Hurricane Katrina: Impact on Bermuda - Essay Example

Running Head: HURRICANE KATRINA Hurricane Katrina Impact on Bermuda & International Insurance Markets Academia Natural calamities are not in the hands of mortals. However, controlling the aftermath trauma is the responsibility of survivors. Monetary compensation is never a replacement for the loss of human life and property. With tools available to convert losses into monetary terms, the people left to continue with their lives can find some relief from the miseries otherwise he or she have to undergo. Insurance is the most time-tested and accepted instrument to its fulfillment. Hurricane Katrina is so far the worst in insurance outgoes. Gross property loss in the year 2005 is estimated to be $ 83 billion. Though mired in legal tangles, insurers have paid up a large section of the affected thus mitigating their hardships to some extent. Some of the arguments looks very brazen such as damages caused by breaching of the levees does not come under the category of tornadoes though it is a well known fact that breaching happened due to water surges caused by hurricane Katrina. Under the circumstances the state has to interfere to ameliorate the sufferers of levees breach since they cannot wash their hands off for the breaching. There is also the need to restructure and reposition the insurance market to meet bigger and more devastating calamities, which is a certainty due to changing global environments. Impact of Hurricane Katrina on Bermuda and International Insurance Markets Introduction Insurance is described as a precautionary hedging instrument against likely future losses. It is used for managing the possible risks of the future, which may or may not take place. Thus, through insurance, a person buys future happiness and smooth living. According to Oxford Dictionary Insurance is a contract undertaking to provide financial compensation for loss or damage or injury etc., in return for a payment made in advance once or regularly. Though loss of life or injuries cannot be measured in financial terms, still, in this materialistic world it is quantifiable and tries to compensate the potential future loss financially. Today insurance industry is one of the largest industry sectors in the world and is three times the size of the oil industry in terms of revenue generated. The roots of insurance might be traced to Babylonia, where traders were encouraged to assume the risks of the caravan trade through loans that were repaid only after the goods had arrived safely (Hammarabi, 1795 – 50 BC) 1, a practice resembling bottomry, the ancient maritime law where money is lent to a trader at lenders risk. The concept of insurance evolved through the centuries in Europe and later in the United States. Insurance developed rapidly with the growth of British imperialism in the 17th and 18th century 2. The New York fire of 1835 highlighted the need for adequate reserves to meet unexpected large losses. Since the late 19th century there is a tendency for the states to enter the field of insurance, especially in the social sectors. Insurance products are developed according to the need, situation, circumstances and social commitments. All insurances, however, can be broadly divided into: Consumer Insurance generally consists of home and its contents both animate and inanimate, equipments including transport and compulsory third party covers and Life insurance that covers all personal aspects such as death compensation, illnesses, disability, etc. Some Life insurance products also work as an instrument of saving and investment. Business Insurance takes care of business assets including capital and revenue generation, liability arising from business activities and profession or injury and damage to property and protection against loss arising from accidents. Some insurance that are pertinent to our topic are: Property Loss Insurance. This is an all-risk insurance and the most expansive form of coverage, with typical exclusions for nuclear accident, pollution, flood and earthquake, which are obtainable by additional endorsement and premium. Commercial General Liability Insurance (CGL). This includes recoverable physical injury to a person, such as sickness, disease, and physical injury. It also covers loss from death. Modern CGL policies are quoted in terms of combined aggregate limits for bodily injury and property damage with separate limits for automobile coverage and other endorsements. Reinsurance is an arrangement in which a company, the reinsurer, agrees to indemnify a primary insurance company against all or a portion