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It was a storm that will be remembered for a long, long time. One of the worst disasters ever to strike the United States, Hurricane Katrina will most likely rank as the largest insured loss in history.

With losses for Katrina estimated in a range of $40 billion to $60 billion, the insurance industry faces a number of serious challenges. Fitch Ratings, for instance, has said it might change its outlook on the property/casualty sector to negative from stable depending on how certain developments play out.

"So far as we can see, at this point there are no threats of insolvency as a consequence of what has occurred," said Tom Upton, managing director of S&P, in reference to the larger rated companies.

Katrina will affect the insurance industry in a number of ways, however.

At the very least, the losses will wipe out some portions of the insurers' earnings for 2005 and will force some companies to have to raise capital to repair their balance sheets. But if losses reach as high as $60 billion or more, which would represent 10 percent of the total worldwide property/casualty insurance and reinsurance surplus, then we're talking about a market correction," says James H. Costner, a senior vice president at Willis Risk Solutions.

"It's probable, at this point, that we're going to go through a market dislocation resembling what we went through at the end of 2001 or in 1992 after Hurricane Andrew," Costner says.

Part of the problem is that reinsurers will get hit with a large portion of the losses from Katrina, and that could prompt them to raise rates and reduce capacity, which would put a lot of pressure on the primary insurers.

The industry is also at risk from a lawsuit by Mississippi Attorney General Jim Hood to force insurers to pick up the tab for flood damage, which is generally excluded from homeowners' policies.

Katrina also will hit the commerical insurers harder than in the past because the storm hit a large metropolitan area with a great deal of business and industry. Other hurricanes have tended to hit mostly residential areas.

The disaster will force the industry to review the assumptions used in its catastrophe modes and in its underwriting practices as well.

Meanwhile, the insurance industry may be tied up for years trying to sort out which losses are covered by the insureds' policies.

IS THE INDUSTRY VULNERABLE?

It is true that the insurance industry of 2005 was much stronger than it was when Hurricane Andrew struck southern Florida in 1992.

After that wake-up call, insurers began reducing their exposures in hurricane-prone areas and increased their use of catastrophe reinsurance and other financial instruments to manage the risk.

Insurers also have enjoyed the benefits of a hard market over the past few years, and that has allowed them to rebuild their capital positions.

The industry could have handled a loss in the range of $20 billion to $25 billion without much of a problem. S&P's Upton and A.M. Best vice president Anthony Diodato say the industry can handle a $40 billion loss, and even a $60 billion loss, without the threat of insolvencies and still have something left over to pay for more catastrophe losses.

But Costner says he believes losses of $60 billion would put a serious strain on the industry, and each additional catastrope would be just that much more salt on the wounds.

Hurricane Rita will saddle the industry with even more losses, even though it does not appear that the damage will be anything like what Katrina caused.

"How many hits can an industry take in quick succession?" says Norm Baglini, professor of risk management at Temple University in Philadelphia and president emeritus at the American Institute for CPCU. "Katrina and Rita back to back are really going to take their toll," he says.

Hurricane season, meanwhile, is not over yet, and there is still the potential for another deadly storm. And although hurricanes have been the focus of attention these past few months, the industry also is at risk from other kinds of disasters.

COMMERCIAL INSURERS HIT

One of the unique features of Hurricane Katrina is its impact on the commercial-insurance sector.

Hurricane Andrew hit primarily residential areas of Florida, and so its toll was felt mostly by personal-lines insurers. Katrina, however, took aim at large metropolitan centers and hit hard at key business and industrial sites.

"I believe every hurricane has caused commercial-line losses," says A.G. Edwards analyst Paul Newsome. "This appears to be unique in the proportion of the commercial lines that are going to be impacted. It looks like a very large proportion of the total loss will be borne by the commercial-lines insurers relative to the personal-lines insurers. And that is a unique feature of Hurricane Katrina."

Leading commercial insurers in Louisiana, Mississippi and Alabama, where Katrina hit the hardest, include St. Paul Travelers, State Farm, Zurich, Allstate and Nationwide, according to the Insurance Information Institute. Those insurers declined immediate comment, saying it was far too early to tell what the impact of the storm would be on their operations.

Commercial insurers are likely to experience losses from damage to property, as well as from business interruptions. Business-interruption losses could be significant. While in other storms, businesses have usually been able to get back up and running fairly quickly, this time many will be shut down for quite some time.

"With other storms, there has been the ability to get up and running at a somewhat faster pace than we are likely to see with this storm," says Aaron Davis, who handles commercial property accounts as vice president with Aon's property syndication group.

The losses may be significant enough to drive prices higher in certain lines and in certain parts of the country and to prompt insurers to continue their efforts to limit their exposure in hurricane-prone areas.

"It certainly has the potential to turn the market and moderate the pricing decreases we've been seeing in the market," Davis says. "The larger the loss becomes, the greater the likelihood of it having a material impact on pricing and market behavior."

It is not clear, however, if the storm will lead to a broader turn in the market.

"It's a question of whether the spike will be confined to regional exposures, or whether it will eventually filter into the market as a whole," he says.

Reinsurers are likely to end up picking up a big part of the Katrina losses. Losses from Katrina were severe enough that insurers were likely to blow through their retentions and tap their reinsurance. After using up their retentions, insurers may have to buy costly reinstatements to cover losses from Rita.

Or if reinstatements are not available, the losses from Rita will come straight out of their capital, Costner says. Insurers also may have trouble collecting their reinsurance if reinsurers are overwhelmed by the Katrina losses.

"The reinsurance policies are only as good as the reinsurers' ability to pay," Baglini says. "If all of the primary companies are with the same reinsurers, you got to hope you are standing at the front of the line and not at the back of the line when you go to collect."

Reinsurers, weakened by the losses, may reduce capacity, and that could lead to higher premiums for primary insurers. If insurers are not able to get enough reinsurance, they may cut back capacity as well, and that could hurt businesses that rely on insurance to satisfy lender requirements, Costner says.

Meanwhile, one of the big challenges for the industry will be deciding which losses are covered under an insured's policy and which are not.

"There's a tremendous sorting out of what coverage applies where," Costner says. Policy language tends to be written to deal with the loss of an individual structure.

"There are coverage problems when a whole city is leveled, some of which nobody has ever had the imagination to ask before," Costner says. "These questions will have to be answered for the very first time in history."

LESSONS LEARNED

After each landmark catastrophe, the industry learns new lessons and tries to improve on its practices.

The lesson from Andrew, for instance, was that a number of personal-lines insurers needed to spread their risk more and reinsure more, Baglini says.

After Sept. 11, "the wakeup call there was that there was the possibility of a clash event, one that causes many types of insurance to be involved in the same loss-causing event," he says.

With Katrina, the industry is still in the early days of trying to sort out the claims and analyze its modeling and underwriting practices.

"As insurance companies have experienced these hurricanes, they have realized that even though they have tried to control their accumulations, that the technology they've used to make decisions really hasn't been effective, so they are on a lot more risk than they thought they were; so their losses are higher than they expected," Baglini says.

Commercial insurers will not be able to solve their problems simply by adding an exclusion for floods, Costner says.

"What we're showing here now is if you have a Katrina, you're going to get losses from many perils," Costner says. "So maybe the thinking that you can put on a flood exclusion and avoid the losses is now obsolete."

Katrina may not send shock waves through the industry the way Andrew did. But it still will be remembered for a long time.

"This is something you will find most people in the industry talking about for some time to come," Aon's Davis says.

PATRICIA VOWINKEL is a frequent contributor to Risk & Insurance®.

October 15, 2005

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