The torrential flooding across eastern Australia in January may rank as the most costly natural disaster to have ever hit Australia, but it will not impact the catastrophe bond universe. As Investment Magazine went to press, the floods had killed 20 people and were expected by authorities to incur up to $5 billion in damage and cut projected economic growth by 1 per cent, or $13 billion, this year. The floods could also become Australia’s most costly insured event, with an expected $4 billion in claims arising from damaged parts of Brisbane and $2 billion from Rockhampton alone, according to AIR International, a specialist catastrophe risk modelling firm. “If accurate, this would rank among Australia’s most costly insured events,” stated Guy Carpenter, a reinsurance broking company.
At presstime, the Insurance Council of Australia confirmed it had received more than 7,000 claims worth $365 million – excluding industrial and mining claims and the impact on Brisbane. But the impact on reinsurers, the primary issuers of catastrophe bonds, remained unclear as flood cover was not standard in many buildings and contents insurance policies in Australia, the broker stated. According to AIR International, residential flood cover in Australia varied considerably by insurer and location, and while most commercial policies included flood coverage, agricultural crops were generally uninsured. Because of this inconsistency, and the difficulty in modelling the expected insurance costs of floods, reinsurers have not been compelled to transfer their flood risk to catastrophe bond managers. The deepest catastrophe bond markets are typically developed economies where insurers have deep penetration and are vulnerable to disasters that are high in magnitude and low in frequency, like US hurricanes, Japan earthquakes and windstorms in Europe.
These liabilities are too large for any collection of reinsurers to cover unless they transfer some of this risk to the capital markets. Many disasters that make headlines – the Queensland floods, the Christchurch earthquake and the Air France A380 plane crash – can be adequately covered by insurers and reinsurers, said Ryan Bisch, an alternative investments specialist at Mercer Investment Consulting. “With big earthquakes and hurricanes, there aren’t enough reinsurers to cover it,” Bisch said. “Cat bonds tend to get issued in areas where traditional reinsurance capacity is full.” To gain traction in the catastrophe bond market, the potential magnitude, frequency and insurance cost of the events must be accurately modelled.
When a hurricane approaches the coast of Florida, for instance, modelling experts begin gauging its strength and predicting when and where it will make landfall, Bisch said. They also calculate an expected level of destruction and insurance losses. But since flood risk is more difficult to model, and can be absorbed by insurers and reinsurers, it is rarely the major peril in a catastrophe bond. But it can be packaged alongside risks like US hurricanes and Japanese earthquakes as a diversifier. In the final quarter of 2010, Swiss Re issued US$170 million in a series of three catastrophe bonds to mitigate its exposure to US hurricanes and California earthquakes – with Australian earthquake risk thrown in as a diversifier. The reinsurer included the low-probability event to make the market more comfortable with further exposure to US hurricanes and earthquakes.