adam McNestrie an earnings hit to carriers with exposure to the affected states.

Nevertheless, it will likely be more painful than the headline numbers suggest because it comes in the first quarter when (re)insurers can normally expect a low cat loss period. The convective storm, Atlantic hurricane and Japanese typhoon seasons are still to come, with Q1 losses therefore skewing to things like European winter storm (a long benign peril), Australian cyclone and earthquakes. 

Coming off four active cat years, the Q1 loss adds to the mounting impression that the “zero” cat loss year is a thing of the past.

These years – call them $50bn or less of total insured cat losses – spread across a wide range of small events would leave excess-of-loss (XoL) cat reinsurers with clean years, and deliver outsized returns, compensating for the cat-impacted years.

Despite the presence of a fair amount of quota share cover in Texas that will pick up first dollar losses, the geographic spread of the event and the overall loss quantum suggest something of a skew to the primary market. Sources said that the loss could still be more than 50% retained if it remains below $20bn.

An early narrow focus on the particular events is understandable and appropriate, but I want to take a step back and look at four implications.

First, the crucial takeaway from the event is that the cat market is carrying significant (and obviously unquantifiable) latent risk.

The Deep Freeze again demonstrates the inconvenient truth that the cat market does not have a good handle on the risk that it is running.

Here we have an event in the biggest insurance market in the world with (supposedly) the best modelling. But the divergence between model output and reality looks substantial, with dated models pointing to extreme loss potential in the high single-digit billion range for winter storm.

Negative surprises have become the calling card of the cat market in recent years.

Hurricane Irma surprised versus the modelled output for similar events based on bad behaviour from policyholders, and the industry that has built up around inflating claims in Florida.

The run of California wildfire losses in 2017 and 2018 shocked the market by demonstrating the scope for a string of multi-billion losses in a single season, including $10bn+ fires. This totally transformed the market’s view around both frequency and severity.

After an extremely long period of benign loss experience, Japanese wind demonstrated a period of elevated frequency with $30bn+ of typhoon claims and four of the six biggest losses ever in 2018-19. And through Jebi, it showed the market had no handle on what an extreme storm would do – with a four-fold creep from initial estimates making all involved look foolish.

The extent to which cedants can successfully push Covid-19 non-damage BI losses into cat XoL treaties remains to be seen, but at least some will leak through, demonstrating yet another instance of hidden risk in the system.

This Deep Freeze now joins the list of unpleasant surprises, with a more severe than expected natural catastrophe again exacerbated by human factors – with under-invested energy infrastructure again aggravating the loss as it did with the California wildfires.

Second, if there is so much latent risk in the system that has emerged over the last four years, what is next? 

It seems naive to assume that the particular pattern of events that we have seen in recent years represents a full manifestation of hidden risk.

Moreover, what we have seen has been a string of medium-sized cats in which metro areas with peak exposures have largely been spared.

What happens when Miami is hit by a Cat 4 or 5 storm? Or Tokyo by a powerful earthquake?

Are the most extreme losses as badly modelled and imperfectly understood as small-to-medium-sized cats seem to be?

Third, the cat market’s biggest concern over the last decade has been a perceived structural reduction in returns driven by ILS. In focusing there it may have been looking the wrong way on threats.

The maturation of the ILS market certainly drove a significant drop off in cat pricing, with cat pricing falling 30% from 2012 levels by its 2017 nadir.


And at least from 2017 to 2018, ILS capital flows disrupted reinsurers’ ability to exercise their historic post-loss imposition of payback pricing.

These pressures have eased through ILS’ 2018-20 travails, although there were signs of a recovery from ILS around 1 January.

All along, however, the bigger threat may have been around latent risk, including the part played in that phenomenon by the claims inflation driven by climate change.

Industry messaging around the latter part of this is certainly gaining pace, although the degree to which it is built into reinsurer models is questionable. (See Inside P&C’s Climate change - The cat market’s social inflation?)

But talking about latent risk in the round also represents a mea culpa on the part of reinsurers and is therefore more difficult public messaging than an evolving risk picture.

However, even here you could argue that messaging may be showing some signs of changing, with Swiss Re indicating that 50% of its losses have come from secondary – or largely unmodelled – perils over the last few years, risk which it said it is now actively trying to scale back.

Fourth, investors hate volatility in results, and the more latent risk is made manifest, the more likely it is that boards will push management teams to reassess their approach to cat risk.

When events like this happen, the traditional market tends to focus on the predicted reaction of ILS investors to badly modelled or little understood exposures.

But just as ILS investors may feel they have yet further confirmation here that models are inadequate and that their managers do not understand the risk that they are originating, surely boards at traditional carriers must be asking questions about capital allocation to cat lines.

With rumours picking up that some major reinsurers may not be paying staff bonuses based on 2020 results, there is also scope for board scepticism to meet the amplifying force of out-of-pocket staff to prompt a change in underwriting behaviour.

And if that is too much to expect in a well capitalised reinsurance market keen to show growth to demonstrate effective timing cycle, it should at least prompt a little soul-searching.


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