of the primary insurance risks underwritten by the ceding company. The reinsurance practice is close to the insurance practice. Reinsurance can provide a ceding company with several benefits, including a reduction in net liability on individual risks and catastrophe protection from large or multiple losses. Reinsurance also provides a ceding company with additional underwriting capacity by permitting it to accept larger risks and write more business than would be possible without a concomitant increase in capital. Reinsurance, however, does not discharge the ceding company from its liability to policyholders. Reinsurers themselves may feel the need to transfer some of the risks concerned to other reinsurers, in a procedure known as ‘retrocession’. Hedge funds generally have exposure to reinsurance companies in one or two ways (Cooney, 2005) 3. Either they make equity investments in publicly traded reinsurance companies, or set up their own reinsurance operations. Hedge funds are attracted to reinsurance business because natural calamities are random occurrences and not linked with economic vagaries that other financial markets undergo. The Calamity The innocent sounding word Katrina derived from the Greek word "katharos", which means "pure", is the short form of the feminine name Katherine. How such a naïve name was given to such a horrendous hurricane is only academic. Hurricane Katrina 4, which hit the US on 29 August 2005 accounts 1,300 people killed, thousands displaced and billions worth of property destroyed. Aftermath of Katrina The insurance cost of Katrina is estimated to be more than $40 billion, the largest single insurance loss ever recorded. Global insured property losses for 2005 is estimated at $83 billion of which about $72.6 billion is attributed to North America alone (Priebe, 2006) 5. Approximately half of these global losses was borne by the reinsurance industry, which had not recovered from 2004 aftershocks. Hedge Funds have made sizable investments as specialty reinsurers in Bermuda and will be affected by the loss from Katrina. Companies involved in property reinsurance, especially those focused on catastrophe reinsurance will definitely get the hit. One of the most complex aspects of resolving claims from Katrina lies in the detail and the scope of the claims. Many claimants thought they were covered, while insurance firms said they were not. Arguments have often hinged on whether destruction to a property was caused by wind or flood damage. Ultimately, insurance remains an imprecise science based on risk assessment. Cases filed by homeowners against their insurance companies after Hurricane Katrina are still pending with federal courts (Courts, 2007) 6. Those suing say they did not get enough money to cover the damage to their houses. But the insurance companies maintain they have settled almost all Katrina claims and that their offers were fair and categorize the complainants a disgruntled minority. Some say that more than 98 percent of its claims have been settled. "That doesnt mean people are happy, that means people took a check," said New Orleans Attorney Allan Kanner. Another negative is that most of the hurricane victims may feel they should just get over it and move ahead in life. Local community feels that the litigants are a greedy lot and fear it may end up in enhanced premiums. According to Insurance Information Institute 537 lawsuits were pending against insurers as on July 27, 2007. Another 174 went into mediation and 84 of them got settled. Natural disasters have two adverse economic impacts. Besides destroying property it disrupts the economic activities. While the effect of property destruction is long-term the disruption in economic activity has instant consequences. During restoration stage the flow of income will be boosted because of reconstruction activities. The economic effect of property losses results in increased consumption of fixed capital and raw materials supported with transfer payments from insurances. Uninsured losses will piggy ride consumption of fixed capital but with reduced transfer payments to compensate. It is difficult to fathom the after effects of Hurricane Katrina had the Bermuda insurance and reinsurance industry were not there to pay out over $17 billion in claims. Families and business owners have literally rebuilt their livelihood from this insurance. Impact of Bermuda Based Insurers and Reinsurers on US Economy Insurance cannot eliminate the risk, but it prevents the economy from paralyzing (GSP, 2007) 7. Risks taking are part of entrepreneurship and insurance backs up this through