Capital Market Solutions for Catastrophic Exposures in Canada
Steven McElhiney | November 9, 2009
Catastrophic (CAT) exposures are always on the front burner of any risk management program. The presumed low frequency, high severity event is why we buy insurance. Understanding what threatens your specific facility will enable you to make informed decisions on assumption, or risk transfer.
Canada is the world’s second largest nation by landmass. However, according to Statistics Canada, nearly 70% of the population centers are within 100-kilometers of the U.S. border in an area approximately 4% of the nation’s total landmass. (There is significant CAT exposure north of this area but the financial loss potential is much lower in comparison.)
CAT exposures in Canada encompass all the traditional classifications: earth movement, wind, and flood—most of which have happened in the last 24 months. This means the concentration of exposures around cities such as Quebec City, Montreal, Edmonton, Calgary, Toronto, Vancouver and Winnipeg create a unique potential for large losses.
Risks in Canada
Earthquakes
Financial losses from earthquake in Canada have, historically, been low. However, the potential for large loss events is real. Canada sits on the North American Tectonic Plate and is subdivided into 12 seismic zones. The majority of the seismic events that may threaten populated areas occur in the western Canada’s Offshore B.C. Region and Cascadia Subduction Zone (running directly against the Pacific and Juan De Fuca tectonic plates) and the eastern Canada Lower St. Lawrence and Charlevoix Seismic Zones (primarily Quebec).
This area is one of the few in the world where all three types of tectonic plate movements occur (plates can slide past one another, collide, or move apart). The Juan de Fuca Plate is moving towards the North American plate and sliding under it (subduction), moving away from the Pacific Plate and sliding along the smaller Explorer Plate to the north. Scientists at Earthquakes Canada believes the Juan de Fuca and North American Plates are locked together creating a build up of energy in the earth’s crust. The frictional energy released by the opposing forces is released in an earthquake. Geological evidence suggests this locking of the two plates occurs on a recurring basis and results in a Megathrust event approximately every 300 years (the last being in 1700 causing an estimated magnitude 9 earthquake as measured on the Richter scale). This tension also causes several hundred small quakes near British Columbia each year.
Canada’s eastern areas are located within the geologically stable portion of the North American Plate. Scientists don’t completely understand why the region is seismically active, but it is generally believed to be caused by weaknesses in the earth’s crust in these areas allowing regional stress fields to relieve pressure. Most of the seismic activity occurs in the Charlevoix and Lower St. Lawrence Seismic Zones with the highest number of events emanating under the St. Lawrence River.
Permafrost
Northern Canada has permafrost exposure that should be taken into consideration when analyzing earthquake risk in effected areas. Permafrost is soil normally at or below the freezing point of water for two or more consecutive years. Ice may be present at volumes exceeding the potential hydraulic saturation of the ground material.
The 2002 Denali, Alaska earthquake caused permafrost liquefaction near the Trans-Alaska Pipeline System causing lateral movement of the buried pipeline a number of feet. There was visible distortion and torsional twisting of equipment. Liquefaction was taken into account when the pipeline was designed and proved its worth as no leakage occurred during the 7.9 Richter scale event.
Tsunamis
Tsunamis are generally caused by underwater displacement of earth and are a threat whenever an earthquake occurs offshore. Canada has experienced seven known tsunamis on the east and west coasts beginning with the last great Megathrust of 1700. The most recent tsunami occurred in 1975 when an undersea landslide caused a tsunami at the Kitimat Inlet of northern British Columbia’s Douglas Channel. The greatest loss of life occurred in 1929 when a 7.2 magnitude offshore earthquake near Burin Peninsula, Newfoundland caused an offshore landslide resulting in a tsunami that wrecked the town of Lord’s Cove killing 27 people.
Canada is exposed to wind storms and have significant loss of life and property due to wind events. Since 1950, Atlantic tropical cyclones that make Canadian landfall have been a Category 2 storm or less as wind speeds (hurricanes and others) tend to weaken as they cross the 49th parallel. Widespread flooding and wind damage have resulted from these storms causing storm related deaths, agricultural losses and flood property loss.
Wind
Canadian inland windstorms are generally not as severe as those that occur in the U.S.
Tornadic activity peaks in August as warm tropic air meets colder Arctic fronts. Global warming may be changing this trend as an F-5 tornado (most severe) was recorded for the first time in 2007 near Elie, Manitoba.
