Will the Insurance Industry Get Slammed by Sandy?


The industry most at risk from Sandy's damage will be the insurance industry. It seems perfectly obvious, right? Well, it turns out that may not be as clear-cut as it seems.

In insurance parlance, Sandy is a catastrophe (OK, really in any parlance, Sandy is a catastrophe). If we want to get nit-picky about it, here's how Allstate (NYS: ALL) describes catastrophe losses to its shareholders:

We define a "catastrophe" as an event that produces pre-tax losses before reinsurance in excess of $1 million and involves multiple first party policyholders, or an event that produces a number of claims in excess of a preset, per-event threshold of average claims in a specific area, occurring within a certain amount of time following the event. Catastrophes are caused by various natural events including high winds, winter storms, tornadoes, hailstorms, wildfires, tropical storms, hurricanes, earthquakes and volcanoes.

The specifics will vary a bit from company to company, but the basic idea is the same: Any event that incurs huge, unexpected losses in a specific area and time period is considered a catastrophe.

The first thing you need to know
If you've been following the coverage of Sandy online and on TV, one thing you've probably seen are plenty of pictures of water ... everywhere. Water in homes, water on streets, water in subways, water covering cars. That's a lot of private-market insurance payouts on the way, right? Wrong.

Far and away the largest flood insurer in the country is the National Flood Insurance Program (NFIP), a government program under FEMA. At the end of 2011, there were 5.7 million policies in force under NFIP covering nearly $1.3 trillion in property. When Katrina hit in 2005, it was the NFIP that was on the hook for much of the flooding damage -- that year the fund shelled out almost $18 billion in claims, as compared with just under $1 billion per year on average during the prior five years.

So when you see canal-like streets in New York City and think about flood damage everywhere, think about poor Uncle Sam.

The other thing you need to know
So sure, Uncle Sam will be in the picture to mop up with flood coverage, but we don't want to overlook wind damage, destruction from falling trees, the costs of business interruption, and the like. These will indeed be costs that insurers have to absorb.

But the truth is that this hasn't been a particularly overwhelming year for catastrophe payouts. Through the first six months of this year, Allstate paid $1.1 billion in catastrophe losses. That compares with $2.7 billion in the first six months of 2011. AIG's (NYS: AIG) Chartis unit had catastrophe losses of $408 million through the first half of this year, as compared with $2.3 billion the year before.

Travelers (NYS: TRV) , which has released its full results for the third quarter, has absorbed $808 million in catastrophe losses through three quarters of 2012 versus $2.5 billion in 2011. And finally, Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) recognized $1.9 billion in pre-tax losses from catastrophe coverage through six months of 2011 but called its exposure through the first half of this year "relatively insignificant."

The big difference is the absence of other crippling events so far this year -- events like the earthquake and tsunami in Japan, floods in Australia, earthquake in New Zealand, and major storms in the U.S. including Irene, Lee, and the Joplin tornado.

Obviously, for shareholders, lower losses are better because it means better profits. But if you're an investor in an insurance company, then paying out losses is part of the game. The key is investing in insurers that have strong enough balance sheets and proper underwriting standards to be able to withstand larger events like this. Travelers, for instance, still posted a $1.4 billion profit in 2011 despite the heavy year of losses.

A hidden benefit?
Fans of schadenfreude might also note that a big catastrophe event like this could actually benefit the better insurers in the industry. Insurers have been dealing with what's known as a "soft market," which essentially means there is too much capital chasing the risks that need to be covered. That leads to high competition, low -- and sometimes unrealistic -- premiums, and lower profits.

When a big loss like Sandy comes along, the weak hands in the market -- that is, the insurers that were too competitive with their pricing or flubbed their risk modeling -- get hammered and sometimes taken out of the picture. With less competition, premium rates can go up, and the better insurers that were able to weather the storm (ba-dum!) are able to pocket healthier profits.

The bottom line, though? Avoid the knee-jerk reaction of assuming that Sandy will be ruinous for insurers.

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The article Will the Insurance Industry Get Slammed by Sandy? originally appeared on Fool.com.

Matt Koppenheffer owns shares of Berkshire Hathaway. The Motley Fool owns shares of AIG and Berkshire Hathaway and has options on AIG. Motley Fool newsletter services recommend AIG and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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