July 7th, 2009

Get the Most Out of Cat Models, Part II: Lessons from Ike

Posted at 1:15 AM ET

hurricaneJohn Tedeschi, ACAS, MAAA, Managing Director and Chief of Catastrophe Modeling
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It has taken many months for the (re)insurance industry to digest the effects of Hurricane Ike and its impact continues. One of the largest natural catastrophes in history in terms of insured losses, the Gulf of Mexico storm was in part overshadowed by the simultaneous financial catastrophe that struck business centers around the world. The implications of both emerged at the same time, as risk managers sought to keep pace with damage to both the asset and liability sides of the balance sheet.

From September 2008 to March 2009, insurers and reinsurers revisited their loss estimates for Hurricanes Gustav and Ike, and the numbers slowly crept higher. By the time the results stabilized, many carriers saw substantial increases in Hurricane Gustav and Ike losses relative to shareholders’ equity grow by more than 20 percent. Though some companies’ losses did not vary substantially from the results estimated immediately following the hurricanes, others saw upward revisions of greater than 40 percent. The capital implications of the storms were profound, leading many carriers to look at the drivers.

How did the major catastrophe models miss the possibility of an Ike-strength hurricane?

In the hunt for answers, many (re)insurers began to question whether their exposure data was of high enough quality. Several potential flaws were identified, from modeling firm data to insurer-supplied data to insufficient imagination in identifying key risks and exploring scenarios. There was no single cause of the vast change in loss estimates in the half-year following Hurricane Ike, and the (re)insurance industry remains focused on applying remedies to all areas of risk and capital management. The use of models, however, has attracted particular attention, as there is plenty of room for improving how they are applied to risk identification and evaluation - and ultimately to reinsurance decision-making.

Among the gaps in model usage was the absence of customized approaches to risk-bearers’ portfolios. Typically, each modeling firm uses a standard approach — a baseline, effectively — that constitutes an excellent starting point. What was missing last year, though, was a deeper look at each cedent’s situation in order to gauge the reliability and applicability of exposure and claims data; measurement against company risk appetites, tolerances, and profiles; and the development of solutions that accurately reflect a carrier’s strategy as a whole.

While this requires a broad change in how (re)insurers view and transfer risk - with a clear role for Enterprise Risk Management (ERM) — there are clear implications for the use of models. To start, carriers need to reevaluate whether the models they are using have adequate stochastic events, especially for highly concentrated portfolios. Any deficiencies, of course, would result in suboptimal reinsurance purchases, leading to gaps and the possibility of disproportionate catastrophe losses.

Instead of focusing solely on one model, for example, (re)insurers may need to broaden their scopes to include different data sources, varied models, and a wider evaluation of the factors that could contribute to outsized insured losses. Models are tools to be considered within a larger field of risk and capital management capabilities, and over-reliance can cause unexpected losses … the reverberations of which could reach all the way to market capitalization.

Tomorrow: Model Diversification

Part I: Manage the Unknown >>
(Monday, July 6, 2009)

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