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What could turn out to be the No. 3 costliest hurricane in U.S. history--and the most intense ever recorded in the Atlantic--barely got any press in 2005. Hurricane Wilma, with insured losses upward of $12 billion, just happened to occur in the same storm season as an unprecedented 25 other named storms and $50.3 billion in total property/casualty catastrophe losses. And Wilma just happened to follow the No. 1 storm in American history, Katrina.

If this historic 2005 hurricane season taught the property/casualty industry anything, it's this: Get used to it. Frequency and severity of hurricane hits seem to be on an upswing, not just for 2006, but for the next couple decades. No wonder the word "megacatastrophe" has serious currency these days. (See sidebar on page 27.)

A hurricane with losses equal to or greater than Hurricane Katrina's now has about a one in 20, or 5 percent, annual chance in the United States, according to the Boston-based modeling firm AIR Worldwide Corp. In the face of these shifting odds, some state insurance commissioners are running to Washington for help. They're pushing legislators because they say the present insurance system cannot be relied upon after such destructive events.

"Mother Nature comes up against reality, and the reality is that the system doesn't work," explains John Garamendi, commissioner of the California Department of Insurance, in November in New York at the 17th Annual Executive Conference for the Property/Casualty Industry.

Earlier that month, Garamendi had co-hosted the National Catastrophe Insurance Program Summit in San Francisco to discuss megacats and a new financing system to handle them. Garamendi and the other commissioners at the meeting--including Kevin McCarty from Florida, Howard Mills from New York and Michael T. McRaith from Illinois--floated the idea of a public-private insurance pool for natural catastrophes, similar to one passed into law in 2002 to reimburse losses sustained from terrorism.

Garamendi and company, who have the backing of Allstate, plan to lobby Congress posthaste. Hopes for tying this safety net in place for the 2006 season, however, are slim. Opposition must be overcome from other players in the P/C sector, who make the argument that the safety net could subvert the very insurance system that it's meant to reinforce.

Steven R. Pozzi, managing director and senior vice president, Chubb & Son, and chief underwriting officer for Chubb Commercial Insurance, sums up the concern, saying in an interview, "A national safety net, if it really was spread, makes a lot of sense, but not to the point where it subsidizes irresponsible behavior."

Even if it could gain support from skeptical carriers, the public-private partnership would still face the realities of D.C. in an election year. The capital will be flooded with rhetoric in 2006, effectively drowning the bill, says Ernst N. Csiszar, president and CEO of Property Casualty Insurers Association of America. He adds, however, that such legislation may be passable in 2007.

In the meantime, insurers are sifting through the rubble left by Katrina, literally and figuratively, to better prepare for the 2006 hurricane season. And what are they learning? Some would say lessons they ought to have learned already.

TECHNOLOGY NO MAGIC BULLET

Take that whole severity and frequency discrepancy again. In public, many carriers seem to have learned one lesson from it--which is to make AIR, Risk Management Solutions Inc., EQECAT and other modelers the whipping boys for it.

In their defense, models have been valuable and surely don't deserve heaps of scorn. They have helped the insurance industry survive the $100 billion price tag of the last two hurricane seasons, says Hemant Shah, president and CEO of Newark, Calif.-based Risk Management Solutions.

"The models to some extent have gotten a bad rap this season," says Steve Smith, vice president of the ReAdvisory group of the reinsurance intermediary Carvill. They are good at deciphering relative risk and at capturing exposure. "They'll tell you which risk is riskier than the other."

But as useful as modeling technology is, Smith says, insurers should not solely rely on it to mitigate future catastrophe losses. Robert Ricker, president and executive director of Citizens Property Insurance Corp., the insurer of last resort in Florida, also said as much at the property/casualty executive conference, explaining that insurers shouldn't rely on models completely but instead view them as only one part of their "toolkit."

Insurers should have already known this, according to some. "Our thought has always been, at least for us, that they were a model, not an oracle," says Pozzi. "Once you rely on that to do your underwriting for you, then it's your own fault."

