Opinion: The US cat market’s fundamental structural challenge
All through the year, I have been chronicling the travails of the cat market.
After the winter freeze, I wrote about the latent risk in the system resulting from the lack of a grasp that the market has on the exposures it is writing, as has become evident from the succession of negative surprises around everything from California wildfires to typhoons and, most recently, US winter storms.
And after Hurricane Ida, I asked whether this unappreciated and unpriced for risk would lead to a bonfire of PMLs at cat writers (something which looks like it may now be unevenly playing out).
I want to develop these arguments somewhat today, and to present a fresh thesis explaining why the cat market is even worse than you think.
Escalating loss costs are clearly a major problem, and one which will leave the cat market shooting at a moving target.
But this issue is severely aggravated by an additional structural problem in the US: the constraint on the operation of the market resulting from regulatory oversight.
This impacts the ability of insurers to respond to the dynamic loss environment in cat in three ways.
First, it prevents them in key states, including California, from dropping clients as quickly as they would want.
Second, the rate-filing system constrains their ability to move pricing up as rapidly as required.
And third, the same framework places a politically motivated cap on absolute rates, constraining the amount of money that comes into system.
In another industry, you could imagine these kind of price controls being operated in a way that is at least somewhat sympathetic to the needs of private enterprises to deliver returns to shareholders.
But P&C insurance is a disliked industry at best, and a hated one at worst.
Supporting an unpopular part of the financial services sector at the expense of the little guy – whether it be homeowners or small businesses – is unlikely to become a widespread stance.
Climate change may arm insurers with a new argument in their rate filings, but the politics of this means they are always likely to be trying to push water uphill.
The inability of the primary admitted market to respond commercially to the threat creates a problem throughout the value chain because there is only one ultimate source of premiums.
At an industry level, the US commercial and personal lines markets deliver only modest underwriting profits (if any at all), and with investment yields depressed the industry does not consistently earn its cost of capital.
Thin margins will make it challenging for primary writers to absorb a significant increase in reinsurance pricing. When you are reliant on your customers for your access to premium flows, you can’t kill them with pricing.
It is not hard to argue that catastrophe risk is underpriced right now. But one of the typical arguments of (re)insurers around their ability to respond to adverse trends – and why their model can thus be considered resilient in the face of climate change – is that contracts are repriced annually.
If there are indeed structural constraints around pricing that they will be unable to address, then the problem the market faces is worse than is fully appreciated.
Non-climate-change loss-cost amplifiers
The contribution of climate change to elevated loss activity has been heavily covered elsewhere, with key drivers including increased storm frequency, wetter storms and greater severity in secondary perils like wildfire.
And setting aside what are likely to be relatively short-term loss drivers resulting from supply chain disruption (which could be worth 15%-25% this year), there are three long-term trends in the US that will exacerbate losses.
First, the US has chronically under-invested in its infrastructure, causing or amplifying a number of major cat losses.
A significant proportion of the loss activity from wildfires in California reflects under-investment in maintaining the electricity transmission and distribution lines owned by companies like PG&E.
Other losses have mushroomed as a result of failing infrastructure, most tragically in the case of Hurricane Katrina where New Orleans flood levies failed, but also in the case of this year’s deep freeze in Texas where the power grid’s collapse inflated claims.
The Biden administration finally succeeded in getting an infrastructure bill signed into law earlier this week, although the $1.25tn package is a long way short of the initial $3tn ambition, owing to difficulties in securing Congressional support for a more ambitious deal.
This money may help as it comes on tap, but there are questions about whether it is too little, too late, with the American Society of Civil Engineers suggesting that $2.6tn of investment is needed over the next decade to catch up the ground lost over the preceding decades.
Second, there is scope for some aspects of Florida-type behavior around claims to spread to other states, penalizing the cat market with a form of social inflation.
The Florida market has been highly challenging to write in recent years, not only owing to the frequency of loss events, but also due to a combination of unscrupulous claimants, an aggressive plaintiff bar and sympathetic juries.
These factors have been most pronounced in Florida, and there are exceptional factors at play in the Sunshine State, but the rest of the country is not immune and an intensification of such trends elsewhere over time does not seem unlikely.
Third, there is a continued tendency for property development to pay insufficient attention to catastrophe risk, resulting in increased concentrations of value in places where you would not want them.
Modelling firm AIR Worldwide found in a January report that coastal property values in the period 2012-18 increased by 27% on average, with around 50 million people living in counties along the Atlantic and Gulf coasts.
It noted that the combined annual growth rate of exposures over the last decade had been 4%, and if this continued it would equate to a doubling of 2012 coastal exposures by 2030.
The case for skepticism
All in, the case for skepticism around running a significant cat bet seems increasingly compelling, and given investor distaste for volatility, it seems likely to be an area where management teams will come under substantial pressure over time.