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Addressing the Underinsurance Gap in Natural Disaster Coverage

May 14, 2024

In a hardened market, traditional reinsurance faces challenges from other non-traditional sources.  Understand the changing dynamics, challenges, and possible solutions to maintain adequate surplus.

Natural disasters are becoming more frequent and severe due to climate change, urbanization, and population growth. According to the Swiss Re Institute, global economic losses from natural catastrophes amounted to $202 billion in 2020, of which only $89 billion were insured. This means that the global protection gap, or the difference between economic and insured losses, reached $113 billion, or 56% of the total losses.

This underinsurance gap poses a serious challenge for the insurance industry, as it exposes insurers to higher volatility and potential insolvency in the event of a major catastrophe. Insurers rely on reinsurance to transfer some of their risks and protect their balance sheets, but reinsurance capacity and pricing are subject to market cycles and fluctuations. 

In this blog, we will explore some of the factors that affect the availability and affordability of reinsurance for natural disaster coverage and some of the possible solutions to address the underinsurance gap.

Reinsurance Market Dynamics 

While reinsurance can help insurers reduce their capital requirements, diversify their risks, stabilize their earnings, and access new markets and products, it’s not a limitless or cheap source of capital, and insurers have to compete with each other and with other sectors, such as alternative capital providers, for reinsurance capacity.

The reinsurance market is cyclical, alternating between periods of soft and hard markets. While a soft market is characterized by abundant capacity, low prices, and relaxed terms and conditions, a hard market is characterized by scarce capacity, high prices, and strict terms and conditions. 

Like the general insurance market, the reinsurance cycle is influenced by several factors, such as the frequency and severity of losses, the availability of capital, the demand for coverage, the regulatory environment, and the competitive landscape.

In recent years, the reinsurance market has been experiencing a hardening trend driven by the accumulation of losses from natural catastrophes, such as hurricanes, wildfires, floods, and earthquakes. According to Aon, the global insured losses from natural catastrophes totaled $268 billion between 2017 and 2020, which is 40% higher than the average of the previous 16 years. These losses have eroded the profitability and capitalization of reinsurers, forcing them to increase their prices and tighten their underwriting standards.

Another factor that has contributed to the hardening of the reinsurance market is the emergence and growth of alternative capital, such as catastrophe bonds, collateralized reinsurance, and industry loss warranties. 

Alternative capital is a form of risk transfer that does not involve traditional reinsurers but rather institutional investors, such as pension funds, hedge funds, and private equity firms, who are willing to assume insurance risks for higher returns. 

Alternative capital has increased the supply and competition in the reinsurance market, especially for peak risks, such as US hurricanes and earthquakes, but it has also increased the volatility and uncertainty, as alternative capital providers can withdraw or redeploy their capital more quickly and flexibly than traditional reinsurers.

Challenges for Insurers

The hardening of the reinsurance market poses several challenges for insurers who seek to obtain adequate and affordable reinsurance for their natural disaster exposures. Some of these challenges are:

1. Limited Capacity

Reinsurers may have less capacity or appetite to offer reinsurance for certain regions, perils, or lines of business due to their own risk appetite, capital constraints, or regulatory requirements. This may force insurers to retain more risk on their own balance sheets or to seek alternative sources of capital, which may be more expensive or less reliable. 

2. Increased Prices

Reinsurers may charge higher premiums or commissions to reflect the increased risk and cost of capital, as well as to recover their past losses and improve their future profitability. This may reduce the profitability and competitiveness of insurers, who may have to pass on the higher costs to their policyholders or accept lower margins.  

3. Tighter Terms and Conditions

Reinsurers may impose stricter terms and conditions on their reinsurance contracts, such as higher deductibles, lower limits, more exclusions, or more stringent reporting and claims handling requirements. This may reduce the coverage and protection that insurers receive from their reinsurance arrangements and increase their operational and compliance costs.

4. Reduced Flexibility

Reinsurers may offer less flexibility and customization to their reinsurance clients, such as multi-year contracts, aggregate covers, or reinstatement provisions. This may limit the options and solutions that insurers have to manage their risks and optimize their capital efficiency. 

Possible Solutions to Address Underinsurance Gap

To address the underinsurance gap in natural disaster coverage, insurers and reinsurers need to work together to find innovative and sustainable solutions that can enhance the resilience and affordability of insurance for individuals, businesses, and society. Some of these solutions are:

1. Improving Risk Modeling and Data Quality  

Insurers and reinsurers need to invest in improving their risk modeling and data quality to better understand and quantify their natural disaster exposures and potential losses. This can help them to price their risks more accurately, allocate their capital more efficiently, and design their reinsurance programs more effectively.

2. Expanding Alternative Capital 

Insurers and reinsurers need to explore and expand the use of alternative capital to diversify their sources of risk transfer and increase their capacity and flexibility. Alternative capital can also help to lower the cost of reinsurance by providing cheaper and more abundant capital and narrow the protection gap by offering coverage for previously uninsured or underinsured risks.

3. Developing New Products and Markets 

Insurers and reinsurers need to develop new products and markets to meet the evolving and unmet needs of their customers and society. For example, they can offer parametric insurance, which pays out based on predefined triggers, such as wind speed or rainfall, rather than actual losses. Parametric insurance can provide faster and simpler claims settlement, lower administrative costs, and greater transparency and certainty for both insurers and policyholders. 

4. Enhancing Risk Mitigation and Prevention

Insurers and reinsurers need to enhance their risk mitigation and prevention efforts to reduce the frequency and severity of natural disaster losses and improve the insurability and sustainability of their risks. For example, they can provide incentives, guidance, and support to their customers and stakeholders to implement measures such as building codes, land use planning, early warning systems, and disaster preparedness and response.  

5. Collaborating with Public Sector and Society 

Insurers and reinsurers need to collaborate with the public sector and society to create a more resilient and inclusive insurance system for natural disasters. For example, they can participate in public-private partnerships, such as national or regional catastrophe pools or funds, which can provide a framework for sharing and pooling risks, resources, and responsibilities among insurers, reinsurers, governments, and other parties.

Ensure Future Resilience for Natural Disasters 

Natural disasters are a major source of risk and opportunity for the insurance industry, as they pose significant challenges for insurers and reinsurers, but also create a huge potential for growth and innovation. The underinsurance gap in natural disaster coverage is a complex and multifaceted problem, that requires a holistic and collaborative approach from all stakeholders. 

By improving their risk management, expanding their risk transfer, developing their products and markets, enhancing their risk mitigation, and collaborating with the public sector and society, insurers and reinsurers can address the underinsurance gap and provide more resilient and affordable insurance for natural disasters.

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Julien Victor
Managing Director, Reinsurance Management
For the past 25 years, Julien has successfully developed and implemented the reinsurance offering of Effisoft (WebXL product), as the CEO of the company, which was eventually sold to Prima Solutions and renamed Prima XL. Before joining Effisoft, Julien was a Junior Marine Underwriter on the London market, as well as a consultant for Deloitte. He joins Duck Creek as Managing Director, following the company’s acquisition of Prima XL in July 2022.