However, insurance companies do not always like having to take all these risks. So enter the reinsurance companies. By selling off some of the very risk that they took on in exchange for insurance premiums, the insurance companies are able to diversify some of the risk and the debt (in case of accident or disaster) to a completely different company. So, if a natural disaster comes in and affects a whole city (which could affect a large percentage insurance company’s clients), how could the company afford to pay the claims by themselves?
While that idea is a very novel one (insurance companies seeking out insurance), it’s actually very hard to calculate how this specific market can be efficient. In order for the reinsurance program to run an efficient business, they too must calculate the specific level of compensation that they must charge in the form of premiums, or else they will also be in trouble when a large problem occurs and multiple claims spring up.
The way that the reinsurer works is a double edged sword. Yes, they buy only a small portion of the risk and claims (or a percentage) from insurance companies, but what if they do not diversify enough? What if an asteroid hits a city and kills one million people or a massive earth-quake in Japan causes a nuclear meltdown?
If a minor incident (or no incident) occurs, the company pays out a very large sum to the individual(s) making the claim, and nothing had happened. If, however, a major event such as a natural disaster occurs like the events currently unfolding in Japan, how does a reinsurance company calculate that value? The damage itself will be countless, it will almost be impossible to sort through who lost what, what items were damaged by what events, the business interruption losses, etc.
How does a reinsurance company plan for this event? The news is constantly being updated, however, as of this writing some estimates are that the claims alone are already anticipated to be at an (estimated) $50 billion. That number will most likely continue to grow.
When you also account for long term planning, the reinsurers themselves did not foresee a catastrophe on the scale that occurred in Japan. There is no way the reinsurers can account for “Black Swan” events, because by definition black swan events are impossible to predict. While everyone is NOW debating the safety of nuclear plants, the next black swan could be entirely different in nature, such as a massive asteroid wiping out a country.
As an example, only a few weeks ago the headline news was all about the unprecedented and unexpected uprising in Libya. Then a 9.0 magnitude earth-quake struck off the coast of Japan, and the topic of conversation completely changed.
Some specific estimates are currently coming in, but it will be very difficult to tell the total damages and effects of the disasters for quite some time. The estimates have suggested anywhere from tens to hundreds of billions of dollars in damage, but then again, at this point who knows? Part of the problem in calculating the damage is that the Japanese government itself has created a structure where the individuals can either claim 5%, 50%, or 100% for their losses. Under those terms, the total property and casualty losses would be estimate at around $16.5 billion, with the Japanese government being hit with around $52 billion. The reinsurers would suffer the rest of the insurance damage.
Another aspect to consider is that, for one reason or another, many of the Japanese people do not participate in the insurance market themselves. According to The LA Times approximately only 10% only of all Japanese homes are fully insured. The paper also states how powerful the damage itself can be, as with the 1995 Kobe earthquake; while over $100 billion in economic losses occurred only $3 billion were insurance losses. So, while the damage itself could be countless, there is still a lot left to occur before we see the final damage number.
A reinsurance company at this point has many questions to face. It is unclear if these reinsurers will have made a profit in Japan when all of the damage and claims are actually calculated.
It is also unclear as to how you can properly plan ahead for an event such as this; one of the very events that reinsurers are supposed to be in business for. After all it is impossible to account for black swans in any potential risk model. Reinsurance companies can be making billions of dollars one year, and then a black swan occurs, which wipes out all the profit they ever made. This was similar to the case with AIG, which was selling CDSs on CDOs to insure against possible default. In 2007, Joe Cassano, an executive in the Financial Products division of AIG stated, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions”. In 2008, AIG reported a loss of nearly $100 billion, wiping out all the profit the company had earned since the early 1990s.
VaR and similar risk measurements are merely a symptom of the inability of humans’ to predict the future. Investors must be keen of this fact when investing in insurance companies.