Flood
The largest source of losses from CAT exposures in Canada continues to stem from flood. Generally, flooding is caused by snowmelt mixed with spring storms in areas where concentration of values is high. The potential for high severity events caused by earthquake exists and scientific data indicates such an event is probable.
Traditional Reinsurance Opportunities and Solutions
Given the backdrop of the various exposures that exist, there is longstanding international market capacity for Canadian catastrophic exposures from international reinsurers.
In terms of how much coverage ceding carriers buy and by way of severity, earthquake is the leading peril reinsured.
For reinsurers, the number one CAT exposure is earthquake in British Columbia followed by quake in the Quebec region.
However, in terms of frequency, wind and hail account for the majority of losses, particularly, in Western Central Canada— the Alberta, Saskatchewan and Manitoba regions.
Wildfires are a relatively new risk that reinsurers have to account for, especially in heavily populated areas. Fire has almost always traditionally been covered, but contracts are now including restrictions and hours clauses to help define whether a CAT loss has occurred. The highest risk for wind and hurricane losses is in the Nova Scotia region.
Traditional reinsurance is provided on either a pro-rata basis (to build individual account capacity and insurance company surplus relief) or on an excess of loss basis for the catastrophic aggregation exposures. In recent years reinsurers are getting away from writing as much pro-rata for CAT perils and are focusing more on excess of loss unless the contract is subject to an occurrence limit. This change is in part due to an increase in company retentions and the willingness of reinsurers to take on 100% of the loss above a certain dollar amount.
Use of CAT Bonds
A Catastrophe Bond, or “CAT” bond, is a securitized form of reinsurance that involves three key parties. The first is the ceding company (or sponsor). In turn, they will pay premiums into a Special Purpose Reinsurance Vehicle (“SPV”), the second party, created for the transaction. That SPV will hold a principal amount in trust that has been provided by external investors (the third party to the transaction). These investors will be paid a periodic return on the SPV investment (generally variable interest). There is potentially a need for a fourth party, a “swap counterparty” to address any fixed rate versus variable interest conversion needs.
These investments have grown significantly from $2.5 billion (CDN) in such securitizations in 2005 to over $13.0 billion in 2007. (The next year, 2008, led to a dramatic decline of just $4 billion of issuance, due to the financial crisis.) The investors in the bonds are global institutional investors and high-net-worth individuals. The bonds are increasingly desired due to their lack of correlation with the stock market.
Concept of Basis Risk
The “triggers” for reimbursement of losses can vary. The key triggers include industry indices; parametrics (based on certain event hurricane or earthquake events), or based on the indicated results of one of the key industry catastrophe models. Industry losses (such as the PCS index) can be problematic as the specific losses of any one company may not correlate precisely with the industry losses. This introduces the concept of “basis risk” (a company’s results are not well correlated with industry losses from an event) and is one of key criticisms of this type of product. This risk can be mitigated through one of the other trigger mechanisms that more closely correlate with the cedent’s actual exposures.
The normal perils that have be addressed by CAT bonds include:
- U.S. Wind
- U.S. Earthquake
- Japanese Earthquake and Typhoon
- Mexico Earthquake
- UK Flood
It is interesting to note that Canadian exposures have been largely ignored as the basis of CAT bonds to date.
There are some compelling advantages of CAT bonds compared to traditional reinsurance. The credit risk is negated due to full collateralization. The timing of the recovery can be much quicker than traditional reinsurance. Thus, the time value of money needs to be incorporated in any cost analysis.
To some extent, they have not been fully tested by actual events. There could be so called “cliff risk” when the size of the event leads to a complete loss of investor’s principal.
Industry Loss Warrants
Industry loss warrants (ILWs) are one of the older, more common, forms of capital market solutions that have been in effect since the 1990’s.
In essence, ILWs are derivative contracts and are a generalized alternative to a Catastrophe Excess of Loss contract. Basis risk (company loss exposures do not correlate with the underlying recovery of the instrument) is common and, accordingly, these products best fit only the largest entities with the broadest account diversity. This factor has lessened the appeal of the product and the growth has been very limited since their initial introduction. As a positive factor, these solutions can be implemented very quickly and efficiently to provide generalized protection.
Initially, these products were offered on a nationwide basis and have since evolved into more of a regional peril focus. Hedge funds are very active in providing the capacity for these instruments and have found superior investment returns from this product.
Steven M. McElhiney, CPCU, president, EWI Risk Services. |
