A Decade of Advances in Catastrophe Modeling and Risk Financing INSIGHTS October 2015
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INSIGHTS October 2015 A Decade of Advances In Catastrophe Modeling and Risk Financing INSIGHTS October 2015 CONTENTS 1 Introduction 2 The Evolution of Catastrophe Modeling 4 Modeling’s Role in Underwriting and Risk Management 5 A Focus on Data Quality 7 Risk Finance Optimization 8 Conclusion INSIGHTS October 2015 INTRODUCTION Ten years ago this summer, Hurricane Katrina pounded New Orleans with surprising intensity, becoming the costliest storm ever to hit the US. Three years later, damage from Hurricane Ike extended far deeper inland than previously thought possible. In 2012, Superstorm Sandy brought record levels of storm surge to the Northeast. And in recent years, major earthquakes off the coasts of Japan and Chile led to severe structural damage and massive tsunamis. After a major catastrophe, individuals, businesses, governments, and others look for lessons to help decrease the potential impact from future events. In the insurance industry, much of the focus following disasters falls on catastrophe models, which have undergone several rounds of change as new events add new data. Advances in technology and analytics have also transformed the models and the way insureds view and deploy their insurance capital. A Decade of Advances In Catastrophe Modeling and Risk Financing 1 INSIGHTS October 2015 THE EVOLUTION OF CATASTROPHE MODELING The first hurricane loss model was In the two decades since Andrew, After Katrina, analysis from introduced in the late 1980s by catastrophe modeling has become a actuaries and modelers revealed AIR Worldwide. But most insurers necessary and permanent part of the that many assumptions had been did not initially adopt catastrophe underwriting process, and models incorrect. For example, models modeling, even after September have grown more sophisticated. underestimated the potential 1989’s Hurricane Hugo became the New insights gained from successive damage that could be caused by costliest hurricane in US history to hurricanes have revealed an coastal flooding driven by wind that date (see Figure 1). Instead, the important truth for underwriters or storm surge. Models also industry continued using traditional and insurance buyers: Catastrophe often incorrectly assumed that actuarial methods and past models need constant updating all properties were built to meet experience as a basis for estimating based on experience. Even an up- existing codes. This lesson was potential future losses. to-date model can miscalculate the driven home by Hurricane Ike in potential damage from a storm that 2008, which caused severe wind and That changed after Hurricane behaves in an unforeseen manner — flood damage to inland and Northern Andrew struck Florida and potentially by a significant margin. states — including Arkansas, Louisiana in August 1992. Andrew Illinois, Indiana, Kentucky, cost insurers $15 billion — nearly Underwriters learned this the hard Michigan, Missouri, New York, four times Hugo’s cost — surprising way when Hurricane Katrina struck Ohio, Pennsylvania, Tennessee, them and leading to multiple in August 2005. The massive storm and West Virginia — that far bankruptcies. Andrew thus served cost insurers more than $41 billion, exceeded industry expectations. as a wake-up call; insurers quickly mostly in New Orleans. Hurricane embraced modeling, seeking a more models severely underestimated the Insureds and regulators have scientific approach to estimating loss potential, with initial damage sometimes questioned changes to catastrophic loss exposure estimates identifying only about models as they can lead insurers to and risk aggregation. one-fourth of that total. adjust rates, bringing increases to some buyers. For example, many risk managers criticized changes made in 2006, which projected a FIGURE 1: Most Costly Hurricanes in US History (In Billions) 40% increase in annual insured Source: Insurance Information Institute losses along the Gulf Coast, Florida, and Southeastern US compared to DATE HURRICANE DOLLARS WHEN OCCURRED IN 2014 DOLLARS previous models. But overall, these AUGUST 2005 KATRINA $41.1 $48.4 changes have helped insurers and insureds alike to better understand AUGUST 1992 ANDREW $15.5 $23.8 and manage risk. For example, the OCTOBER 2012 SANDY $18.8 $19.3 lessons learned from Katrina, Ike, SEPTEMBER 2008 IKE $12.5 $13.6 and other storms contributed to better preparation ahead of Sandy. OCTOBER 2005 WILMA $10.3 $12.1 AUGUST 2004 CHARLEY $7.5 $9.1 SEPTEMBER 2004 IVAN $7.1 $8.6 SEPTEMBER 1989 HUGO $4.2 $7.1 SEPTEMBER 2005 RITA $5.6 $6.6 SEPTEMBER 2004 FRANCES $4.6 $5.6 2 marsh.com INSIGHTS October 2015 How Hurricane Models Have Improved Over Time The three leading hurricane modeling firms — AIR