Weather and the Insurance Industry - part 2

With the threat of an increase in the frequency of events such as hurricanes, the industry researchers who determine their likelihood have to make a few changes.  Regions such as the Gulf Coast already face problems with insurance, in such high-risk areas the cost of property insurance is sky-high and are only set to increase.

In my opinion, the Insurance industry is not fit for these events, and as a result they increase prices. The potential to make huge losses in the future is large.  The insurance market is inherently unsuitable for natural disasters.  Yet insurers still try to make it work in hazardous areas by increasing prices, in the hopes that they can afford to pay out the necessary funds if and when hazard occurs.  With this in mind it is clear that there could be opportunities that exist to ‘go short‘ in the future.

A brief and extremely simplified explanation of going short: Options give an investor the opportunity to go long or short on a company’s shares.  When an investor goes short, he or she has purchased a put option on the underlying security, expect the share price to be lower than it is today.

There are possibilities in the future for market analysts to find out which particular properties in particular areas could be more vulnerable to adverse weather conditions, and thus which insurance companies may have to pay out large sums of money in the future given that natural disasters are set to continue and potentially increase.

While I believe there may be increasing interest in the options market in insurance given an increase of natural disasters in future, we will certainly see increased activity in shorter duration financial activities such as spread betting. Spread betting essentially has the same payoff structure as options but is processed in a much short time frame, in the order of hours/days.  For example, one may expect to see much more activity in spread betting on insurance shares as scale five hurricane approaches the gulf coast. 

This paper by B. Blau et al.  (2008) Looks into how investors are profiting because of hurricanes Katrina and Rita, and after observing the effects of Katrina on the shares prices of insurance companies how their behavior adapts during and prior to Rita. 

References-

Diamond, D. Verrecchia, R.  (1987) Constraints on short-selling and Asset Price Adjustment To Private Information, Journal of Financial Economics 18 (1987) 277-311. North-Holland

Immergluck, D. (2011), Critical Commentary. Sub-prime Crisis, Policy Response and Housing Market Restructuring, Urban Studies 

Weather and the Insurance Industry - part 1

In previous blogs I have discussed the impacts of climate change of weather, with a particular focus on the increased frequency and magnitude of extreme weather events, such as hurricanes. Even now much of Wales and South-west England is experiencing floods, while North America suffers an Arctic cold-spell (to put it lightly).  When it comes to calculating the probability of extreme weather events one industry has a direct financial nexus.  The insurance industry. 

Insurance is designed to minimize loss.  Many commodities can be insured ranging from phones to lives.  However, for insurance to function properly the market has to be characterised in a particular fashion: there has to be a fairly constant percentage of the hazard occurring and a large client base is required.  For example, a property insurance protecting against burglary, where the statistics for the number of burglaries in a certain district is readily available and a percentage of burglaries taking place is easily calculable.  From this insurers can calculate the number of clients that they require to take out the insurance and the price of the insurance given the number of burglaries they expect to take place in a given time frame. 

Some events cannot be insured against, the most famous recent example being the 2007 sub-prime crisis. This was a result of an extremely high volume of mortgage borrowers defaulting on their loans at a similar time.  The insurers who had taken out credit default swaps based on the AAA rating of the mortgage-backed securities  (MBS), which were created from the mortgages, could not afford the resulting payouts when these swaps occurred at the same time. 

This “Black-Swan” event is a good example of how the insurance industry cannot operate when everyone is affected by the same hazard at once. This is exactly the case with natural disasters. 

References-

Engel, K. and McCoy, P. (2011) The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps. New York: Oxford University Press.

http://www.thisamericanlife.org/play_full.php?play=355

Freak Weather in the States

This picture could not be ignored, arguably the best analogy yet for the ridiculously cold weather now affecting the US. Produced by science blogger Greg Laden. A result of climate change? Greg Laden discusses in his blog.

Stormy Weather Ahead?

After a hefty Christmas break my next sub-topic will be weather.  In recent years it has become evident that climate change is having a knock-on affect on weather.  Primarily it has been noted that the frequency and debatably the magnitude of hydro meteorological events in particular is being increased due to changes in temperature. 

A mere few months ago did we witness the most powerful typhoon ever recorded.  Typhoon Haiyan hit the Philippines, a mighty category 5, flattening homes, schools and hospitals along its path of destruction and leaving a death toll of over 5,000. In addition, changing temperatures may also have implications for cyclical events such as El Niño and La Niña.  It has been suggested that increased intensity and frequency of the El Niño and La Niña events (which now occur every two to three years) in recent decades is a result of warmer sea surface temperatures and thus a product of global warming.

Terrestrially increased temperatures generate drier and hotter weather conditions, initiating droughts and wildfires. Increased temperatures have also lead to an increase in the speed at which the polar ice caps are melting, which arguably will result in rising sea levels and the flooding of low-lying land throughout the world.

 How will industries such as insurance react to these increasingly frequent events, and how have they in the past?  In 2011, property/casualty insurers were exposed to over $100 billion dollars in global natural disaster related losses, with over 50% of those losses stemming from severe storms, tornadoes, flooding, and wildfires alone.  With the latter few paragraphs in mind, it is clear this value is only set to increase, seeing great potential for conflict though hopefully breeding collaboration.

Here’s a nice document that sums up the insurance industries response to climate change, focusing on the challenges faced, their impact on society and how to move forward.