Lloyd's fears Rita may bring $60bn stress test to life

As Hurricane Rita swept towards America's Gulf coast yesterday, insurance experts in the City of London will have experienced a sensation of deja vu: the prospect of a major storm hitting the Texan city of Houston - now directly in Rita's path - is one of the market's "realistic disaster scenarios". The threat of this specific calamity acts as a so-called "stress test" which insurance experts use to calculate whether the market has the financial strength to deal with a major disaster.

The un-computed reality, however, is that Rita is the second big storm to hit America's southern states in the space of a month. Right now, with Katrina predicted to be the costliest insured natural disaster in history, the financial impact of both storms coming so close together can only be guessed at.

As part of its financial emergency planning, Lloyd's has required each of the syndicates that make up its market to pretend that the industry has been hit by a $60bn (£33bn) loss caused by a windstorm hitting Texas and slamming into Houston. Under Lloyd's pretend pattern of damage, there would be $10bn of losses caused to offshore energy - oil rigs and the like - and $50bn of mainland property losses.

Katrina, of course, is already forecast to hit the insurers with claims of this sort of level. The largest single bill faced by the industry before came with the clean up after Hurricane Andrew in 1992, costing $21bn. Meanwhile, the four hurricanes that hit Florida last year cost a total of $28bn, according to the big European insurer Swiss Re.

Referring to the confluence of Katrina and Rita, Roger Field, group underwriting director at Brit Insurance, said: "These are very large indeed and to have two of this size in one year is without doubt exceptional." That fact was certainly understood in the stock market yesterday, where speculation swirled of a full blown profits warning at Munich Re, the world's biggest reinsurer. Munich's market value has fallen £700m since Katrina struck; yesterday the selling spread to other big European names, such as Hannover Re and Zurich Financial Services, while in London insurers with exposure to Lloyd's syndicates such as Brit and Goshawk were also marked lower.

Brit, which runs the eighth largest syndicate at Lloyd's, was busy yesterday running computer models on Rita - even before she hit land. Its claims department was preparing to make contact with local loss adjusters, who go in to assess the cost of the damage caused by disasters. While the people of Houston and the surrounding areas were preparing to evacuate, the loss adjusters are often the people looking for a way in to the damaged areas.

This was also the case when Katrina struck New Orleans, though on that occasion loss adjusters were refused entry for several days in the face of flood waters.

It is clear now that the flood waters caused the insurance industry specific difficulties. Insurers expect flood waters to gush in and then subside quickly, rather than stagnating, as they did around New Orleans. In this case the water also mixed with oil and other pollutants. Insurers fear that buildings under water for such a long time will have to be completely rebuilt.

The situation has been made even more complicated by the fact that a decision will need to be made about how much of the damage was caused by the hurricane and how much by the flood that followed. This is crucial. Flood cover is excluded from many policies around New Orleans since flooding has long been considered a real threat. All other damage will be covered by the policies sold by insurers.

The complexity of assessing the damage caused by Katrina means that the total bill will not be known for many months. Lloyd's of London has made an initial estimate of £1.4bn for the direct losses it expects to incur as a result of Katrina. But this is only a first attempt at calculating the Katrina losses based on predictions made by its syndicates. The final bill could rise substantially.

Analysts at stockbroker Numis yesterday predicted that Rita would be "another expensive loss to the insurance industry although perhaps not as costly as Katrina, where flood damage in New Orleans has been such a major factor". They pointed out that the trading environment for insurers could actually improve as a result of the storms. The expectation of the industry is that it will be able to push up the cost of insurance as result of the disasters, potentially boosting profits.

One insurer, Kiln, which runs four syndicates at Lloyd's, confirmed the expectation of higher insurance rates yesterday by announcing it was asking Lloyd's for permission to take on more business than it first planned. Until Katrina struck, Kiln had been expecting to have to cut the cost of the insurance it sold, not raise the price.

As Rita is not expected to hit land until Friday night, the insurers will not know for certain her intensity or trajectory until then. But at least the Lloyd's of London disaster planners will know that they have picked a scenario that is potentially realistic. It may not be too long before they discover whether their estimate of losses matches the reality.