September 14th, 2010

Modeling the Impact of a Casualty Catastrophe

Posted at 2:00 AM ET

small-lewinDavid Lewin, Managing Director

Look no further than today’s headlines to see how a single catastrophic event or lawsuit can have far-reaching effects. Over the past few years, several incidents, seemingly isolated, have ballooned into cross-border, cross-industry and cross-business line catastrophes. Chain reactions of liability — such as the Deepwater Horizon oil spill, the collapse of Lehman Brothers and the Chinese Drywall product recall — have led insurers to ask: How do I assess the impact of a major legal liability catastrophe on my portfolio? And it’s not just the industry waiting for an answer: stockholders, analysts, rating agencies and regulators are listening, too.

Casualty catastrophes are nothing new. There have been several in the past decade alone, and they seem to be coming with increasing frequency and severity. Since they are almost impossible to predict and difficult to hedge, however, they have remained a salient challenge for the insurance industry.

Unlike property catastrophes, casualty catastrophes know no geographical boundaries or fixed values. Moreover, historical casualty catastrophe data is scarce. A casualty catastrophe is an event in which liability risk spreads rapidly across industries and borders, transmitting exposure along a variety of trading relationships or through common practices. When this occurs, claims have the potential to be filed against companies that seem to have little in common with the root cause.

Product recalls, precipitous stock price declines and a host of other events can trigger casualty catastrophes that can ultimately impact auditors, lawyers, investment banks, service providers, subcontractors and just about every link in a company’s supply chain. Because of the rapid pace of socio-political, legal, economic and technological changes, and the emergence of new underlying factors, the past provides little guidance to the future.

Despite the risks that clearly exist in the marketplace, the industry has had no defined methodology for allocating capital to potential casualty catastrophes. In the Lloyd’s Market, underwriting management agencies have for some years been required by the Franchise Board to estimate the impact of Realistic Disaster Scenarios on a number of lines of business, but this has been a manual and subjective process for long-tail liability scenarios. Increasingly, there is recognition across the insurance industry globally of the need for a more scientific approach to modelling casualty risk. And as regulatory requirements put more pressure on insurers to demonstrate their allocation methodology, the need for a rigorous methodology and a robust modelling solution is critically important.

Working in conjunction with risk modelling consultants Arium and using Arium’s proprietary software, Guy Carpenter & Company, LLC has developed CasCatTM, the industry’s first casualty catastrophe modelling platform. CasCat makes it possible, for the first time, to evaluate the catastrophe exposure of a casualty portfolio and estimate the financial impact of a given scenario on that portfolio.

CasCat maps out hidden links between different insureds using complex connectivity data based on industry and trading partner relationships. Built on network theory, CasCat is able to stochastically model the potential quantum and spread of liability through an insurance portfolio, allocating the assumed insured loss from a specified disaster scenario across different policies and jurisdictions. Working closely with casualty clients, Guy Carpenter advisors use CasCat to distribute potential liability depending upon the selected scenario and industry code that forms the event’s starting point.

The links identified by CasCat for each scenario can be visualized in network maps. While the impact of these links depends on the insureds within a given casualty portfolio, the model provides an efficient and consistent methodology for generating scenario event sets.

Modelling is only part of the casualty catastrophe risk management process. To be truly effective, it must exist as part of a larger risk and capital management strategy, encompassing a carrier’s entire portfolio. Guy Carpenter’s approach to this challenge involves collaborative effort among our client, our line of business specialists and our Global Analytics team. Together, we apply CasCat to the client’s casualty portfolio to identify, understand and manage the threats to their capital.

Casualty catastrophes are happening, and an increasingly interconnected global economy suggests that they will persist and grow in potential severity. To protect their capital - and their operations - insurers need to implement a mix of modeling capabilities and risk and capital management techniques. Prudent planning, careful modelling and intelligent hedging can mean the difference between a capital drain and a competitive advantage.

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