Worldwide, EQECAT, and RMS — typically have made revisions based on the lessons learned following major storms such as Hurricanes Katrina and Ike and Superstorm Sandy. Updates to the widely used RMS model include the following: • New models released after the 2004 and 2005 Atlantic hurricane seasons — which included Hurricanes Charley, Frances, Ivan, Jeanne, Katrina, Rita, and Wilma — reflected greater frequency of hurricanes and insured losses that modeling firms expected would continue for the next several years. • After Hurricane Ike in 2008, models were updated with higher inland wind speeds and greater building vulnerability. Models also incorporated research about the weakness of commercial structures’ roofs and poorer- than-expected construction quality in Texas and along the Gulf coast, and added new storm surge models. • The storm surge models were updated with HURRICANE KATRINA (2005) new flood data from FEMA and the NFIP HURRICANE IKE (2008) following 2012’s Superstorm Sandy. HURRICANE (“SUPERSTORM”) • The latest updates include a recalibration SANDY (2012) of vulnerability curves based on recent hurricane-related claims, and new secondary modifiers that allow for improved accuracy of potential storm-surge damage. The reality is that nature will at times deliver an unexpected twist into the way a storm behaves. And modelers will respond by analyzing the losses and recalibrating their models. A Decade of Advances In Catastrophe Modeling and Risk Financing 3 INSIGHTS October 2015 MODELING’S ROLE IN UNDERWRITING AND RISK MANAGEMENT The catastrophe modeling process 3. Vulnerability: The model coverage. It also allows insurers to includes four key steps: calculates the mean damage demonstrate capital adequacy to ratio and coefficient of variation rating agencies. 1. Event generation: A computer- to buildings and their contents, run model pulls from a database and the resulting loss of use — for Meanwhile, insureds and their representing the full spectrum example, business interruption. brokers primarily use models to of likely events that can impact help make choices about how much the insured’s exposures. Each 4. Financial model: This model property insurance to purchase and event is described by physical calculates losses to different how to structure those policies. By characteristics, location, and financial participants, running a catastrophe model, an frequency of occurrence, and the including the insured, insurers, insured can develop a set of losses model calculates the likelihood and reinsurers. for various return periods, usually and severity of an event at various from 100 years to 1,000 years. The insured locations. Insurers use catastrophe models insured can then choose a return to determine their probable period that matches its risk appetite 2. Hazard: The model determines maximum loss (PML) for various and current market conditions and the event intensity at each insured return periods. This allows them insurance pricing to gain a greater property for every simulated to calculate an average annual understanding of its total property event that is likely to cause a loss (AAL), which indicates the portfolio risk and catastrophe loss at that location. It examines minimum annual premium that exposure. In turn, this informs important site characteristics, the insurer would need to collect decisions about limits, retentions, including soil condition, distance over that return period to cover and other terms and conditions. from the coastline, and elevation its expected loss. This ultimately to determine ground motion, peak informs insurers’ decisions about wind gust, and other location- how to manage risk aggregations, specific conditions. deploy capital, and price insurance REFINING EARTHQUAKE MODELS Although revisions to hurricane models have more frequently Modelers also used the update as an opportunity to recalibrate grabbed the attention of insurers and risk professionals, building vulnerability curves, incorporating claims data earthquake models have also evolved over time. The most recent from international events and engineering studies. These US earthquake model updates, released in 2009 by AIR and vulnerability curves show the relationships between the amount RMS, were not spurred by any single earthquake. Instead, the of ground shaking and expected damage to a building given its catalyst was the release of the United States Geological Survey’s construction characteristics. National Seismic Hazard Mapping Project (NSHMP), a scientific consensus on earthquake hazards. Subsequent earthquake models for other regions have also incorporated lessons learned from recent events. For example, Most notably, the 2009 updates included next generational both RMS and AIR prioritized the modeling of tsunami risks attenuation (NGA) relationships; earthquake attenuation following