the security it provides. World over insurance has become an ingrained feature of economic activity. In the aftermath of 9/11 banks refuse to lend money for new constructions in major cities without the terrorism insurance policies. From $187.9 billion in 1990 insurance industry grew to $593 billion in 2005 and is the 12th largest industry in the United States. Bermuda insurers, especially the reinsurers, have helped stabilize the US economy when affected by natural disasters, terrorist’s attacks and other external disruptions. They accounted for $15.5 billion in 2002 and $28.1 billion in 2005. Table 1 Growth of Bermuda Insurance Industry in the US Gross Output by Industry[Billions $] 2002 2003 2004 2005 U.S. Insurance Co. and related activities $ 458.9 $ 498.7 $ 569.6 $ 593.0 Bermuda share of Net Premiums 3.4 percent 4.4 percent 4.7 percent 4.7 percent Bermuda share of U.S. Insurance GDP $ 15.5 $ 22.0 $ 26.8 $ 28.1 Source: Bureau of Economic Analysis, Gross-Domestic-Product-by-Industry Accounts, Insurance Information Institute and IBNR Weekly, #26, Vol. XIV, June 28, 2007. Dowling and Partners. These Bermuda-backed claim payments cast a soothing effect on calamity property losses and helped large number of Americans rebuild their lives. They arrive not just in emergencies but play an active role in the economic health on a continuous basis. These companies generate a significant volume of commercial and business activities throughout the US as given below: Bermuda firms employ approximately 9,600 Americans directly in the United States and indirectly generate an additional 95,045 jobs. Bermuda insurers provided enough funds to replace 87,042 homes including 45,419 homes in Louisiana and more than 24,000 homes in Mississippi. Following Hurricane Katrina, the claims paid by Bermuda insurers helped 14,170 people return to work as employment recovered in 2006. Provide 40 percent of the hurricane and earthquake reinsurance in the US. Bermudians controls 26 percent of the total U.S. reinsurance markets. They generate as much as $ 96 billion of the gross output for the U.S. insurance markets. Underwrite 57 percent of the total US crop insurance and reinsurance markets. As in any developed countries, insurance industry plays a key role in the economy of the United States. In addition to a stable source of employment, the industry provides products and services that protect businesses and individuals from natural disaster losses. These risk management products directly support the growth of US businesses, most of which could not operate without insurance cover. The assets of the insurance firm besides being a risk-mitigate also offer itself as low cost business finance. They also help primary insurers to distribute the risk on their policies by reinsurance support during unforeseen heavy payouts. As given in Table 2 below Bermuda domiciled firms accounted for nearly 28 percent of the total US reinsurance market in 2006. They are market leaders in hurricane and earthquake coverage and enjoy 40 percent of the US market. Table 2: Bermudas Role in Reinsurance Total U.S. Premiums Ceded ($ In Millions) Domicile 2001 2002 2003 2004 2005 2006 Bermuda $ 14,955 $ 16,018 $ 21,266 $ 24,826 $ 27,498 $ 27,456 United States $ 41,629 $ 48,036 $ 47,496 $ 42,685 $ 42,404 $ 42,948 All Others $ 22,362 $ 30,151 $ 32,243 $ 29,096 $ 34,564 $ 27,228 GRAND TOTAL $ 78,946 $ 94,205 $101,005 $ 96,607 $104,466 $ 97,632 Source: Reinsurance Association of America From 1989 to 2005 catastrophes in the U S caused more than $450 billion in property losses. Thanks to the insurance industry, overall economy maintained a positive growth through that entire period. The insurance industry ensured that the economy continues to grow despite interruptions. The economic downturn of the early 1990s was attributable to economic factors and not nature’s vagaries. Insurance absorbed the damages and kept growth on course during the rest of the decade. It was in 2001 that 9/11 and other economic forces combined to derail the economy. By 2004-05 the economy was back on track when natural catastrophes in the form of massive hurricanes made a slight dent. The 2005 Hurricane season was unprecedented in the sheer size of its impact. In a jiffy more than $66 billion disappeared into thin air. Insurance payouts helped people to rebuild and get back to normal life mitigating much of the trauma. It should be noted that Bermuda insurance firms paid almost $17 billion in claims, which is more than 25% of the total property damage, a very significant slice. The impact of the catastrophes was more visible on economic