May 5th, 2011

Tohoku Quake and Tsunami…An Industry Meets the Challenge - Reinsurance Market Short-Term Implications

Posted at 1:00 AM ET

klein_chris_bioChris Klein, Director of Reinsurance Market Management
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The recent catastrophe in Japan has implications beyond reinsurance rates and balance sheets. Carriers have already begun to watch for rate changes and anticipate changes to catastrophe models. Both issues, along with the capital implications, will set the tone for the industry in the near term.

All three major catastrophe model vendors have Japan earthquake models designed to compute probabilistic loss estimates. The effect of a following tsunami is not considered in these models, however, which is consistent with the rest of the world. Additionally, the vendor models use research by the Headquarters for Earthquake Research Promotion (HERP) to develop their earthquake event catalogs. As HERP and others did not expect a 9.0 magnitude event occurring, the catalogs were capped closer to 8.4.

That said, the role of the vendor models in the primary insurance underwriting and risk management in Japan is relatively limited compared with other peak zones. Instead, most insurers use their own models within the framework of regulatory and rating agency capital controls. Japan’s strong construction codes also appear to have been effective, as buildings withstood the shaking well.

In addition to how the market uses models, insurers in Japan benefitted from their ability to hold catastrophe reserves. These are tax-advantaged provisions held to pay future catastrophe losses. Though the catastrophe reserves are classified as liabilities under Japanese accounting standards, they are generally treated as capital by external observers such as rating agencies and investors. Indeed, the Japanese FSA has adopted this position and includes catastrophe reserves in the official solvency margin ratio calculation.

Catastrophe reserves represented about a third of the total adjusted capital of the five largest Japanese non-life insurance companies at the financial year ending March 31, 2010. Earthquake claims will be paid from these reserves first, which are expected to mitigate or prevent operating losses. However, a decrease in catastrophe reserves will affect regulatory and rating agency capital adequacy. We believe there is sufficient capital to avoid rating downgrades, but there may be some effect on risk appetite, especially for asset risk, which exceeds underwriting risk by a wide margin in the rating agencies’ capital models. Some companies may make adjustments and perhaps look for extra capital. Guy Carpenter expects reinsurance to remain a relatively low-cost source.

So far the rating agencies do not expect to take widespread rating actions, since much of the industry was dealing with the disaster from a position of capital strength. Solvency and liquidity were not considered to be threatened. Standard & Poor’s has revised its outlook on several Japanese insurers from stable to negative, but it has held the ratings at double-A minus, in line with the sovereign rating cap for Japan. Some smaller reinsurers have had their A minus ratings placed on credit watch with negative implications, though not by all rating agencies. Where this has happened, the actions appear to have been the culmination of losses arising from the string of catastrophes in the Asia-Pacific region.

So what does the reinsurance market face in the coming months?

The answer is uncertain and is affected by many factors. Strong balance sheets and good liquidity do not usually portend a sharp upwards correction for the market as a whole. However, the psychological effects of a series of unexpected losses, particularly in the Australia-New Zealand region, should not be underestimated.

With many reinsurers’ 2011 catastrophe budgets exhausted in the first quarter, underwriters are not waiting for capital to be consumed. Instead, they are resisting price decreases now in an effort to reduce the impact of negative catastrophe cash-flow. And, we have the impact of RMS version 11 in the United States. So, over the mid-year renewals, we expect prices in loss-affected areas to respond accordingly, but elsewhere, cedents will expect decreases despite underwriter resistance. Looking ahead to the January 1, 2012 renewal, which is still too early to forecast, it seems as though the market will be more sensitive than usual to even moderate catastrophes, especially in the United States.

Of course, the situation in Japan - and around the world - is still unfolding. And as more information is released, perspectives are bound to shift. This is what makes a keen understanding of the Japanese insurance industry and global capital situation crucial.

As we head toward the 2011 hurricane season in the United States, the importance of diligent capital management is likely to be magnified. Since Hurricanes Katrina, Rita and Wilma, (re)insurers have seen the value of having robust capital positions when disaster strikes - the simultaneous financial crisis and landfalling of Hurricanes Gustav and Ike in September 2008 is the most recent example. Suffice to say, the industry was in position to handle a record quarter of losses this year. As the situation continues to develop, the effects for the hurricane season in the United States - and around the world - will become clearer.

Part I: Introduction >>

Part II: Economic Impact >>

Part III: Impact on Commercial Insurance >>

Part IV: The Earthquake and the Japan Renewal >>

This week, Guy Carpenter is running a series of articles about the state of the reinsurance market in Japan that can be used to help you manage your capital effectively. To have these articles delivered directly to your inbox every day, click here to register for our GC Capital Ideas alerts.

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