There’s no denying the frequency (aka secondary) perils have taken front and center stage when it comes to weather-related disasters and insurer claims.

Over the past 10 years, severe convective storms, winter storms and wildfires collectively have caused two-and-a-half times more insured damage than hurricanes. In only one year in the last 10 have hurricanes caused more insured loss than the frequency perils.

While individual event losses from these perils are not likely to be solvency-impairing for major insurers, the annual aggregate losses can be volatile from year to year, creating unpredictable earnings swings. Insurers are willing to pay to smooth out this volatility, creating new market opportunities for reinsurers and investors who are confident in their ability to price and underwrite the risk. With new pricing tools and innovative reinsurance structures, forward-looking companies can capitalize on these already large and growing opportunities.

What’s Driving the Increases in Losses From the Frequency Perils?

As with the property damage from all catastrophes, the No. 1 driver of increasing losses is the increase in property values—specifically the repair and replacement costs and the number of structures in harm’s way. Construction cost increases generally align with or outpace the rate of inflation, and the COVID-induced supply shortages caused housing costs to skyrocket over the past several years.

The cost to rebuild the same single-family home has more than doubled since 2011. Likewise, commercial and industrial construction costs have risen significantly. Combine these cost increases with the growing numbers of structures in areas prone to severe weather, and every loss seems like a new record. In reality, there is very little upward trend in insured catastrophe losses when normalized for exposure growth.

Climate change is having an impact on insured losses, but the impacts to date have been relatively minor. There is scientific consensus and high confidence that wildfires are increasing in both frequency and severity. For other frequency perils, there is lower confidence in climate change impacts.

Climate change impacts can be quantified, and KCC scientists estimate that warming temperatures and the resulting increases in an atmospheric variable called the vapor pressure deficit (VPD) have led to a doubling of the wildfire loss potential since 1985. This equates to an annual increase of just under 2 percent.

The VPD is the difference between the actual atmospheric moisture and the total moisture if the air were saturated. As temperatures continue to warm, the VPD is likely to continue to increase, enhancing the conditions for large wildfires. VPD can be monitored and incorporated into new models and pricing tools on an annual basis so reinsurers can stay current with the trends.

Severe convective storms (SCS) dominate the annual aggregate losses from all atmospheric perils in the U.S., including hurricane, but there’s no scientific consensus on how climate change may be impacting this peril. There’s no conclusive evidence of an upward trend. Any perception that the risk, after adjusting for exposure growth, is increasing is likely due to past underestimation of losses.

Historically, reinsurers have not had too much exposure to SCS. But as property values have risen, SCS losses have been creeping into the low layers of reinsurance programs. This has caused many reinsurers to pull back and require insurers to raise their retentions. Because the frequency perils are more challenging to model and hence price relative to hurricanes and earthquakes, many reinsurers have opted to avoid losses from these perils.

Why the Frequency Perils Are Challenging to Model and Price

First-generation catastrophe models are best suited to estimate losses from low-frequency, high-severity events like hurricanes and earthquakes. Hurricanes have relatively simple structures and windfields. Once over land, hurricanes lose their energy source and tend to decay or dissipate at a relatively predictable rate.

Likewise, the pattern of earthquake ground motion given an event magnitude, depth and faulting mechanism is reasonably predictable.

Hurricanes and earthquakes can be modeled using a dozen or so parameters along with statistical estimation techniques. Reinsurers and ILS investors are comfortable with the hurricane and earthquake models and therefore confident in their ability to price contracts covering these perils. They have been less confident in the models for the frequency perils.

Winter storms, SCS and wildfires are amorphous and influenced by many factors, and no two storms are alike. Winter storms and SCS vary in shape, size and intensity as these systems move across the country. They cannot be modeled with a static set of parameters.

The recent California events illustrate the relatively unpredictable nature of wildfires. The speed and direction of wildfire spread are determined by localized surface-level winds along with what’s happening in the upper atmosphere with respect to low- and high-pressure systems. Strong winds driving embers miles out ahead of the fire perimeter create random spot fires, and all of these aspects make this peril challenging to model.

The frequency perils require more advanced physical modeling techniques that incorporate all of the physics of the atmosphere, as well as local conditions on the ground. Physical modeling techniques require terabytes of high-resolution atmospheric data in three dimensions and over time and much faster processing speeds. Until recently, physical models were not available to reinsurers.

KCC scientists invested years of research and analysis to bring second-generation models based on advanced physical modeling techniques to fruition. These models have undergone extensive and rigorous testing by insurers to ensure model accuracy at high resolution. Now reinsurers can benefit from this new technology and confidently model and price the frequency perils.

Reinsuring the Frequency Perils

The frequency perils don’t fit nicely into traditional reinsurance structures and terms. In most contracts, catastrophe reinsurance pays out based on the size of individual event losses. But for the frequency perils there are no standard meteorological definitions of “events.”

Weather is continuous across the U.S., and almost every day of the year severe weather is happening somewhere. Upper-level wind patterns can set up for weeks leading to continuous severe convective storm activity. Hail and tornadoes can occur across multiple states in dynamic and unpredictable patterns. While very large tornadoes or tornado outbreaks may be referred to by name, meteorologists don’t generally assign names or event definitions to severe convective storm activity.

Neither do winter storms fit neatly into event definitions and hours clauses. While the severe Arctic Air Outbreak of February 2021, which caused nearly $20 billion in insured loss was dubbed “Uri” by the Weather Channel, Uri was just one of four small extratropical cyclones (ETCs) that formed in a wave set up by the cold weather pattern. ETC Uri caused relatively little damage. The bulk of the insured losses resulted from the persistent sub-freezing arctic air that lasted from Feb. 9-20, causing extensive water damage from burst pipes.

Even the recent wildfires pose challenges to reinsurers. Will the Palisades and Eaton Fires be considered one event or two? Clearly, the fires had two distinct perimeters, but the large losses were caused by the same atmospheric event: the severe Santa Ana wind event that lasted for several days. So, one could argue it either way—the Palisades and Eaton Fires could be defined as one event or two, and those debates are happening now.

Annual aggregate contracts that trigger based on an aggregate rather than occurrence retention eliminate any need for debate or the artificial imposition of event definitions. These contracts are more suitable for the frequency perils. While there are existing aggregate covers, they are less popular with reinsurers and ILS investors, and hence less prevalent in the market. Reinsurers and investors favor occurrence-based contracts that pay out based on large individual event losses.

While it does happen on occasion, in most years, the frequency perils don’t cause large individual event losses. Rather it is the accumulation of many thousands of small claims throughout the year that lead to large annual losses. Insurers generally have enough protection for potential solvency-impairing event losses but now would like additional cover to smooth out the spikes in annual aggregate losses.

The Opportunity

The rise of the frequency perils presents the most significant opportunity for reinsurers and ILS investors since Hurricane Andrew in 1992. Hurricane Andrew caught many reinsurers by surprise and caused the supply of catastrophe reinsurance to shrink at the same time demand shot up. Market leaders and new entrants quickly embraced the new catastrophe modeling technology in order to capitalize on the demand-supply imbalance and resulting profit opportunities.

There is no longer a supply shortage for the one-shot hurricane cover, and that market is saturated. Now the growing demand is for more reinsurance protection for annual aggregate losses covering winter storms, SCS and wildfires. While there was a reluctance in the past to cover these perils, new second-generation models and pricing tools enable reinsurers and investors to confidently price and underwrite these covers. Just as after Andrew, market leaders are embracing the newest technology to capitalize on today’s opportunities.