Turning the tables: Coping with a new era of risk

A new era demands new approaches including a federal charter and a national plan for addressing disaster insurance issues

As the most expensive natural disaster in U.S. history, Hurricane Katrina raised serious questions about the capacity of today’s insurance industry — specifically, the ability to cover future catastrophes of this scale or even larger.

With some experts predicting that the 2006 hurricane season could be worse than 2005, we have to ask, would our industry be able to respond appropriately if a Category 5 hurricane scored a direct hit on Houston, Miami, New Orleans or even New York?

A repeat of the 1926 Miami Hurricane alone could cause losses of $130 billion if it occurred today; and only $65 billion would be insured. A northeastern storm, similar to the 1938 Long Island storm, would have an even greater economic impact.

Beyond hurricanes, what would happen if a major earthquake were to hit, not San Francisco or Los Angeles, but St. Louis? This may seem unlikely, but it is actually a scenario which requires serious consideration. Today, geologists warn that this region is due for another major quake sometime before 2050.

Beyond these and other natural events, we continue to face the man-made risks associated with terrorism. As the recent arrest of 17 suspected terrorists in Canada demonstrated, terrorism will be with us for the foreseeable future. The terrorist attack of 9/11 resulted in some $40 billion to $50 billion in insured losses and much more than that in uninsured losses — financial and otherwise. For a more coordinated multi-city attack or a nuclear event, the impact on every level would be horrendous.

The concerns about a Mississippi Valley earthquake and the ever-present threat of terrorism reflect my belief that we have entered what I call a “New Era of Risk.” Think about it: eight of the 11 most expensive disasters in U.S. history have occurred in the last five years alone, while the other three disasters on that list all took place between 1989 (Hurricane Hugo) and 1994 (the Northridge Earthquake). This reflects inflation to a degree, but to a greater extent, it reflects the sheer density of development.

Turn the tables
In the insurance business, we help clients assess their risks, prepare for any number of scenarios, mitigate their exposure — that is transfer it to another party. If something bad does happen, we help in the aftermath. Today, we need to turn the tables on ourselves and ask if our industry is adequately prepared for the “next big one” — the high-impact disaster that joins these others in terms of massive damage and destruction.

The insurance industry is stronger today than it has been in years. The industry’s aggregate policyholders’ surplus for the U.S. property and casualty market is currently estimated at $427 billion, an ample amount to absorb a single natural catastrophe. While in modeling, disasters only happen one-at-a-time, in real life, we have to be prepared for multiple, concurrent events that could wreak havoc not only on the insurance industry but also on the entire American economy.

The American Academy of Actuaries modeled that a medium chemical, nuclear, biological or radiological attack on New York City would result in $446.5 billion in losses. Such an event in San Francisco would inflict $92.2 billion in damage.

The 2005 North American hurricane season resulted in more than $83 billion in losses and hurricane experts predict that the 2006 season will be just as bad if not worse. A Category 3 hurricane hitting the Northeast could cause $300 billion in damages, according to the National Association of Insurance Commissioners.

Remember the earthquake that geologists predict will hit the middle of the continental U.S. by 2050? Experts assume there could be $275 billion in economic losses and $100 billion of insured losses.

All this is in addition to the fiduciary duty the industry has to pay every day claims and those arising out of “expected” catastrophes. So what happens if any two of these events occur more or less simultaneously? There simply is not enough capacity in this new era of risk.

Single national plan
This is why it is critical that the U.S. establish a single plan to deal with disaster insurance issues. Whether this takes the form of a National Disaster Insurance Program that resembles Pool Re in London or having carriers set aside surplus on their balance sheets with some tax benefit or some other mechanism — we need a program that we can all agree upon.

The laws governing the insurance industry do not reflect the reality that this new era presents. It seems we have gotten very good at holding different meetings around different size tables. What we need is a single meeting with everyone around the same table to figure out what the right vehicle is. Whatever the result, it should provide the financial resources to cover losses from catastrophic disasters as an insurer of last resort. Natural and man-made disasters are permanent problems to which we need a permanent solution.

Opponents of a plan — especially one that requires federal involvement — argue that absorbing losses from catastrophes is the price that insurance companies must pay for doing business. No question, carriers should be and are the first line of defense — but the discussion cannot stop there because it is not that simple. When all the claims are paid out in Louisiana, every dollar of home insurance profits ever earned in the state will be wiped out. So carriers are faced with some choices. Generally speaking, they go in one of two directions: drastically increasing premiums or abandoning certain categories of risk. Not taking action could bankrupt their business and then we would all be in worse shape.

Market restrictions
In the area of windstorm and flood insurance, coverage for accounts renewing in the last quarter of 2006 will be severely restricted if we have an active hurricane season. Deductibles for commercial properties in what insurers perceive as wind-prone areas that were historically 1 to 2 percent of values affected in a storm are now increasing to a minimum of 5 percent of values for many accounts.

Insurers are withdrawing stop loss agreements, which are typically to a nominal level of $1 million or so, to limit insured losses in named storms. Rate increases of 50 to 100 percent — more in some instances — are common.

Even worse, stricter building codes have not been universally adopted throughout Florida or in other coastal states.

We are seeing similar trends when it comes to earthquake insurance. Western Re/Managers Insurance Services notes that since the beginning of 2006, California earthquake rates have risen 25 to 35 percent. Two major California earthquake insurers have announced cutbacks in capacity, while a third has withdrawn from the market completely.

Also, natural disasters don’t just affect those in the directly-impacted area. Along with those on the Gulf Coast affected by Katrina, farmers in the Midwest took a hit as increased transportation costs made their crops less competitive. In New York, consumers paid higher home heating prices as the result of last summer’s hurricanes. Out West, local officials are fighting to stop proposed cuts in funding for fighting wildlife fires to pay for reconstruction in New Orleans.

These developments make clear the critical need for a national approach to absorb the increased risk of catastrophic damage.

Optional federal charter
The backstop provided by a National Disaster Insurance Program is not a new idea. After Hurricane Andrew in 1992 and the Northridge Earthquake in 1994, there were proposals to create such a program. Unfortunately, parochial concerns short-circuited that effort. Again, it was different sets of people sitting around different tables.

This is a major reason we need an optional federal charter for the insurance industry. The state-by-state system is not only a burdensome administrative hurdle for us, but it complicates the insurance submissions process.

No doubt many Americans wish we had established a plan or had properly built the National Flood Insurance Program. I do not know any business, insurance or otherwise, that can pay out $23 billion against $2.2 billion in revenues. The program is actuarially unsound and the shortfall will continue unless we all get around that one table.

The Terrorism Risk Insurance Act is a good conceptual model. TRIA makes it possible for insurers to offer terrorism coverage with the knowledge that a single event will not bankrupt them. It also satisfies certain requirements for commercial mortgages.

A new era of risk demands new approaches. We’ve got an opportunity here and it is critical that we seize it by reforming the regulatory structure of the insurance industry. The best way is by adopting an optional federal charter that will finally put in place a single, coordinated, federal process to find the solution that will afford some level of economic security in the face of natural and man-made catastrophic events. It is in the best interests of our country and there’s truly not a moment to waste.

Joseph Plumeri is chairman and chief executive officer of Willis Group Holdings. This commentary is an edited version of his June 15 speech before the Real Estate Roundtable.