BETTER EXPOSURE DATA NEEDED

Pozzi says that what should have been surprising for insurers about Katrina was not that a megacat happened, but that the Gulf was its location. Most folks in the industry would have expected the first great megacat to occur with a Los Angeles earthquake, or a Miami hurricane.

"I think what sobered people," he says, "is, wow, there are probably more of these kinds of events that can have a big capital hit than we had anticipated."

To an outside observer with rudimentary understanding of insurance, this may sound as if carriers simply didn't know what was at stake, and where, before Katrina. To trained number crunchers at AIR, this notion was a provable hypothesis--and the basis of a study, released in November, that looked at exposure data from more than 50 percent of the U.S. property market.

Its conclusions were damning. Insurers lacked or had inadequate data on construction type, occupancy class and even addresses for properties. About nine out of 10 commercial properties had underestimated replacement values. And replacement values are an integral part of the modeling equation. If they're off, then how can insurers and companies expect accurate estimates of just how much they have to lose in the big one? "Some of the purported misstatement of the models had to do with not the models themselves, but poor data in," says Bill Adamson, CEO of Carvill America. "So people will be looking at how they capture data, particularly on the commercial side where there was a wide variance in how people captured data, and they were basically understating their liability."

Certainly, one solution for this problem could also be having a hand in establishing new and stricter codes in areas vulnerable to megacats, such as the codes passed by the Louisiana state legislature in late November.

Such codes work, testifies RMS' Shah. He cited codes enacted in Florida in 1995 and 1998 in the wake of Hurricane Andrew. There is an improvement of a factor of two to three--not just percentage points--when you compare loss data from after the codes to losses from before, he says.

Even where good codes exist, insurers cannot be certain that their data is accurate. Citizens' Ricker tells the story of a new condo tower in Florida where builders had failed to space nails in windows according to code. When a hurricane blew through, all these windows went with it. The condo would be considered a no-loss scenario in the models, Ricker says, but because of poor construction, it became a multimillion-dollar loss in the real world.

Insurers can't count on government officials to catch these discrepancies, says Pozzi. They just don't have the resources to enforce building codes. Instead, both Ricker and Pozzi agree that carriers should take into account on-the-ground gradations of the properties that they are covering, know the date of construction and compare that with local codes. Insurers should rely on their own loss control and agents who have close contact with the insureds, says Pozzi, to get the sort of construction and occupancy data that's needed for accurate exposure calculations.

PRICING GRANULARITY

With accurate data, perhaps insurers could better align their pricing with the severity and frequency of their catastrophe risk--and price more granularly.

"The pricing sophistication," Ricker admits, "has to increase dramatically." Take a situation in which an insured 10 miles inland pays the same premium as an insured on the coast. In a more granular world, he says, the coastal fellow should pay four to five times more. On the personal side, hikes associated with such actuarial sense lead to brawls with consumers and regulators. For commercial carriers, that's not the case. "I think people will be a little bit more cautious about the level of aggregates that they run along the coast . . . how they reinsure it, how they price for it," Adamson says. "They'll be able to pass on those costs."

Pozzi agrees that Chubb would basically follow that strategy, but added that Chubb also specifically underwrites to each potential megacat, such as the Northeast hurricane or the New Madrid earthquake. If Chubb can't get the premium it deems necessary to cover catastrophe exposures in certain areas, then most likely terms, conditions and limits would be reduced. Carriers will also re-examine "secondary issues," Pozzi says. For instance, with business interruption, insurers will pay much more attention to length of time and limitations on business income and could place more restrictive coverages in the terms of time granted on business-income coverage.

Why weren't coverages priced and aggregates considered more carefully before? As Adamson explains, "Certainly there were events that showed a $50 billion, $60 billion, $70 billion loss, but of course, when you never had one, everyone assumes it's theoretic and isn't going to happen."

For buyers on the other side of these lessons, it may seem like they will be paying for adjustments that the sell-side should have made of sometime between Hurricane Andrew and Katrina. But then again, any lesson learned is valuable if it is taken to heart before the next megacat.

"I believe circumstances like this require a certain amount of humility from all of us," Shah says.

MATTHEW BRODSKYis associate editor of Risk & Insurance®.

January 1, 2006

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