Catastrophes and Capital Requirements of Insurers

Overview

So far in this series, we have looked at how catastrophe exposures can impact the profitability of a property and casualty (or P&C) insurer. In the next few sections, we will discuss how such large losses can affect a P&C insurer’s capital requirement and how innovations in the financial markets provide insurers with access to more capital to manage such risks.

For more information on insurers’ capital requirements, please read the Market Realist article How insurers manage their capital requirements.

Catastrophes and Capital Requirements of Insurers

The chart above shows that the P&C insurance industry had a strong capital position due to its policyholder surplus at the end of 2014. Policyholder surplus is the regulatory measure of an insurer’s available capital. To calculate policyholder surplus, subtract the insurer’s reported liabilities from its reported assets.

In the chart, we see two dips in capital between 4Q06 and 4Q14. While the 2008-09 drop in policyholder surplus could reflect that time period’s financial crisis, the drop in 2011 was due to large catastrophe losses. Insured loss in 2011 was around $130 billion. In 2014, it was much lower at around $30 billion.

Impact on capital

It is clear that large losses from catastrophes negatively impact an insurer’s capital. This is because catastrophes result in conditions that are different from assumptions used in estimating the capital requirement of AIG (AIG), ACE (ACE), Allstate (ALL), Chubb (CB), or an insurer held by the Financial Select Sector SPDR ETF (XLF).

An insurer’s capital calculation keeps in mind the predictability of a large number of uncorrelated events. Catastrophe losses are difficult to predict and are correlated. The magnitude of such large losses poses a strain on an insurer’s capital because the insurer needs large amounts of capital for such payouts.

In the next article, we will look at the current capital positions of insurance and reinsurance companies.