Kenneth A. Froot spends more time thinking about natural disasters than the average business school professor. In addition to the rise and fall of the Dow and the long-term implications of the financial crisis in Greece, he has natural perils—hurricanes, earthquakes, floods, and unusually severe European winters—on the brain.
And he thinks you should, too.
Froot, the André R. Jakurski Professor of Business Administration at Harvard Business School, has spent more than 15 years researching how the reinsurance industry—which provides insurance for insurers—manages catastrophic risk. And while he’s seen improvements in the way reinsurers distribute risk over the last two decades, he still questions whether reinsurers in their current form can survive a major catastrophic event.
“Reinsurers assume the risk of, and hold the capital for, those catastrophic events for which insurers are poorly suited,” explains Froot.
A local property-casualty insurance agency can easily hold enough capital to cover losses from house fires or burst pipes; such losses are relatively infrequent and their numbers easy to predict. Natural disasters are a different story: though they occur much less frequently, when they do happen it’s akin to thousands or even tens of thousands of pipes bursting and homes burning all at once. Hurricane Irene, for instance, inflicted an estimated $6.6 billion in insured losses. And they are much harder to predict. Because of this, it becomes very expensive for insurance firms to hold the capital necessary to cover catastrophic losses.
So they turn to reinsurance firms, paying them a fee to assume that risk. Ideally, reinsurers are able to absorb the risk of, say, a hurricane blowing through Vermont, because they have diversified their own risk across the possibility of hurricanes in Vermont, floods in England, and earthquakes in California.
“One relies on the insurance sector to promote risk sharing,” says Froot. “One of the features my research raises is that the level of risk sharing in many instances is very incomplete, very poor.”
Froot examines where insurance companies purchase protection asking, “Do they buy reinsurance contracts for small losses, for in-between losses, for big losses, for gargantuan losses?” Logic dictates that insurers will choose to cover gargantuan losses “because those will wipe you out,” says Froot. – Harvard Business School
The insurance companies will belly up after this year of losses unless the United States government can bail them out. 100% in crop failure claims, and billions in loss payouts for the changing weather patterns that are destined to bring more devastation.
In the past, the insurers have based their losses on past statistics, but can no longer rely on that data. All are nearing the verge of being bankrupt.