A ‘Great Earthquake’ Strikes Chile; Insurance Doesn’t Pose Systemic Risks to the Economy; Berkshire Buys More Munich Re

February was a short month, but a deadly one. In addition to a massive earthquake in Chile, the Northeastern U.S. was hit by three blizzards; floods and mudslides ravaged the Portuguese island of Madeira and beleaguered Haiti, and a violent storm swept through Portugal, Spain and France causing floods and the deaths of at least 50 persons, with a number still missing.

But the most murderous natural catastrophe had nothing to do with the weather. The “great earthquake” that struck Chile early Saturday morning, Feb. 27, was one of the strongest ever recorded. The U.S. Geological Survey (USGS) originally estimated its strength at a magnitude of 8.3, but subsequently increased the scale to 8.8. Severe “shaking intensity” extended nearly 500 kms (app. 300 miles) from the epicenter on the coast just above the city of Concepción. Early estimates have put the death toll at more than 700 people, but this will certainly increase. Nearly 2 million people, out of Chile’s 16 million population, were affected.

As strong as the quake was, its center was south of Chile’s most populated cities. Reports of the extent of the damage are still being compiled, but catastrophe modeling firm AIR Worldwide said the quake was “likely to have caused considerable damage in towns closer to the epicenter.” News reports have confirmed that the towns of Concepción (est. pop. 300,000) and Chillan (est. pop. 170,000), which lie 115 kms and 100 kms to the south of the epicenter, respectively, were the hardest hit, with many fatalities, collapsed buildings and significant loss of infrastructure.

Even though the main population centers were largely spared the worst, they will account for a high proportion of the losses. “Damages in the state of Santiago are expected to exceed 50 percent of the total damages,” said catastrophe modeling firms EQECAT. “Damage in the state of Valparaíso is expected to be about 25 percent of the total damage from this event.”

EQECAT estimated the “total value of economic damage to be in the range of $15 to $30 billion.” It explained that, assuming a conversion rate of 520 Chilean Pesos to the dollar, damages would be “in a range of 8 trillion to 16 trillion” in local currency, which is about “10 percent to 15 percent of Chile’s real GDP.”

As bad as the quake was, it could have been much worse, but for the fact that Chile has had a great deal of prior experience with earthquakes, and has, unlike Haiti, taken remedial action. Dr. Mehrdad Mahdyiar, director of earthquake hazard at AIR Worldwide, noted that the “largest ever recorded earthquake — a Mw9.5 event — occurred just off of Chile’s southern coast in 1960.” He also explained that, as a result, “Chile has a long history of building code evolution, beginning in 1928.”

The codes have been frequently revised, most recently in 1993. “As a result, Chile has more stringent building codes than its neighbors, superior construction quality, and possibly the most highly engineered building inventory in Latin America. This will undoubtedly help mitigate the damage,” he added.

There’s “no systemic risk from insurance core activities,” concluded the Geneva Association in a newly published report. The Association, whose official name is the International Association for the Study of Insurance Economics, backed that up with facts and statistics as proof of what industry leaders have been saying all along.

The insurance industry has a number of fundamental differences that set it apart from other financial industries, notably banking. The Association listed some of those features as follows:

• Insurance is funded by up-front premia, giving insurers strong operating cash-flow without the requirement for wholesale funding;
• Insurance policies are generally long-term, with controlled outflows, enabling insurers to act as stabilizers to the financial system;
• During the hard test of the financial crisis, insurers maintained relatively steady capacity, business volumes and prices.

As a result it “doesn’t fit into the commonly cited definition of systemic risk,” said the report. Few insurers are “too big to fail,” and if they do, it takes place over a longer period of time, and there are regulations in force to cushion the fallout.

However, the report also warned that when an insurer steps into uncharted, i.e. non-insurance, territory it may well run into trouble. Without naming names, it singled out “quasi banking activities conducted by insurers” as having “either caused failure or triggered significant difficulties.” Without proper risk controls both “derivatives trading on non-insurance balance sheets,” and “mis-management of short-term commercial paper or securities lending” do pose systemic risks.

Initially the Association opted for the “implementation of a comprehensive, integrated and principle-based supervisions framework for insurance groups, in order to capture, among other things, any non-insurance activities such as excessive derivative activities.” This would be followed up by more and better risk management, “particularly to address potential mis-management issues related to short-term funding,” as well as more oversight on financial guarantee insurance, and more “macro-prudential monitoring.”

Geneva Association Chairman and CEO of Munich Re, Dr. Nikolaus von Bomhard summed up the results at the report’s presentation in London. “In the public debate, the business model of insurance is unfortunately not always sufficiently demarcated from the business models of the other financial service providers, such as banks,” he said. “The way systemic risks are addressed, must, however, take account of precisely the specific differences and characteristics of the business models and particular activities carried out by institutions. Just looking at the obvious differences, the conclusion can only be that the insurance industry in its core activities does not pose systemic risks for the economy.”

Berkshire Hathaway’s taste for reinsurance investments remains unabated. Munich Re released a statement, in accordance with applicable German law, that National Indemnity’s “share of the voting rights in our company had exceeded the threshold of 5 percent on Feb. 11, 2010, and amounted to 5.097 percent (10,062,586 voting rights) as at this date.”

At the end of January Munich Re posted a similar notice that Berkshire’s stake in the world’s largest reinsurer had exceeded the 3 percent threshold [See www.insurancejournal.com/news/international/2010/01/27/106899.htm].

As Berkshire is the parent of National Indemnity, the question arises as to whether these shareholdings are in effect the same. Asked to clarify the situation, National Indemnity replied: “We do not comment on investment holdings beyond that which is required by regulation.” Whatever the form of the holdings, it appears that Berkshire has increased its stake in Munich Re significantly.

The investment underscores Berkshire’s Chairman Warren Buffett’s confidence in the P/C reinsurance industry. In addition to its stake in Munich Re, Berkshire’s General Re is the third largest global reinsurer. The company also has stakes in Swiss Re, the second largest, as well as substantial interests in the Lloyd’s reinsurance market, the fourth largest.

Topics Mergers & Acquisitions Catastrophe Natural Disasters Reinsurance Market