Risky Business: Insurance Industry Entering ‘New Era’ of Catastrophes

By | May 16, 2011

Given the recent flooding, hurricanes and earthquakes, it appears the number of catastrophic events that inflict mass casualties and severe economic losses has increased – so much so that Dr. Erwann Michel-Kerjan, managing director of the Wharton Risk Management and Decision Processes Center says the world has entered into a “new era of catastrophes” that will redefine the insurance industry.

“For many years, people had the very reassuring assumption … about extreme events … that we’ll maybe see a major catastrophe every 20 to 25 years. … The conventional wisdom that these extreme events are of low priority [doesn’t hold true] in the world where we’re more interdependent with each other,” he said.

As proof, Michel-Kerjan suggests looking at first decade of the 21st century. There were the Sept. 11, 2001, terrorist attacks; followed by the anthrax crisis; followed by the SARS epidemic; blackouts on the East Coast in which 50 million people were affected; the Indian Ocean tsunami in 2004; terrorism attacks in the United Kingdom; Hurricanes William, Rita and Katrina; China’s major earthquake in 2008 that killed nearly 50,000 people only a few weeks after a major cyclone killed more than 100,000 in Myanmar; the financial crisis; earthquakes in Haiti and Chile; the BP oil spill; Japan’s earthquake and tsunami and nuclear issue; and now significant tornadoes and flooding across the United States.

“There has not been a six-month period in the past few years without a major crisis that simultaneously affected several countries or industry sectors,” he said.

How do you price the risk as an insurance company today knowing that insurance is one of the most regulated industries in the world?

Michel-Kerjan doesn’t believe the increase in extreme events means the world is coming to an end. But, he said the increase in significant catastrophes suggests the insurance industry should re-think the way it looks at risk management, especially because the impact of disasters is greater as countries are more interdependent on each other.

“The next 10 years will be worse … If we don’t deal with the real drivers of disasters, we will be slaves to future disasters,” he said.

New Risk Management Framework

Michel-Kerjan said the commonalities among the disasters – the speed in which they occurred and their significant destruction – suggest that the world has changed. Consequently, a new risk management “architecture” is needed, he said.

“Conventional thinking holds that risks are mainly local and routine; that it is possible to list all unforeseen events that could take place, determine their probability based on past experience, measure the costs and benefits of specific risk protection measures, and implement these measures for each risk. Many organizations and governments are making decisions using risk and crisis management tools based on these outdated assumptions,” he said. “As a result, these organizations do not have the agility needed to move quickly to respond to unplanned events and global risks that have occurred at an increasing rate,” he said.

The new risk architecture can be a framework against which people can start to think about catastrophes more strategically, so that they can be better managed, he said. There are six characteristics, or pillars, that define what is happening in the new architecture.

1. Growing interdependencies and globalization. As a result of a growing globalization, social and economic activities are more dependent on each other.

2. Changing in scale from local to global risks that will lead to more devastating consequences when catastrophe strikes. Dealing with large-scale disasters is more challenging on a global scale than dealing with small, local accidents, he said.

3. A high speed, short-term horizon, which can be problematic.

“We are compressing a lot of time compared to where we were five or 10 years ago,” he said. “We want results now. We want return on our investments in the next quarter. All of that is not really good to deal with catastrophes, which most of the time require a long-term view of the world.”

4. Uncertainty, and confusing information distribution. It’s becoming more difficult to quantify risks because of the speed at which they are occurring, he said. The problem is that people generally are not trained or prepared to make a lot of risk management decisions under uncertainty. For instance, calculating risks associated with natural hazards has typically been easier than calculating risks associated with terrorism, he said, but that may no longer be the case.

5. A modified public/private equilibrium. The responsibilities of the public and private sector can change radically, quickly, he said.

“Although government entities certainly play a crucial role, a large portion of critical services that allow our countries to operate is owned or operated by the private sector,” he said. “We must look at how private actions affect public vulnerability so that we are better prepared.”

6. Extreme costs/extreme benefits. With increasing globalization and concentration of populations in high risk areas as people move to the coasts, the cost of catastrophes is increasing, he said. There has been a 600 percent increase in the population in Florida in 50 years, and 1,000 people move to the state every day, for example.

On the other hand, there are opportunities for businesses that can reorient their services and products to help during disaster times.

“If you see more and more catastrophes, that’s a major business opportunity for many companies, who can innovate in the new space. … Ask yourself what type of new technologies can you create to help during disaster time,” he said.

Insurance Industry Crossroads

Given the new risk architecture, Michel-Kerjan said the insurance and reinsurance industry is at a crossroads.

“For many decades, a business model was well-defined. We looked at historical data and were able to calculate a price based on what happened in the past and a risk model,” he said. “It’s very challenging now because there are new things happening, and whether you’re talking about climate change, or the changing nature of terrorism or complex technology called a failure, insurance has a hard time in pricing the risk. How do you price the risk as an insurance company today knowing that insurance is one of the most regulated industries in the world?”

Now also is a difficult time for the insurance industry because it’s more difficult to hedge catastrophe exposure as an insurance company because returns on investments are lower than they used to be, he said.

Nevertheless, Michel-Kerjan suggested the industry embrace the mindset that we’ve entered in a new era of catastrophes and develop different risk models. Models should not just look at risks in a silo, but instead look at the links and interdependencies.

“I’m not saying that’s easy, but you have to take the leadership as an insurance or reinsurance company, or insurance agent to say, ‘this is a different world. We simply cannot continue to do business as usual as we have’ been doing for decades or hundreds of years.”

The National Flood Insurance Program is a good example of adapting to the changing risk environment, he said. The NFIP was put in place more than 40 years ago and now covers more than $1.2 trillion in assets and is one of the largest federal disaster programs in the world.

After examining the NFIP’s data on nearly 5 million policyholders, the Wharton School’s Risk Management Center discovered that the average policy tenure is three to four years. On average, the NFIP loses 50 percent of its policyholders every three years.

The typical flood policy is a one-year contract, which makes it difficult to manage risks, Michel-Kerjan said. Consequently FEMA is exploring multi-year flood insurance contracts to better retain policyholders and encourage better risk management to make America more resilient to flooding.

Taking a long-term view, extreme catastrophes are going to occur more frequently, and result in more severe losses because of global interdependencies. There are natural catastrophes, as well as emerging opportunities for terrorist attacks, pandemics and cyber security breaches, Michel-Kerjan said.

To survive future catastrophes, insurance industry professionals are going to have to manage risks knowing that past losses are no longer good predictors of future losses. And despite more uncertainty about the frequency and severity of risks, he said it’s necessary to adapt to the new risk architecture. Because “you can be paralyzed by managing extreme events … or you can build more resilient systems,” he concluded.

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