Reinsurance risks banking style meltdown

The $575bn industry that protects insurers from earthquakes, hurricanes and other disasters risks a banking-style meltdown if it continues making "dangerous" changes to how it is structured, new research has found.

After a three-year study of the reinsurance sector, a team of business school academics has found that some companies are now packaging together catastrophe risks in a similar way to the carving up of subprime mortgages by big banks before the financial crisis.

As a result, the victims of a costly catastrophe - such as an earthquake or storm that destroys large areas - could run into problems having their insurance claims paid.

Professor Paula Jarzabkowski of Cass Business School, one of the researchers, said mainstream insurers were potentially spreading risks to parties that did not fully understand them.

Many have been increasingly turning to pension funds and other capital markets investors - by issuing securities such as catastrophe bonds - as an alterative to traditional reinsurance.

But Prof Jarzabkowski warned that these insurance companies were in danger of not being covered as well as they believed if an especially costly disaster, such as an earthquake hitting California, were to strike.

"If these instruments work as insurers hope, they can alleviate a lot of hardship and suffering," she said. "If they don't, societies are exposed to having less capacity to rebuild in the wake of a disaster."

In a book to be launched this week, Prof Jarzabkowski and two fellow business school academics suggest that the market has become over-reliant on catastrophe models to assess the risks - and could freeze following a catastrophe.

In Making a Market for Acts of God, the authors warn: "As other financial industries have collapsed, in part through their reliance on inaccurate models, so, too, reinsurance places itself at risk of collapse."

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In the book, the authors say insurers have been increasingly transferring risks through complex "bundled" reinsurance arrangements.

"Bundled deals obscure the underlying risks on which they are based," the book says. "Such shifts in the underlying basis of a deal bear resemblance to changes that were linked to the subprime mortgage crisis of 2008."

However, the book also says the increased supply of capital could have some benefits, in helping to address the problem of underinsurance, which is especially acute in developing countries.

The earthquake in Nepal at the weekend is estimated to have caused between $2.8bn and $4.5bn worth of damage, but insurers are expected to cover less than $100m, according to the disaster analysis group CEDIM.

Last year, the World Bank issued its first catastrophe bond to provide earthquake and hurricane coverage for a group of 16 Caribbean island nations. In general, insurance-linked securities have been largely confined to developed countries.

Investors have been buying them at a record pace. Another $1.5bn worth of non-life catastrophe bonds were issued in the first quarter of the year, bringing the total outstanding to $21bn, according to a report to be published on Wednesday by the broker Willis Re.

However, so far only a handful of catastrophe bonds have paid out for insurers. They tend to be triggered only when an especially devastating event, such as that expected to occur once every 200 years, strikes.

Prof Jarzabkowski said insurers were becoming more reliant on short-term deals with investors such as hedge funds with whom they did not have close relationships, and which allocate only a small proportion of their assets to the sector.

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