The insurance industry can help to protect communities like that of New Orleans, says James Schiro, but it needs stable laws to do so

In the past 14 months, the world had to cope with natural catastrophes on an unprecedented scale. It began with the tsunami at the end of 2004, followed by floods in the United Kingdom early in 2005. Over the summer, we saw forest fires in Spain and Portugal followed by more floods in Switzerland, Germany and Austria. In early autumn, an unparalleled series of hurricanes struck the American Gulf coast. Finally, an earthquake in Kashmir brought death to more than 70,000 and left millions without shelter.

These catastrophes underscore the importance of insurance. Millions who had bought coverage are now in a position to rebuild their homes and businesses and, hopefully, put their lives back together. Unfortunately, many did not buy insurance.

Hurricane Katrina

Let me set aside the tragic events in Kashmir – where insurance is almost non-existent – and focus on the aftermath of hurricane Katrina. Many of those affected had failed to buy the flood insurance on offer from the federal government, even though they were strongly advised to do so and private carriers explicitly excluded flood coverage from their home-insurance policies. The hurricane victims are now in dire straits. We understand their plight and their need for help in an extraordinarily difficult situation.

However, the contractual position is clear. Flood coverage was explicitly excluded from private coverage and it is bizarre to see government officials trying to hold private insurers liable for losses that they did not underwrite, for which they did not collect premiums and against which they, therefore, did not set aside reserves. This is neither the time nor the place to dwell on issues relating to the causes of flood losses and the relevant policy exclusions. It will probably take years before we arrive at a satisfactory resolution of these questions.

A contract is a contract

The denial of contract certainty, as implicitly proposed by litigation in the aftermath of Katrina, could drive the insurance industry out of the business of providing coverage against catastrophic events. Indeed, the sanctity of contracts is fundamental to the concept of insurability. If contract certainty were undermined, our ability to underwrite long-tailed risks (those where the probability of occurrence and the extent of loss emerge long after the contract is written) would quickly diminish. That is why I am concerned that lawsuits filed after Katrina could impair the adequate supply of catastrophe coverage in the future.

In principle, the concept of insurability is simple. The limits of insurability are reached when conditions of assessibility and randomness are not met. If expected losses cannot be anticipated, measured or observed, they cannot be insured; and if losses cannot be insured, the markets will offer no insurance coverage at all.

This is another way of saying that insurability cannot be divorced from the institutional framework ensuring the functioning of markets. Since many of our contracts are long-term in nature, selling and pricing a product without knowing its cost are particular challenges. This is also what fundamentally separates insurers from banks. Whereas a bank’s loss is capped by the amount of the loan, insurance losses or claims payments can be potentially unlimited. The outcome depends to a large degree on the interpretation of the contract in light of an evolving jurisprudence.

This can be easily seen in the case of asbestos. Since the discovery that this widely-used building material can cause fatal diseases, several makers – and even transporters – have been bankrupted. Insurers are paying today for claims on policies written decades ago. In such an environment, insurers and their customers must depend on the sanctity of contracts.

Catastrophe insurance

Another case is posed by large natural catastrophes. They have not always been perceived as insurable. Insurers have learned, however, how to make them manageable, although the sheer scale of destruction can be huge. Let us briefly examine the recent hurricanes.

While we have no conclusive evidence that recent natural catastrophes are the result of global warming, it will be prudent to factor in the obvious. Six of the 10 costliest hurricanes in the US have struck in the past 14 months, and the trend seems set to continue. Not only do they seem to be becoming more frequent but, thanks to economic growth in highly- exposed areas, hurricanes are also becoming more costly.

Today, roughly half of the nation’s national income, involving about 60 million jobs, comes from America’s coastal regions. Not all of these people live in regions prone to hurricanes; but the ones living in the danger zone are like sitting ducks when big storms strike. No one can say that these risks are not known.

Unfortunately, this American example can easily be extended to the rest of the world. Half of the world’s population lives in coastal regions, many of which are vulnerable to extreme weather events. According to the United Nations, mega-catastrophes of the type that traditional models expected to occur once every 100 years are now predicted to happen every 25 years, and the losses will be 10 times higher than those currently experienced.

Living with risk

These figures – and the underlying behaviour – bring us to the issue of accountability. If people are living in areas prone to natural catastrophes, we must ensure that they can also live with the consequences. This calls for prudent risk management that includes precautionary public measures and adequate private and public insurance.

Our industry is prepared to help our customers. We know where the large exposures are, and we have the instruments to make their associated risks manageable. For our efforts to be successful, however, they have to be conducted within a framework enabling insurability. That is why insurability is more than a question of technical analysis. It is an evolving process, which must be based on a public understanding of the role that insurance industry plays in our society.
Let me share with you a few ideas that may shape the future contours of our industry.

»In the past 10 to 15 years, banks have shown us how they de-risk their balance sheets through the securitization of credit risk and by shifting revenue to fee-based services. It strikes me as rather peculiar that risk mitigation should stop on our balance sheets. Just by looking at credit risk, we observe how banks are slicing it in many different ways and passing it on to other market participants. I believe there is room for us to do the same, and I believe we could do so with appropriately-structured products. Catastrophe bonds that securitize large natural risks come to mind. Other solutions may involve special reinsurance contracts known as quota shares. Clearly, there is no boundary to the ingenuity of financial markets and their productive cooperation with the insurance sector.
»Associated with this, I believe insurers still under-utilize their capital. The new international regulations coming under the banner of Basel II (which require banks to allocate capital to loans according to their riskiness) have forced, and perhaps also enabled, banks to drive their businesses with leaner capital structures. Comprehensive risk management involving finite risk, contingent capital and run-offs could do the same for us. Of course, this requires that we succeed in developing the right methods to control the remaining risk and that regulators understand and support our internal risk management models.
»There is also scope for our industry to improve customer service by making more intelligent use of available information technology. Nifty competitors have shown again and again how risk that was perceived to be uninsurable – people with poor driving records, for example – has become manageable by slicing customer data differently. There is plenty of scope for us to improve in many areas.

Insurers have always pushed the frontiers of insurability through innovation. Recent years have seen exciting developments expanding the instruments available for risk transfer and risk-management, and linking work traditionally done by specialists in finance and underwriting. Now is the time to harvest the fruits of these developments and bring them to the market.

The insurance industry is prepared to play a major role in fostering growth and prosperity. Mankind has always lived with risks. Our challenge is to promote the public’s understanding of these risks and to facilitate appropriate risk management solutions by pushing the envelope of insurability. The key role of our industry is to enhance entrepreneurial risk-taking, which is the driving force behind our economic wellbeing. If we stifle risk-taking through ill-advised government and regulatory intervention, we will do so at our own peril. However, if the regulatory framework is conducive, we, as insurers, will not hesitate to make our contribution to collective future prosperity.

CV James Schiro

James Schiro is CEO of Zurich Financial Services. He was chief operating officer of the company before that.