July 8th, 2009

Get the Most Out of Cat Models, Part III: Model Diversification

Posted at 1:15 AM ET

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

There are many modeling perspectives for a reason. Even among the three largest firms — AIR, RMS, and EQECAT — differences are noticeable, as each company has developed its own set of unique strengths. The breadth of results only serves to benefit (re)insurers … as long as they take advantage of it. Limiting catastrophe modeling efforts to only one of the major vendors, even if it’s best-suited to a particular region or peril, can lead to gaps in coverage, unanticipated insured losses, and the destruction of shareholder value. As cedents diversify among perils, regions, and even among reinsurers, therefore, they also could protect their capital by diversifying the models they use.

Historically, (re)insurers rely on past events to plan for the future: loss history is an important source of risk management information. Unfortunately, there tends to be limited experience. Emerging threats, developing markets, and climate change, for example, require forecasting without the benefit of past results. Catastrophe models create information where none would exist otherwise to enable analysis and effective risk management decision-making. These same techniques also enhance the management of established risks.

The assumption and transfer of risk does not occur in a vacuum. Catastrophe models help carriers bridge the gap between events and financial performance by relating risk to premium. A successful portfolio generates sufficient premium revenue to offset losses and expenses while still delivering returns to meet company revenue, earnings, and return on equity (ROE) targets. Catastrophe models only reach part-way across the risk/return chasm, though. The rest comes from supplemental tools and expertise from internal and proprietary models, reinsurance brokers, and risk management specialists to ascertain the impacts of rate levels and disaster scenarios on company financials. Guy Carpenter’s i-aXs® platform, for example, integrates with third-party catastrophe models to provide satellite imagery, real-time data feeds, and risk assessment information to add timely insights to underwriting decisions.

With the uncertainty that pervades catastrophe risk management, no one tool is enough. Instead, (re)insurers should gather as much relevant information as possible, using all the resources at their disposal. Diversifying model usage across the three major vendors mitigates the risk that useful insights will be missed, helping carriers to maximize their returns and increase shareholder value. Additionally, the modeling effort should reach beyond the catastrophe modeling firms. Tools and techniques from other sources should be included in the process — such as scenario based investigation including claims department input, reinsurance broker-conducted analyses, and proprietary catastrophe modeling solutions.

By linking a portfolio’s likelihood of success to the results of only one catastrophe model, a (re)insurer assumes a considerable amount of risk - unnecessarily. There are three major catastrophe model vendors for a reason: each brings a set of strengths to the market. Further, the additional tools and insights available within cedent organizations or from their reinsurance brokers can yield even more relevant information to facilitate effective risk transfer. Casting a wide net can result in a considerable performance upside.

Tomorrow: The Reinsurance Broker’s Role

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

Part II: Lessons from Ike >>
(Tuesday, July 7, 2009)

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