CATASTROPHE MODELING: A NEW APPROACH TO MANAGING RISK Huebner International Series on Risk, Insurance, and Economic Security J. David Cummins, Editor The Wharton School University of Pennsylvania Philadelphia, Pennsylvania, USA Series Advisors: Dr. Phelim P. Boyle University of Waterloo, Canada Dr. Jean Lemaire University of Pennsylvania, USA Professor Akihiko Tsuboi Kagawa University, Japan Dr. Richard Zeckhauser Harvard University, USA Other books in the series: Cummins, J. David and Derrig, Richard A.: Classical Insurance Solvency Theory Borba, Philip S. and Appel, David: Benefits, Costs, and Cycles in Workers’ Compensation Cummins, J. David and Derrig, Richard A.: Financial Models of Insurance Solvency Williams, C. Arthur: An International Comparison of Workers’ Compensation Cummins, J. David and Derrig, Richard A.: Managing the Insolvency Risk of Insurance Companies Dionne, Georges: Contributions to Insurance Economics Dionne, Georges and Harrington, Scott E.: Foundations of Insurance Economics Klugman, Stuart A.: Bayesian Statistics in Actuarial Science Durbin, David and Borba, Philip: Workers’ Compensation Insurance: Claim Costs, Prices and Regulation Cummins, J. David: Financial Management of Life Insurance Companies Gustavson, Sandra G. and Harrington, Scott E.: Insurance, Risk Management, and Public Policy Lemaire, Jean: Bonus-Malus Systems in Automobile Insurance Dionne, Georges and Laberge-Nadeau: Automobile Insurance: Road Safety, New Drivers, Risks, Insurance Fraud and Regulation Taylor, Greg: Loss Reserving: An Actuarial Perspective Dionne, Georges: Handbook of Insurance Sinha, Tapen: Pension Reform in Latin America and Its Lessons for International Polichmakers Lascher, Jr., Edward L. and Powers, Michael R.: The Economics and Politics of Choice No-Fault Insurance Grossi, Patricia and Kunreuther, Howard: Catastrophe Modeling: A New Approach to Managing Risk CATASTROPHE MODELING: A NEW APPROACH TO MANAGING RISK PATRICIA HOWARD GROSSI KUNREUTHER Managing Editors Risk Management and Decision Processes Center The Wharton School University of Pennsylvania assisted by CHANDU C. PATEL, FCAS, MAAA (EDITOR) Springer eBook ISBN: 0-387-23129-3 Print ISBN: 0-387-23082-3 ©2005 Springer Science + Business Media, Inc. Print ©2005 Springer Science + Business Media, Inc. Boston All rights reserved No part of this eBook may be reproduced or transmitted in any form or by any means, electronic, mechanical, recording, or otherwise, without written consent from the Publisher Created in the United States of America Visit Springer's eBookstore at: http://ebooks.springerlink.com and the Springer Global Website Online at: http://www.springeronline.com Contents Preface and Acknowledgements xiii Prelude xvii PART I - Framework for Risk Management 1 Using Catastrophe Models 1 Introduction: Needs, Stakeholders, and 3 Government Initiatives Patricia Grossi, Howard Kunreuther 1.1 Need to Manage Risk 3 1.2 Private Sector Stateholders in the Management of Risk 7 1.2.1 Property Owners 8 1.2.2 Insurers 9 1.2.3 Reinsurers 10 1.2.4 Capital Markets 10 1.2.5 Rating Agencies 11 1.2.6 State Insurance Commissioners 11 1.2.7 Other Stakeholders 12 1.3 Government’s Role in Management of Risk 13 1.3.1 Types of Programs 13 1.3.2 Federal Disaster Insurance 15 1.4 Summary of Chapter 19 1.5 References 20 2 An Introduction to Catastrophe Models and Insurance 23 Patricia Grossi, Howard Kunreuther, Don Windeler 2.1 History of Catastrophe Models 23 2.2 Structure of Catastrophe Models 26 2.3 Uses of a Catastrophe Model for Risk Management 27 2.4 Derivation and Use of an Exceedance Probability 29 Curve 2.4.1 Generating an Exceedance Probability Curve 29 2.4.2 Stakeholders and the Exceedance Probability Curve 32 2.5 Insurability of Catastrophe Risks 34 2.5.1 Conditions for Insurability of a Risk 35 2.5.2 Uncertainty of Losses 36 2.5.3 Highly Correlated Losses 37 vi 2.5.4 Determining Whether to Provide Coverage 38 2.6 Framework to Integrate Risk Assessment with 39 Risk Management 2.7 Summary and Relationship to Parts II-IV 40 2.8 References 41 PART II – Natural Hazard Risk Assessment 43 3 The Risk Assessment Process: The Role of Catastrophe 45 Modeling in Dealing with Natural Hazards Mehrdad Mahdyiar, Beverly Porter 3.1 Introduction 45 3.2 Hazard Module 47 3.2.1 Locations of Potential Future Events 47 3.2.2 Frequency of Occurrence 51 3.2.3 Parameterizing Severity at the Hazard’s Source 54 3.2.4 Parameters for Local Intensity and Site Effects 55 3.3 Inventory Module 