Catastrophic losses, such as those caused by natural disasters like hurricanes, can have ripple effects across various insurance lines and impact the pricing strategies of insurers and reinsurers. When a major catastrophic event occurs, it can drain the capital reserves of insurers and reinsurers, leading them to reassess their risk exposures and adjust their pricing strategies across multiple lines of business. In addition to insurance players, there are others that are less spoken about, and they are financial institutions like banks and alternative capital providers.
Flow Of Risk: From Reinsurance To Mortgage Market
Let's step back and look into the flow of risk in the financial and insurance domain. There is an interconnectedness of various entities in the financial system, and risks can propagate from one entity to another. In the context of banks and reinsurers, the Risk Flow illustrates how losses incurred by one party can have ripple effects on the other, creating a cascading impact on the broader financial system.
Imagine a scenario where a major hurricane strikes Florida, causing widespread damage to residential properties. In this situation, homeowners' insurance companies would be the first line of defense against these losses, as they are responsible for paying claims to policyholders for the covered damages. If the hurricane's impact is severe enough, the claims paid by insurance companies could deplete their capital reserves, potentially leading to insolvency or financial distress for some of these insurers. This is where reinsurers come into play.
Reinsurers provide insurance coverage to insurance companies, essentially insuring the insurers themselves. When faced with significant claims from a catastrophic event like a hurricane, insurance companies rely on their reinsurance agreements to transfer a portion of their risk exposure to reinsurers. However, if the hurricane's impact is so severe that it exceeds the reinsurance coverage limits or if the reinsurers themselves face financial difficulties due to the magnitude of the claims, both insurance companies and reinsurers could experience substantial losses.
This is where the flow of risk connects to banks. Many banks have significant exposure to the mortgage market, holding residential mortgage loans on their balance sheets or investing in mortgage-backed securities. If homeowners face financial hardship due to property damage or loss of income resulting from the hurricane, they may struggle to make their mortgage payments, leading to an increase in mortgage defaults. Additionally, if insurance companies and reinsurers face solvency issues due to the catastrophic losses, their ability to pay claims to homeowners could be impaired. This, in turn, could exacerbate mortgage defaults, as homeowners might not have the necessary funds to repair or rebuild their damaged properties.
As a result, banks could experience significant losses on their mortgage portfolios and mortgage-backed securities holdings, potentially leading to financial distress or even insolvency for some institutions. Furthermore, this flow of risk can extend beyond banks and reinsurers. If banks face losses due to mortgage defaults, they may need to raise additional capital or sell assets, which could impact other financial institutions, investors, and even the broader economy.
Similarly, if reinsurers face substantial losses and need to raise capital or liquidate assets, it could affect their ability to provide reinsurance coverage to insurance companies, potentially leading to higher insurance costs or reduced availability of coverage in certain markets.
To mitigate the risks associated with the flow of risk, banks, insurers, and reinsurers often employ various risk management strategies, such as diversification, stress testing, and hedging techniques. Regulators also play a crucial role in monitoring the interconnectedness of the financial system and implementing measures to promote stability and resilience.
The "Demotech Insurers" Phenomenon
When traditional insurers leave high-risk areas like Florida, they are essentially reducing their exposure to potential losses from natural disasters. However, this creates a supply shortage of insurance coverage in these regions. To fill this gap, new insurers enter the market, often focusing solely on these high-risk areas.
These new insurers, referred to as "Demotech insurers" in some literature (ref: When Insurers Exit: Climate Losses, Fragile Insurers, and Mortgage Markets. Parinitha Sastry, Ishita Sen,Ana-Maria Tenekedjieva,2023), lack the diversification and financial strength of traditional insurers. They tend to operate in fewer states, have a higher concentration of risk in their portfolios, and hold less capital relative to their risk exposures. Consequently, they are more vulnerable to insolvency in the event of a significant natural disaster. There has been a surge in these insurers in the recent decade, from having a negligible presence in the 1990s when they entered the market, their share has risen to over 50% since 2018. Demotech insurers are not unique to Florida and are part of a broader country-wide trend, especially in states more prone to weather- and climate-related disasters.
