Can insurers cope with a perfect storm?

They've had it easy in recent years but the salad days are over, says Nick Clark

A devastating earthquake in Chile, wind storms across Europe, and the disastrous oil spill in the Gulf of Mexico have contributed to one of the worst first halves for the insurance industry in a decade. This has led to questions over whether the shine has finally come off the catastrophe insurance industry, after an unprecedented purple patch.

The above are among the 440 disasters that are expected to cost companies that provide catastrophe insurance and reinsurance upwards of $22bn (£14bn) in the first six months of 2010, more than double the average first-half cost since the turn of the century, according to Morgan Stanley analysts. Conditions could well get worse this year, as hurricane season continues until November. There have been only two storms since the season started in June, but the National Oceanic and Atmospheric Administration predicts up to 12 hurricanes. Possibly half will be major.

This will interest more than US insurers, as several members of Lloyd's of London are exposed to wind storms in the Gulf of Mexico as well as Europe, Morgan Stanley found. Two, Amlin and Hiscox, reported first-half results yesterday, which showed the effects of what Amlin called "record catastrophe losses" together with, falling premiums and volatile investment markets.

Its pre-tax profits fell from £177.1m in the first six months of 2009 to £107.6m a year later because of the "high industry catastrophe losses relative to the benign claims environment of 2009". It suffered net ultimate losses for major catastrophe related claims of $190m, triple the figure disclosed a year earlier.

The earthquake that hit Chile in February, the fifth-strongest since 1900, proved the most costly disaster for insurers. The industry's total insured loss stands at $8bn but is expected to rise further. Jon Hocking, analyst at Morgan Stanley, said that "any further developments in losses are likely to fall on reinsurers as most primary insurers would have exhausted their exposure".

Also in February, Windstorm Xynthia battered Europe causing insurers a loss of $3bn. Other natural catastrophes highlighted by the UK insurers included hailstorms in Australia, which hit Amlin by $18m, the earthquake in Baja California, Mexico as well as the Icelandic volcanic eruption. BP's loss of the Deepwater Horizon rig also marks the worst loss in the energy market since the Piper Alpha disaster in 1988. Catastrophe exposure prompted Hiscox profits to fall from £141.4m in the first half of last year to £97.2m.

Catastrophe cover has been a hugely profitable line of business for insurers over the past few years, one market expert said yesterday. After Katrina, premiums jumped, while the rest of the market was relatively unaffected. While insurer's short-term profits are hit by payouts in the wake of a catastrophe, "they tend to get better margins the following year because premiums get pushed up," Tom Dorner, analyst at Oriel Securities, said. The enthusiasm with which many insurers pursued such polices prompted senior executives at Lloyd's to admit concerns over the risk exposure at the end of last year. Several months later, Richard Ward, the chief executive of Lloyd's said: "It isn't overstating the situation to say that the insurance industry is facing a potential perfect storm this year."

The business, which by its nature is unpredictable, has, however, become more sophisticated in recent years. Charles Philipps, chief executive of Amlin, said: "Reinsurance has become pretty disciplined. The models have become much more honed." Many insurers turn to companies such as RMS and AIR Worldwide for modelling technology and consulting. The risk management has improved with Lloyd's introduction of the Franchise Performance Directive in 2002 and Europe's forthcoming "Solvency II" directive is expected to add further security.

The Lloyd's insurers were also protected from the catastrophe payouts by diversifying their business models. Mr Dorner said 2010: "Saw the worst first half on record for catastrophe losses. However, the Lloyd's insurers have mostly delivered profits in the first half because of their diverse portfolios. If there is a major disaster in the second half it could become an issue for the insurers."

Amlin said that the difficult backdrop was "exactly the type of environment that we expect our focus on gross underwriting performance, the quality and diversity of our portfolio and our well-proven management to prove advantageous". However, it cautioned: "Future reinsurance market trends will be affected, as always, by the level of catastrophe activity in the Atlantic, Pacific and European windstorm seasons during the second half of the year."

But despite the hefty losses in the first half, premiums are only expected to rise in Chile. It would take a really big disaster to change pricing, right across the industry. Katrina (which did just that) is estimated to have cost the industry $50bn, while 9/11 cost between $25bn and $30bn. Robert Childs, chief underwriting officer at Hiscox, said: "To really significantly change the market, there has to be a large loss in one of the two major buying zones. For us that would be in the US or Europe. Others will also be heavily affected by Japan." Amlin noted premiums had fallen in the first half and many believe the trend will continue into next year. Mr Dorner said that there was still too much capital in the industry. And this is serving to put the squeeze on insurers.

Yet, despite the gloom, catastrophe insurance and re-insurance remains lucrative. Amlin's falls still only brought the price slightly off the peak of 2007. "Rating levels for catastrophe reinsurance remain attractive and sufficient discipline appears to exist in the reinsurance market to ensure that we do not return to unacceptably low levels of pricing," it said. Oriel's Tom Dorner said: "Pricing is still not far off historic highs, but it will come under pressure if there are no further losses in 2010. For now margins remain attractive though."