The Risks of Hazard

One of the challenges (and joys) of writing The Risks of Hazard is to find an interesting perspective on topics that concern underwriting property insurance. But, sometimes, there is an event that has only one angle: head-on. The “one in a thousand years” rain in South Carolina is a perfect example.

There is no doubt about it – South Carolina has had some seriously bad rain; tons of it, brought by the highly unusual convergence of at least eight key factors. October 4th was the rainiest day on record in Columbia, with almost 7 inches falling on the airport. Charleston set their own single day record on October 3rd with 11.5 inches hitting the city. In addition, it’s already the wettest October on record for most of the state, and we are only a week into it. But, to hear Gov. Nikki Haley state: "We haven't seen this kind of rainfall in the low country in a thousand years," is not just misleading – it is nonsense. Dave Baker at KATC in Louisiana has saved me the trouble of explaining why.

One of the story lines emerging from this year’s Rendez-vous de septembre in Monte Carlo was the continued relevance of P & C insurance and reinsurance. At first, it sounds a bit overdramatic, but there is something to it.

The continued relevance of the P & C industry was first questioned in 2012 by XL Group’s CEO Mike McGavick in an Insurance Journal article. Many of his points were centered on the relationship of insurers and reinsurers with other global industries, including their access to capital. The one point from this three-year old article that resonated for me is this:

As another example McGavick noted that following the floods in Thailand the price of computer chips rose by 10 percent. But the P & C industry’s response hasn’t been to offer solutions. It’s mainly been to impose sub-limits or to exclude it entirely. [McGavick] warned: “We cannot exclude our way to prosperity, and we cannot sub-limit our way to relevance.”

From a P & C executive, a CEO no less, those are fighting words, a rallying cry. Unfortunately, Mr. McGavick was viewed more as a Cassandra (to use IJ’s description) than a Henry IV.

Big data is big news, and rightly so. The ability to glean answers from huge datasets is enabling previously impossible innovation in insurance, just like these gents mentioned a few months ago. There are datasets that comprise decades of building history for most houses in the United States. There are geospatial models of the Earth’s surface, with elevations every 15’ or so for the lower 48 states and Hawaii. Then there are risk models and hazard maps that combine all sorts of scientific data. And then there are historical records of losses and loss-causing events. There are tons and tons of data — to no end.

However, there is an unspoken premise for solutions that excavate answers out of data: the right data is in there somewhere. Even though there are “predictive analytics”, “intelligent algorithms”, “virtual learning” and other software tricks to deliver answers, there is nothing quite like having the right data involved. Sometimes there is no “right” data – wouldn’t it be nice if there was a catalog of future floods or earthquakes? Without some predictive modeling, underwriters would be dealing with the Turkey Problem. But using the right information in predictive models or algorithms is, again, essential.

This blog post is part 2 of 2 exploring how underwriting leakage  manifests itself in the property insurance market. On Tuesday it was rate fluctuations after a catastrophic event. Today, we look at the coverage gap.

To recap briefly, underwriting leakage is the difference between perfection and reality when an underwriter assigns financial conditions on risk. Ideally, there is no difference, but in reality there is always a difference.

The coverage gap is the difference between total economic losses from an event and insured losses. It can be caused by a lack of insurance penetration into a market, a lack of suitable products available, or certain coverages missing from the available products. Here is a recent paper on the coverage gap from Swiss Re (they call it the “protection gap”, but it’s the same thing) that explains it much better. In a perfect world there would be no coverage gap because all the necessary policies would be available at the right price, offering the right coverage. This is the perfect world where there is no underwriting leakage.

The assignment of a price to a risk is the core activity of insurance, and underwriting is the fulcrum on which risk and money balance. Any difference between perfection and reality in that balancing act is called underwriting leakage. Let’s explore two results of that leakage:

1. Premiums become volatile after a natural catastrophe event
2. A coverage gap in the risk pool occurs

1. Volatile Premiums

Underwriting leakage for natural catastrophes becomes obvious after a bunch of claims are paid: prices go up within a year or two. While these premium increases are considered a necessity by insurers, it is a source of frustration to consumers and anxiety to regulators. Consumers don’t like premium rises, and regulators don’t like unpredictable pricing because they don’t like unhappy consumers (i.e. voters).