SPREADING OF RISK CREATES CONCERN

SPREADING OF RISK CREATES CONCERN

The collapse of the London excess of loss market in the early 1990s left many victims trailing in its wake, not least those companies requiring U.S. catastrophe insurance.

The instant retraction of retrocessional excess of loss capacity - insurance for reinsurers - after the Lloyd's LMX spiral collapsed severely curtailed insurers' ability to provide cover for U.S. property catastrophe cover due to the potential enormity of such risks.Since then, the decision by several Bermudan insurers to move into the U.S. catastrophe market has provided some much-needed capacity.

But the method by which many insurers - including those in Bermuda - are spreading their risk in the absence of excess reinsurance has raised doubts over the long-term viability of today's catastrophe cover. When Bermuda's insurers started writing catastrophe insurance in 1993, the tiny Atlantic island showed that it could offer more than a convenient tax haven for captives - dedicated vehicles set up by companies to insure their own risks - and a sunny locale for U.S. liability insurers.

Backed by US capital, the Bermudan cat insurers were formed to cater to U.S. cat requirements that could no longer be met by traditional insurance markets. Like Bermuda's move into liability insurance in the 1980s, the decision was prompted by a shortfall in worldwide capacity.

David Rowland, chairman of Lloyd's, highlighted the need for more capacity when he spoke at the second Bermuda insurance symposium in June. "I have never seen Bermuda as a rival threat to London, but as a linked part of a global market which is inadequate at the moment to cope with our clients' needs," said Mr. Rowland.

As a result of shortfalls in U.S. cat capacity, and a general realization that premiums had been insufficient to cover exposure, U.S. cat rates rose fourfold between 1989 and 1993. They have since stabilized in a generally softening insurance market. But it is another story for cat risks outside the United States, where premiums have tumbled. This, in part, is due to the risk methodologies - colloquially known as "pot filling" - adopted by many insurers since the collapse of the LMX market.

While traditional cat insurers in the Lloyd's and London company markets have tended to spread their U.S. cat risk by writing several classes of business, the new generation of cat insurers are hedging their exposure to U.S. cat risks by writing equivalent cat business in markets outside the United States.

Many cat underwriters are fearful of the long-term effects of this methodology as the desire to write non-U.S. business is driven solely by the insurers' need for balance. "Normally, a coherent business is made by syndicating catastrophe with other classes. An isolated cat market has no inherent balance," according to the Harvey Bowring syndicate at Lloyd's, a well-known leading cat underwriter.

Harvey Bowring itself balances catastrophe business with 10 other classes of business, including U.S. property insurance, U.S. casualty business, and crop and livestock insurance.

The syndicate said, "The flaw in the geographical mechanism is that it is insensitive to local conditions. By reinsuring risks outside the United States to hedge U.S. risks, the insurers are not interested in the exposure in individual countries. If there is a loss in the United States, prices in all other underwriting areas will go up. It becomes a worldwide roller coaster."

So, although renewed interest in cat business worldwide, including the Bermudan's participation, has created more capacity for U.S. cat risks, many traditional cat insurers believe the geographical risk methodology being used will eventually undermine such progress.

"This is kamikaze underwriting. The insurers are putting the cart before the horse. Underwriters should be concentrating on assessing what the business is worth and buying reinsurance to cover its worth, not hedging their risks geographically," said Harvey Bowring.

And the widening gap between U.S. catastrophe capacity - estimated at $12 billion this year - and annual premiums - around $5 billion - will aggravate the problem in the event of a major U.S. catastrophe loss.

With lower margins on the U.S. portfolio, insurers will have to recoup even larger amounts from European and Asian markets - through higher premiums - to compensate for shortfalls in their U.S. portfolios.

"Back in 1993, premiums were healthily close to capacity - at $8 billion to $9 billion. Now capacity is $12 billion, but premium is going down. The problem is, the lower prices fall, the bigger the ultimate corrective action that will be needed in case of a U.S. loss," said Harvey Bowring.

And with U.S. catastrophe limits in excess of aggregate limits in the rest of the world, insurers are having to fight for large market shares in non-U.S. markets to achieve a balance between U.S. and non-US exposure. This has put pressure on international rate levels in markets where there is already overcapacity.

"Bermuda has exacerbated the scramble for business in the international market," said Harvey Bowring. Already, international catastrophe rates have fallen on average 15 percent-to-20 percent this year.