Recently, American Integrity Insurance released a new program under the title "ValueGuard Property Insurance" product for the Florida market. However, I wonder how the impact of Hurricane Ian on their financial solvency will affect their underwriting technique. Based on the further decline in secondary market prices for American Integrity's catastrophe bonds, with one issuance marked as likely facing a total loss, it indicates that the insurer is facing substantial losses from Hurricane Ian. This financial strain can put pressure on the insurer's capital reserves, potentially limiting its ability to underwrite new business or maintain existing policies.
Catastrophe bonds are an important source of reinsurance capacity for insurers like American Integrity. With the expectation of a total loss on one of its catastrophe bond issuances and significant markdowns on others, American Integrity may face challenges in securing sufficient reinsurance coverage for future hurricane seasons. This could lead to higher reinsurance costs, which may need to be passed on to policyholders in the form of higher premiums. It just doesn't look promising for Florida residents, and the newly released Florida Senate bills might also not be enough to solve the problems.
The Florida Senate passed three bills aimed at lowering homeowners insurance costs across the state:
- House Bill 7073, sponsored by Sen. Blaise Ingoglia, reduces property insurance premiums by more than $500 million statewide by eliminating certain taxes and fees that homeowners pay on their policies.
- Senate Bill 7028, introduced by Sen. Jim Boyd, allocates $200 million for improvement grants. These grants are designed to empower homeowners to reduce their premiums by reinforcing their homes. Priority is given to low-income families and seniors.
- House Bill 1029, sponsored by Sen. Nick DiCeglie, establishes a pilot program for condominium associations to apply for mitigation grants.
There is definitely a need for an absolutely new underwriting method in the near future to address natural disasters in regions like Florida. Insurers need to re-evaluate their pricing and risk management strategies for any insurance product, which can lead to inevitable premium adjustments to account for the increased risk exposure.
I am curious to see how regulators are going to monitor the newly introduced ValueGuard Property Insurance product or any other insurance products in Florida and if any new requirements will be imposed on the insurers.
All of the above might leave a bitter aftertaste with very few options to solve the problem. However, I do believe that close collaboration between alternative capital providers and insurers might be the solution or the insurance structure of the future. These new structures will probably be introduced to catastrophe programs as well as cyber programs.
For those insurtechs, and demotech insurers thinking of entering these markets, it is important to remember the flow of risk in the insurance and financial sectors.
Underwriting Approaches
Here are a few ways of how insurers and actuaries approach natural disaster underwriting (using the Miami example):
- Use tools like FEMA's Hazus to simulate different hurricane scenarios and estimate the resulting property damages across geographic (in this case Miami) census tracts or geographical areas.
- Evaluate the insurance coverage levels of homeowners in Miami, including flood and wind insurance policies underwritten by the new, less diversified insurers.
Let's assume that the percentage of homeowners insured by these riskier insurers is represented by the variable "insured_by_risky_insurers."
- Calculate the uninsured losses that spill over to homeowners, considering both structural damages and potential devaluations of land parcels due to climate impacts.
Homeowner losses can be represented by the following equation:
homeowner_losses = (insured_by_risky_insurers * property_damages) + land_devaluation
- Develop models to estimate the likelihood of mortgage defaults based on factors such as negative equity, income levels, and expectations of future home price recovery.
The probability of default for a homeowner can be modeled using logistic regression or similar techniques, taking into account factors like the loan-to-value ratio, income levels, and the magnitude of the climate event:
probability_of_default = logistic_regression(loan_to_value_ratio, income, event_magnitude)
- Utilize data from sources like HMDA and Y-14M to determine the exposures of banks, government-sponsored enterprises (GSEs), and other creditors to different segments of the mortgage market in Miami.
Let's assume that the total mortgage exposure of a creditor in Miami is represented by "total_mortgage_exposure." The potential losses for a creditor can be calculated as:
creditor_losses = total_mortgage_exposure * probability_of_default * (1 - recovery_rate),
where "recovery_rate" accounts for the potential recovery of funds through foreclosure or other means.
In this context, working with a specialized consulting firm like Zala International could prove invaluable for new and traditional insurers. Zala's expertise in quantifying and managing the flor of risk could assist insurers in accurately assessing their risk exposures, developing robust risk management strategies, and exploring alternative reinsurance solutions to maintain financial stability and continue serving the Florida or similar markets effectively.
These are just some of my thoughts on the problem. Should any of our readers have suggestions or comments, please email Layla Atya, and let's create the future of insurance together.
