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May 2008: A few days before disastrous Sichuan quake frogs are escaping area of future quake. Frogs could feel forthcoming quakes and trained by thousands years to leave a dangerous area as the best strategy “Then the Northridge Quake struck, and the losses paid took all of the premiums collected by insurers for last 30 years.” Pete Moraga, Insurance Information Institute of California. US insurers lost $24 billion in 2013 dollars, and Northbridge quake became the fourth-costliest U.S. disaster for property insurers after Hurricane Katrina, World Trade Center tragedy and Hurricane Andrew. In the aftermath of the Northridge earthquake, many US insurers did not even try to recover their whooping losses. They have decided that quake risks couldn’t be correctly assessed and priced and simply preferred to drop quake insurance at all. Premiums for US quake insurance rose several-fold, whilst insurance penetration dropped in response. Can losses of the Northbridge scale occur again for ILS, insurers and reinsurers today? We think so for a few reasons. First, today’s pricing doesn’t reflect the real quake risk, as invasion of ILS money, growth of competition and prolong period without major catastrophes suppress quake risk prices. Second, most players use same risk-assessment and risk-allocation systems, thus creating a crowd effect. As head of a multibillion ILS fund told me, “if a major quake hits tomorrow, the entire market will drop as deep as my fund – so why should I care and why should investors complain?”

Will ILS, Insurers And Reinsurers Face Another Northbridge Moment?

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May 2008: A few days before disastrous Sichuan quake frogs are escaping area of future quake. Frogs could feel forthcoming quakes and trained by thousands years to leave a dangerous area as the best strategy

“Then the Northridge Quake struck, and the losses paid took all of the premiums collected by insurers for last 30 years.” Pete Moraga, Insurance Information Institute of California.

US insurers lost $24 billion in 2013 dollars, and Northbridge quake became the fourth-costliest U.S. disaster for property insurers after Hurricane Katrina, World Trade Center tragedy and Hurricane Andrew. In the aftermath of the Northridge earthquake, many US insurers did not even try to recover their whooping losses. They have decided that quake risks couldn’t be correctly assessed and priced and simply preferred to drop quake insurance at all. Premiums for US quake insurance rose several-fold, whilst insurance penetration dropped in response.

Can losses of the Northbridge scale occur again for ILS, insurers and reinsurers today? We think so for a few reasons. First, today’s pricing doesn’t reflect the real quake risk, as invasion of ILS money, growth of competition and prolong period without major catastrophes suppress quake risk prices.

Second, most players use same risk-assessment and risk-allocation systems, thus creating a crowd effect. As head of a multibillion ILS fund told me, “if a major quake hits tomorrow, the entire market will drop as deep as my fund – so why should I care and why should investors complain?”

Third, the bulk of market quake risks are concentrated today just in two key regions - California and Japan. Everyone knows that a new big California quake is already overdue. But few people know that two major famous Japanese quakes – the Tokyo earthquake (repeated every 100 years, last time in 1923) and the Tōkai earthquake (repeated every 100-150 years, last time in 1854) – are overdue as well. According to estimates, next major US California quake could cause as much as $200 billion in losses. Caught unprepared in a wrong place & time and having gotten a big hit from any of above events in current wrong pricing environment, a player may require dozens years to recover from losses.

Fourth, current risk assessment relies heavily on the “1 in 100 or in 1000 years event” concept. This approach looks nice, but it still has few key drawbacks. To begin with, there are serious doubts about human ability to estimate return periods correctly. Say, once-in-a-century UK floods of 2007 were followed by next “once-in-a-century” floods already in 2015. Traditional models did not expect that Chile could be hit by three M8+ quakes within five years (in 2010, 2014 and 2015), simply because it had never happened before and, therefore, had been considered highly unlikely. Last year, an ordinary hurricane, Patricia, in a few days suddenly turned into the most powerful hurricane ever in Mexican history. Just during 18 months in 2010-2011, catastrophic earthquakes hit Haiti, Chile, New Zealand and Japan. One might say that we live in “special times” when “historically rare” events occur. However, we have another explanation – that such events in fact occur on the Planet much more often than we have assumed so far.

Moreover, the “one-in-a-hundred years event” concept could not tell you in which specific year you will run into a huge loss. And users of a typical assessment (the type of “the probability of M8 quake in California in next 30 years is 7 percent”) need to remember that, to verify whether the 7% estimate was right or wrong, they will need to remain in business at least for next 100 years. My professor in Oxford said once that an excel spreadsheet creates very dangerous illusion that by extrapolating of past events into excel cells we can predict the future. Echoing him, top ILS Bermuda manager told me that using just past events in quake risk assessment is like driving the car by looking in a rear mirror. In fact, the Tohoku M9.0 2011 catastrophic quake and tsunami have not been predicted by any models simply because events of such scale had never happened in this area in Japanese history. We do live in risky times, real quake risks are hugely mispriced and misunderstood, and ILS investors should remember that ILS can deliver not just uncorrelated returns, but uncorrelated losses as well.

On the positive side – you are welcome to the new Planet where major quakes can be foreseen. Today any corporate could get access to real quake forecast and be

fully convinced that a major quake can be predicted just in 4-5 weeks. A constantly growing number of investors, corporates, insurers, reinsurers and ILS have been already convinced and actively start using real earthquake forecasting in their business. In coming years we will learn many funny stories on how big corporates magically bought quake insurance just one month before a big event and how incredible smart insurers started buying big reinsurance protection exactly 2-4 weeks before a major quake in a specific region. Access to real quake forecasting services creates priceless competitive advantages for players who will simply know when and where next major quakes strike and, therefore, will be fully prepared. And, vice versa, as Warren Buffet famously said: “It's only when the tide goes out that you learn who's been swimming naked.” Stay tuned.

Oleg Elshin, President, CEO at Terra Seismic, www.terraseismic.com

[email protected]

Further readings:

Forbes: Big Data : Saving 13,000 Lives a Year By Predicting Earthquakes

www.forbes.com/sites/bernardmarr/2015/04/21/big-data-saving-13000-lives-a-year-by-predicting-earthquakes

Big Data in Practice: How 45 Successful Companies Used Big Data Analytics to Deliver Extraordinary Results

http://eu.wiley.com/WileyCDA/WileyTitle/productCd-1119231388.html

BNAmericas: Predicting earthquakes no longer a “rough science”

www.bnamericas.com/en/news/insurance/predicting-earthquakes-no-longer-a-rough-science