Now that the full scope of the devastation is becoming apparent, realistic estimates in damages for Hurricane Katrina have started rolling in. There is no other way to say it: The destruction of lives, property, and economic activity attributable to this storm has been historically grievous. Preliminary damage reports for insured losses make Katrina as much as twice as costly in terms of financial destruction as Hurricane Andrew, which had held the record for being the most costly storm up until now.
Andrew's total losses are generally given to be between $26 billion and $31 billion, with insured losses having been $15 billion. Katrina's insured losses have been pegged at between $20 billion and $30 billion, with total losses potentially exceeding $100 billion. Sen. Harry Reid, D-Nev., said yesterday that the federal recovery effort (read: your tax dollars) will cost as much as $150 billion. Given the numbers above, I'm having a hard time reconciling that math, but keep in mind we're talking the number of elephants in a Volkswagen here. The number will be staggeringly large, whether it's $50 billion, $100 billion, or $150 billion.
For the insurance industry, megacatastrophes offer a good news/bad news conundrum. Let's call it a bad news/bad news/bad news/good news conundrum. When insurance companies hold the policies for destroyed property or lives, they must pay. When that property and those lives are all destroyed in one gigantic event, those payments come fast and furious and may overwhelm the amount of money the insurer has set aside in reserves to pay these claims at any one time. Sometimes this happens to companies even if they've done a good job. If an insurer lays off risk onto a "reinsurer" and that reinsurer fails (as happened by the dozen in Florida in 1992), the responsibility for those claims falls back onto the primary insurer, which could lead to more bankruptcies.
Oh, that's right. I claimed that there was some "good news" here. For the remaining insurers, the reduced level of capital sloshing around looking for policies to write generally serves to "harden" the market, allowing insurers to generate higher premiums for their coverage. After Andrew, Allstate (NYSE:ALL) scaled back its presence in Florida, while Prudential essentially abandoned the property and casualty market in Florida out of concern that it could not possibly charge premiums high enough to meet its risk. The companies that stepped into the breach included Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb), Aspen Insurance, Partner Re (NYSE:PRE), and White Mountains Insurance (NYSE:WTM).
What the remaining companies found -- both in Florida and in the overall U.S. market -- was a much higher pricing power. The same was true following the World Trade Center attack -- insurance for high-rises and high-profile properties changed dramatically. Of course, to be able to operate in the environment with better pricing discipline, a company had to first survive the disaster with enough capital to continue writing policies. You know the saying "That which doesn't kill you makes you stronger"? Perhaps nowhere is that truer than in insurance.
At Motley Fool Hidden Gems, we've been tracking the estimated claims exposure to Katrina for our two recommended companies that will feel the impact: Montpelier Re (NYSE:MRH) and United Fire & Casualty (NASDAQ:UFCS). Neither has given its own estimates, but we think we have enough tea leaves to read to determine that both companies will be out of pocket some big bucks, yet both will be fine in the long run. (We give more specific findings in our mid-month report to subscribers, released today.) The real worry throughout the industry, though, is twofold: (1) How many reinsurers will fail, pushing claim responsibility back onto the primary insurers, and (2) what's next?
It's the "what's next" that should keep investors in the sector up at night. This year, the National Oceanic and Atmospheric Administration projects that there will be five to seven "major" hurricanes. Remember, the peak season for hurricanes has just started. (Katrina landed one week in the calendar year after Andrew did.) Last year's final storm, Tropical Storm Otto, didn't dissipate until Dec. 1. That's a long time left for another big storm to hit. Thus far this year, Dennis, Emily, and, of course, Katrina can be categorized as "major." That leaves two to four more "major hurricanes" predicted by the experts. The next one could be the death blow for insurers who survived Katrina with some of their reserves intact.
The 2004 storm season wasn't exactly smooth sailing for insurance companies, either. There were four major hurricanes in Florida -- Charley ($14 billion in damages), Frances ($9 billion), Ivan ($13 billion), and Jeanne ($7 billion). There was the Southeast Asian tsunami ($4 billion). And there was Typhoon Tokage in Japan ($9.3 billion). Insurance companies have already seen their reserves drawn down by this series of storms, and some would argue that Katrina may be the death knell for more companies as a result of its coming after a very expensive 2004.
That's why a "Stan" is so unnerving. We could still see major storms Ophelia, Philippe, Rita, Stan, Tammy, Vince, or Wilma that could make landfall and do extensive damage -- this year. If it happens, some insurance companies that made it through the storm of the century intact might not survive a second blow at even a fraction of the magnitude.
As Warren Buffett famously said, "In insurance, surprises are almost never good things." It's one area of investment where gambling on marginal players carries substantially higher levels of risk. And a company that has reserved and priced risk poorly may not survive the next surprise and get the chance to correct its mistake.
Hurricane Bill? 2009. Bill Mann is an advisor for the Motley Fool Hidden Gems newsletter service. Bill owns shares of Berkshire Hathaway. You can see all that Hidden Gems has to offer by signing up for a no obligation30-day trialfor free. The Fool has a disclosure policy.
