Fitch: Katrina Causes Unprecedented Challenges/Risks for P/C Insurers

September 19, 2005

Circumstances surrounding Hurricane Katrina are unprecedented in many ways, said Fitch Ratings. So much so that the rating agency may need to reassess the core risk profile of the property/casualty insurance industry.

Fitch believes is it premature to anticipate how circumstances will play out, and thus continues to maintain a Stable Ratings Outlook on the U.S. Property/Casualty industry. However, the possibility of a change in Outlook to Negative is real at some point, and Fitch will continue to monitor developments closely.

Fitch believes the following risks related to Hurricane Katrina will drive our future outlook on the U.S. property/casualty industry:

–Our updated view on the reliability of catastrophe modeling to support our risk-adjusted capital adequacy analysis of insurers,

–The ultimate resolution of flood-related losses, including resolutions of the well-publicized suit by the Mississippi Attorney General to effectively void flood exclusions in homeowners and other property insurance policies,

–The ultimate size of insured losses retained by insurers, and the degree to which insurers exhaust their catastrophe reinsurance protections, and

–The risk of a pricing squeeze on insurers should reinsurers raise rates for reinsurance to a materially greater degree than primary companies are able to raise rates on their insurance policies.

Though Fitch believes that the probabilistic vendor models used throughout the insurance industry to assess catastrophe exposures represent the current state-of-the-art, we are increasingly concerned that there are many sources of loss in the event of a major catastrophe that fall outside of the scope of, or are not fully captured by, the modeling analysis. These sources can include flood, long-term business interruption, looting and fires, as well as ancillary losses on general liability, directors and officers or errors and omissions policies.

As a result, the catastrophe models may not be providing a complete, prospective view of the true underlying risk of loss facing insurers for large or unusual events. Fitch believes the industry’s recent history, including the massive scope of damage caused by Hurricane Katrina, 2004’s high-frequency hurricane season and the events of Sept. 11, highlight the industry’s exposure to unforeseen, and under-modeled, events and conditions. Only in retrospect do these events and conditions seem foreseeable, and Fitch is concerned about the effect on the industry of future unforeseen events that will inevitably occur.

Should Fitch ultimately conclude that there is a need to assume that a higher degree of uncertainty exists surrounding the reliability of modeled catastrophe loss assessments, such uncertainty would represent a heightened risk exposure that could put downward pressure on insurer ratings.

Fitch believes the attempts of the Mississippi Attorney General to effectively void flood exclusions included in most property insurance policies highlights the ‘deep pocket’ risk borne by the insurance industry.

While Fitch is not speculating as to the outcome of the suit, Fitch believes a loss by the industry, or significant compromise on the part of the industry that results in the payment of significant flood-related losses, would heighten our view of the industry’s ‘deep pocket’ exposures.

To the extent Fitch could no longer rely on basic policy exclusions, or other loss mitigation efforts in its risk assessments of an insurer’s financial profile, that too would put downward pressure on insurer ratings.

Further, though reinsurers are intended to ‘follow the fortunes’ of their primary companies, Fitch believes it is highly likely reinsurers would dispute payment of any flood-related claims.

Fitch believes the nature of the industry’s ‘deep pocket’ risks are especially acute in the case of Hurricane Katrina, since only a fourth of policyholders are reported to have purchased flood insurance, which could severely raise the cost, and limit the availability, of funding for rebuilding efforts. This has put the insurance industry in the center of a heated political issue. If perceived ‘deep pocket’ risk becomes great enough, insurers may respond by holding less capital in exposed areas or by exiting markets. As happened in Florida, the industry may form special state subsidiaries in the states affected by Hurricane Katrina that are not necessarily guaranteed or supported by the larger parent organization. Such a trend could result in lower rated insurance capacity in these catastrophe-exposed areas.

Fitch believes that insurers may start to run the risk of exhausting the coverage on their reinsurance contracts. Should this be the case, any further upward revisions in loss estimates could result in incremental losses that are largely born by primary insurers. This would highlight the possibility that the insurance industry may be ‘under-reinsured’ for large or unusual loss events, especially as losses prove to be larger than expected given the so-called return period of the event.

Anecdotally Fitch understands that Hurricane Katrina may ultimately be assessed as a 50-80-year return period event, yet most insurers purchase catastrophe cover to protect against losses for modeled 100-250-year return period events. This possible risk exposure of potentially being under-reinsured relative to expectations, together with the costs of buying additional reinsurance coverage to mitigate this risk, could put downward pressure on ratings.

While losses from Hurricane Katrina will likely result in increases in insurance pricing, Fitch believes that reinsurers will be able to raise pricing at a faster pace, and to a greater degree, than primary companies.

This is due to the fact personal lines coverages are subject to rate regulation whereas reinsurance pricing is not. Should this occur, not only could primary insurers’ profit margins be squeezed, but it could also lead to possible withdrawals from the affected states by some companies, which could result in restructuring charges and other exit costs. It could also cause insurers to purchase even less reinsurance in the future. All of these developments could put downward pressure on ratings.

Currently Fitch’s best estimate is that the degree of pricing increases post Hurricane Katrina will be lower than those experienced after 9/11, in which a significant ‘hard market’ for insurance pricing emerged across many lines of business. Losses from 9/11 were followed by very high levels of losses from asbestos and other reserving issues, as well as material equity and bond default-related investment losses, which are not present in the post-Katrina environment. Fitch believes it was the culmination of claim, reserving, and investment losses that led to widespread hardening post-9/11.

Fitch recognizes other issues facing insurers related to Hurricane Katrina.

Insurers will likely experience an unprecedented level of commercial property claims from business interruption exposures. For most natural catastrophes, personal lines coverage dominates overall losses. Further, Fitch believes it is likely a number of businesses may have purchased insufficient business interruption coverage, which could, in turn, lead to D&O or E&O claims. Both highlight potentially heightened risk exposures in insurers’ commercial lines books to losses from large and unusual natural catastrophes.

Fitch believes that at the same time insurers are suffering from large claim-related losses, they may also experience losses on municipal bonds held in their investment portfolios tied to issuers in the affected regions. Though the frequency and severity of near-term municipal bond defaults remain uncertain, Fitch believes that due to strong portfolio diversification, such losses for most insurers should be quite modest.

Nonetheless some correlation will exist between insured and investment portfolio losses. Also, some insurers will likely need to liquidate portions of their invested assets to cover Katrina-related claims, which would reduce future investment income.

Finally, Fitch believes the industry will be taxed greatly from an operational perspective, and as a result would face severe operational risks from another major event this year. Fitch recognizes that claims operations are being stretched, and as a result there is a heightened risk of mistakes, fraud, and insurers incurring extraordinary expenses to handle claim volumes. Though Fitch believes the industry is performing as well as could be expected, we believe another major event in the near term could be very difficult for the industry to absorb operationally.

Fitch notes that while a number of the issues above will also affect our Rating Outlook for the Global Reinsurance industry, it is not inevitable that our U.S. Property/Casualty and Global Reinsurance Rating Outlooks will coincide. Fitch believes that reinsurers are more distanced than primary companies from several of the noted risks, such as exposure to paying flood-related claims and regulatory constraints on pricing. This makes it less likely that Fitch would move its Outlook for reinsurance companies’ ratings to Negative.

Fitch will monitor the development of all of the above noted issues closely, and will provide follow-up commentary as new information becomes available.

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