growth of catastrophe-affected states as given below: Table 3: Catastrophes and State Economic Growth Annual Percent Change in Gross Domestic Product State 1999-2000 Recession 2002-03 2003-04 2004-05 2005-06 2000-01 2001-02 United States 6 percent 3 percent 3 percent 5 percent 7 percent 6 percent 6 percent Alabama 2 percent 4 percent Drought 4 percent 5 percent 9 percent 7 percent 6 percent Katrina, Wilma, Rita Arkansas 2 percent Tornadoes 3 percent Drought 5 percent 5 percent 8 percent 6 percent 6 percent Katrina, Wilma, Rita California 9 percent 1 percent 3 percent 5 percent Fires 8 percent Fires 7 percent 7 percent Florida 6 percent 6 percent Drought 5 percent Allison 7 percent 9 percent 10 percent Charley, Ivan, Jeanne, Frances 7 percent Katrina, Wilma, Rita Louisiana 6 percent 2 percent Drought 0 percent Allison 9 percent 11 percent 11 percent Ivan 7 percent Katrina, Wilma, Rita Mississippi 2 percent 3 percent Drought 3 percent Allison 6 percent 6 percent 4 percent Ivan 6 percent Katrina, Wilma, Rita New York 6 percent Floyd 4 percent 2 percent Sep 11 3 percent 7 percent Isabel 6 percent 6 percent It will be seen from above Table that tornados and drought affected Arkansas growth in 1999-2001. California’s growth from 9 percent in 1999 to 1 percent in 2001 was the result of technology meltdown. Economic cycles and natural disasters took the combined toll on Louisiana and Mississippi when drought and hurricanes coincided with the end of the IT boom in 2000-02 and the post-9/11 recession. On the whole these natural disasters had very little impact even on the directly affected states because of the inherent resilience of the U.S. economy and an effective insurance safety net. The Levees There were all indications that New Orleans was going to be hurt very badly (Kunreuther,2007) 8. The Times-Picayune got a Pulitzer Prize for their articles on this subject. One of the characteristic failures of the flood defense system in New Orleans occurred at the 17th Street Canal when the concrete wall and its extended sheet piles got flushed away by horizontal sliding. Euphemistically, in 1953 when Zeeland in Netherlands was devastated by a flood calamity the Dutch visited Louisiana to study the levees built along the Mississippi River in the 1920s and 30s (BBC, 2007) 9. Reversing the historical roles a delegation led by Louisiana Governor visited Zeeland province in the Netherlands in January 2006 to understand how Netherlands has taken up their challenge. Thousands of people, forced out of New Orleans by Hurricane Katrina, may not be insured for the damage to their homes. Standard US household insurance policies do not cover flood damage. Instead, homeowners have to buy a second policy through the National Flood Insurance Program to cover floods. Only 46 per cent of New Orleans householders had purchased that. In a surprise ruling in Sept 07, a three-judge panel of the U.S. Fifth Circuit Court of Appeals ruled that homeowners, renters and commercial-property policies do not cover damage caused by levee breaks (Goliath, 2007) 10. The appellate court overturned an earlier decision by U.S. District Judge in November 06 who had accepted that flood damage exclusions in the policies were ambiguous and should therefore be resolved in favor the homeowners. The Appellate court ruled that the term "flood" may be read only to refer to a natural event and not the result of human errors in the construction and maintenance of the levees. This ruling brings a windfall worth hundreds of millions of dollars to insurers covering Hurricane Katrina damages. The states may be forced to step in to cover the losses on peoples homes. Its lack of planning and monitoring has been blamed for the extent of the damage to New Orleans. The PXre Fiasco PXre, was a Bermuda based reinsurance company with a worldwide presence in reinsurance products and services primary focused on providing property catastrophe reinsurance and retrocession coverage. The Company misrepresented the magnitude of the losses caused by hurricanes Katrina, Rita and Wilma in 2005. Their Executives allegedly made a series of materially false and misleading statements or omissions about PXre’s business, prospects and operations during 2005-06 thereby enticing investors to purchase PXre’s securities at artificially inflated prices in violation of regulations. The consequent litigation led the company into deep financial crises and in March 2007 it merged with Argonaut Group, another Bermuda based insurance company. Thus a youthful 22-year-old company doing successful business in insurance industry became a casualty of Katrina’s