July 6th, 2009

Get the Most Out of Cat Models, Part I: Manage the Unknown

Posted at 1:15 AM ET

hurricaneJohn Tedeschi, ACAS, MAAA, Managing Director and Chief of Catastrophe Modeling

Insurer and reinsurer reliance on catastrophe models has become part of the fabric of risk management. Though they provide guidance rather than clear courses of action, these tools help quantify risk and deploy their capital as effectively as possible. But, they aren’t perfect. Every catastrophe model has specific strengths and weaknesses, which is why risk-bearers tend to use several models to evaluate exposures, with the final decisions on whether to cover a particular risk shaped by loss history, company objectives and risk manager judgment. As a result, models are crucial to (re)insurer success … as long as they are used properly.

Catastrophic events tend to be rare and devastating. A large storm or earthquake may not occur often, but it has the potential to cause profound levels of insured and economic loss, with the financial implications lasting far longer than the event itself. The nature of mega-catastrophes in particular is such that forecasting is not an exact science, and quantifying the damage is difficult to accomplish with confidence. This concern is widely known: the key to success is managing it to the extent possible. As a tool in the broader risk management effort, catastrophe models provide vital information to the decision-making process.

Catastrophe modeling firms are on the front lines of risk quantification. AIR Worldwide Corporation (”AIR”), Risk Management Solutions (”RMS”), and EQECAT — among others — pull information from governments, universities, and other sources to analyze the conditions that cause natural catastrophes. Despite the fact that they all use generally the same starting point, the models have different strengths — such as North American hurricane, Asia-pacific exposures, and climate change — mostly as a result of interpretation. For this reason, many (re)insurers diversify their use of models to identify gaps and take appropriate action. By integrating the hazard results from several models, cedents can mine the expertise of several sources to create a clear view of exposure.

In assessing the damage to which a particular structure or region is exposed given the intensity of an event, the catastrophe modeling firms use a variety of approaches. Some include claims-specific data, engineering information, and stress data on simulated structures — for example, wind tunnels and shake tables. Local construction expertise and government data is added to the analysis, as well. Overall, the objective is to understand at as granular a level as possible the threats to a particular insured (and insurer) and the likelihood and extent of loss. The analysis is where a considerable amount of uncertainty enters the process. Issues related to vulnerability tend to lie outside the modeling companies’ area of expertise.

The losses from catastrophic events can have a dramatic impact on property risk treaties — and all aspects of the events affect the entire chain of primary pricing (and coverage) for both property risk and catastrophe treaties. Understanding the interplay among the issues that can drive insured losses and how the catastrophe modeling firms address them can materially affect the structure of a reinsurance program.

The determination of projected financial implications tends to be the simplest aspect of a catastrophe model, but it can reveal some of the weaknesses in the hazard and vulnerability analyses. To make the financial component more powerful, modeler expertise on a region or peril needs to be supplemented with an intricate understanding of the insurance and reinsurance structures involved, which is usually provided by the reinsurance broker. Thus, hazard, vulnerability, and financial factors converge - with model analysis, broker insights, and a cedent’s knowledge of the risks it covers. When this happens, coverage is optimized to help risk-bearers maximize their possible returns on capital deployed.

The glue that holds the modeling process together is imagination. The assumptions made and subsequent scenarios reviewed using data and methodologies from a variety of sources are the fundamental drivers of a successful catastrophe modeling — and risk and portfolio management — program. The various inputs are important, but it’s the ability to synthesize them with a company’s internal expertise and that from other advisors that reduces volatility, bolsters return on equity (ROE) and drives firm value.

Tomorrow: Lessons from Ike

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