reverberation. The Future The availability of property insurance in coastal counties along the east coast from Florida to Cape Cod and the cost of coverage have become grave concerns as insurers pulled out from high-risk areas to reduce potential hurricane losses. According to the Insurance Information Institute, from 1993 to 2003 the rate of return on net worth for all U.S. homeowner insurers was 2.8 percent, compared to 25 percent for Florida homeowner insurers. But when the years 2004 and 2005 are added, the picture is reversed. Over the period 1990-2006, the rate of return for U.S. homeowners’ insurances averaged minus 0.7 percent. For Florida insurances it averaged minus 38.1 percent despite 2006 being a profitable year. As per regulations profits from another state cannot be used to subsidize rates elsewhere as rates charged must be based exclusively on past trends and expected future losses of that state. Profits in an industry like insurance must be seen over the long term. A single hurricane or a string of large losses can wipe out profits from previous years or even decades. Kunreuther of Wharton University says that no one wants to think about these disasters until after they occur and this was the case with Katrina also. He suggests house owners take a protective cover that cost a couple of thousand dollars. However they feel that they are not going to occupy the dwelling for long, which has all the trappings of ‘ill affordability’. "I live from payday to payday" is the common refrain. But one should understand that when they take that measure they are really reducing the risk. Anyway they are required to buy insurance on the wind portion and for an additional endorsement on the flood portion for hurricanes they should be rewarded a premium discount. A study by the Institute for Business and Home Safety (IBHS) on losses in the area hit hardest by Hurricane Charley in 2004 found that homes built after 1996 suffered less damage than homes built earlier when building codes were not so stringent, underlining the importance of enacting and enforcing strong building codes and strengthening older homes through retrofitting. According to data from the claims analysis, homes built before 1996 suffered an average loss of $24 per square foot compared to $14 per square foot for homes built between 1996 and 2004. Despite steps that governments and insurers have taken in recent years to strengthen insurer capacity for catastrophe risk, the industry has not been tested by a major catastrophic event or series of events with $50 billion or more in insured losses (GAO, 2005) 11. While insurers suffered losses of over $20 billion in Florida from the 2004 hurricanes, steps such as implementing stronger building codes and stricter underwriting standards may have limited market disruptions as compared with the aftermath of Hurricane Andrew in 1992. For example, in 2004, only 1 Florida insurance company failed in contrast to the 11 that failed after Hurricane Andrew. However, a more severe catastrophe or series of events could severely disrupt insurance markets and impose recovery costs on governments, businesses, and individuals. Insurance Capacity Development According to a US Government Report (Report, 2005) 12 Bermuda reinsurance capacity has expanded in the aftermath of Hurricane Andrew in 2004, said that the growth of the Bermuda reinsurance market since 1989 has enhanced the industry’s capacity to withstand natural catastrophes. According to an industry report, many reinsurance companies specialized in catastrophe risk were incorporated in Bermuda after Hurricane Andrew in 1992 and 9/ 11 attacks to take advantage of the high global premium rates for catastrophe coverage. Bermuda’s favorable tax environment with no corporate income or capital gains taxes, a flexible regulatory environment where companies can be easily incorporated and availability of insurance professionals have contributed to the growth of its insurance market. Bermuda reinsurers currently provide about of 50 percent of all Florida reinsurance significantly contributing to the worldwide growth of reinsurance market. Conclusion The specialization of Bermuda firms in reinsurance is a critical in the overall interlocking system of risk management that sustains economic growth in the world today. Insurance and reinsurance are not static tools but integral parts of a flexible system that has allowed the U S economy to recover from serious calamities over the past few years with minimal economic disruption. The insurance industry is a primary economic mixer in the flow of capital that sustains the economy. It functions like a normal financial sector, but in times of crisis, it interferes in restoration of the economy. Experts predict that worse storms and more expensive natural disasters are likely to occur in the future and the industry should be ready to meet such eventualities. Appendix ‘A’ Some Popular Views “Floridians are pummeled on a regular basis by hurricanes. We know full well the support our insurance market receives from Bermuda insurers and reinsurers. These companies supplied critically important capital to our region when we were hit with the terrible storms of 2005 -- Katrina, Rita and Wilma. In Florida, they alone paid enough to rebuild more than 12,000 homes. We need these carriers and their capacity – they write business other insurers don’t want to write.” Rep. Don Brown, Chair, Insurance Committee, State Representative, Florida House of Representatives “American jobs supported by non US companies that invest heavily in the United States are often overlooked. Bermuda-based insurers and reinsurers directly employ nearly 10,000 people in the United States. In addition to jobs, the insurance claims payments that come from these companies – an estimated $17 billion in 2005 for catastrophic loss claims alone --also make an important contribution to the U.S. economy.” Todd M. Malan, President & CEO, Organization for International Investment (OFII), an association of U.S. subsidiaries of companies headquartered abroad. “Louisiana needs insurance capital to protect against future hurricane losses. Bermuda’s reinsurers paid approximately $3.9 billion in Louisiana residential property losses from Hurricane Katrina. In addition, their commercial property and business interruption claim payments contributed about $4.7 billion to help return our employees to work and rebuild our economy. Coastal states are dependent on capital from all over the world to protect our people – Bermuda insurers provide a big share of that needed capital.” Jim Donelon, Commissioner of Insurance, State of Louisiana Appendix ‘B’ Hurricane Katrina Over Gulf of Mexico August 29th 2005 - Satellite Image, Hurricane Katrina References Cited BBC, “Louisiana Studies Dutch Dams”, Perro de Jong, Story from BBC NEWS: Published: 2006/01/13 11:43:28 GMT © BBC MMVIII retrieved from: http://news.bbc.co.uk/go/pr/fr/-/1/hi/world/europe/4607452.stm accessed March 28, 2008. Cooney Bob, “How Katrina May Hurt Hedge Funds”. Chairman, President and CEO of Max Re Capital. August 30, 2005 by Amanda Cantrell, CNN/Money staff. Retrieved from: http://money.cnn.com/2005/08/30/markets/hedgefunds_katrina/index.htm accessed March 28, 2008. GAO “Catastrophe Risk - U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks” Report to the Chairman, Committee on Financial Services, House of Representatives February 2005. GAO-05-199. Retrieved from: www.gao.gov/cgi-bin/getrpt?GAO-05-199 accessed on March 28, 2008. Goliath “Insurers Win Major Katrina Flood Ruling”. September 01, 2007. Retrieved from: http://goliath.ecnext.com/coms2/gi_0199-7276850/Insurers-win-major-Katrina-flood.html accessed March 28, 2008. GSP Consulting Corp November 2007 “Analysis of the US Economic Impact of Bermuda Based Insurers and Reinsurers”. Retrieved from: http://www.abir.bm/downloads/ABIREconomicImpact.pdf accessed on March 28, 2008. Hammarabi, The Code of Hammarabi, 1780 BC, Internet Ancient History Source Book, The Ancient Near East, Mesopotamia. Retrieved from: http://www.fordham.edu/halsall/ancient/hamcode.html accessed March 28, 2008. HighBeam Encyclopedia: Insurers win major Katrina flood ruling. Insurers win major Katrina flood ruling. Retrieved from: http://www.encyclopedia.com/doc/1E1-insuranc.html accessed March 28,2008. Katrina & Recovery, Katrina Compensation Case Goes to Court, February 12, 2007 · Kunreuther, Michel Kerjan, 2007. “Strategies For Dealing With The Risks Of 9/11, Katrina, ...” Conversation With Wharton Experts. Published: September 27, 2006 in Knowledge@Wharton. Retrieved from: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1562&CFID=65480053&CFTOKEN=30704372&jsessionid=9a30d3c3af6e69649132 Priebe, David, 2006. “Mobile Capital Creates New Opportunities—and New Optimisms” Head of global specialty practices and chief executive officer of Guy Carpenter & Company, Ltd., Bermuda Reinsurance Web Site retrieved from: http://www.bermudareinsurancemagazine.com/nov06/article1.html accessed on March 28, 2008 Story from BBC NEWS. Published: 2006/08/28 08:28:50 GMT © BBC MMVIII Retrieved from: http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/5273974.stm accessed March 28,2008. Read More