58 3.4 Vulnerability Module 59 3.4.1 Identification of Typical Buildings 60 3.4.2 Evaluation of Building Performance 60 3.5 Loss Module 64 3.6 Summary 65 3.7 References 67 4 Sources, Nature, and Impact of Uncertainties 69 on Catastrophe Modeling Patricia Grossi, Don Windeler 4.1 Introduction 69 4.2 Classifications of Uncertainty 70 4.3 Sources of Uncertainty 70 4.4 Representing and Quantifying Uncertainty 74 4.4.1 Logic Trees 74 4.4.2 Simulation Techniques 76 4.4.3 Uncertainty and the Exceedance Probability Curve 78 4.5 Case Studies in Uncertainty 79 4.5.1 Hurricane Hazard: Florida 79 4.5.2 Earthquake Hazard: Charleston, South Carolina 82 4.6 Summary and Conclusions 89 4.7 References 90 vii PART III – Linking Risk Assessment With 93 Insurance 5 Use of Catastrophe Models in Insurance Rate Making 97 Dennis Kuzak, Tom Larsen 5.1 Introduction 97 5.2 Actuarial Principles 98 5.3 Use of Catastrophe Models in Rate Making 100 5.3.1 A Simple Rate Making Model 100 5.3.2 Differentiating Risk 102 5.4 Regulation and Catastrophe Modeling 106 5.5 Case Study of Rate-Setting: California Earthquake 108 Authority 5.5.1 Formation of the CEA 108 5.5.2 Rate-Setting Procedures 109 5.5.3 Future Research Issues 115 5.6 Open Issues for Using Catastrophe Models to 115 Determine Rates 5.7 Summary 117 5.8 References 118 6 Insurance Portfolio Management 119 Weimin Dong, Patricia Grossi 6.1 Introduction 119 6.2 Portfolio Composition and Catastrophe Modeling 120 6.2.1 Portfolio Composition 120 6.2.2 Catastrophe Modeling – Bottom-up Approach 121 6.2.3 Portfolio Aggregation 124 6.3 Portfolio Management Example 125 6.3.1 Understanding Risk 126 6.3.2 Underwriting and Risk Selection 127 6.4 Special Issues Regarding Portfolio Risk 127 6.4.1 Data Quality 128 6.4.2 Uncertainty Modeling 129 6.4.3 Impact of Correlation 130 6.5 Summary 132 6.6 References 133 viii 7 Risk Financing 135 David Lalonde 7.1 Introduction 135 7.2 What Risks Should Be Financed? 136 7.2.1 Level of Risk 137 7.2.2 Probable Maximum Loss (PML) 138 7.3 Risk Financing Mechanisms 139 7.3.1 Generating Funds Internally 139 7.3.2 Risk Transfer – Reinsurance 141 7.3.3 Risk Transfer – Securitization 143 7.3.4 Securitization Structures 145 7.3.5 Dealing With Basis Risk 156 7.4 The Costs of Risk Transfer 158 7.5 Evaluation of Risk Financing Schemes 159 7.5.1 Analyze Current Risk Profile 160 7.5.2 Customize Decision Model 160 7.5.3 Establish Performance Measures, Constraints, 160 Critical Function 7.5.4 Develop Risk Management Alternatives 161 7.5.5 Evaluate Alternative Strategies 161 7.5.6 Select, Implement, and Monitor Strategy 162 7.6 Summary 163 7.7 References 164 PART IV – Risk Management Strategies 165 Using Catastrophe Models 8 The Impact of Mitigation on Homeowners and Insurers: 167 An Analysis of Model Cities Paul Kleindorfer, Patricia Grossi, Howard Kunreuther 8.1 Introduction 167 8.2 Framework of Analysis 169 8.3 Construction of Model Cities 171 8.3.1 General Model Structure 171 8.3.2 Mitigation Measures 172 8.3.3 Books of Business for the Insurance Companies 172 8.3.4 Insurance Company Premium and Asset Levels 174 8.3.5 Incorporating Uncertainty Into Analysis 174 8.4 Insurer Decision Processes 175 8.4.1 Impact of Mitigation on Losses and Insurer Behavior 175 8.5 Homeowner Decision Processes 178 8.5.1 Factors Influencing Mitigation Adoption Decisions 178 ix 8.5.2 The Interaction of Mitigation Decisions and Insurance 180 Decisions 8.6 Implications for Workable Public-Private Partnerships 181 8.6.1 Role of Building Codes 183 8.6.2 Long-Term Mitigation Loans 184 8.6.3 Lower Deductibles Tied to Mitigation 184 8.7 Conclusions 186 8.8 References 187 9 The Impact of Risk Transfer Instruments: 189 An Analysis of Model Cities Howard Kunreuther, Paul Kleindorfer, Patricia Grossi 9.1 Introductions 189 9.2 Framework for Evaluating Alternative Strategies 189 9.3 Evaluating Different Strategies for the Insurer 191 9.4 Impact of Indemnity Contracts on Insurer Performance 193 9.4.1 Excess-of-Loss Reinsurance Using Strategy 1 194 9.4.2 Comparison of Performance Across Insurer’s Strategies 196 9.5 Catastrophe Bonds As Additional Sources of Funding 197 9.5.1 Structure of Catastrophe Bond for Oakland 198 9.5.2 Impact on Insurer’s Performance in Oakland 201 9.5.3 Performance of Catastrophe Bonds Across Different 203 Regions 9.5.4 Multi-Region Catastrophe Bonds 204 9.6 Extensions of the Analysis 205 9.7 Conclusions 206 9.8 References 208 10 Extending Catastrophe Modeling To Terrorism 209 Howard Kunreuther, Erwann Michel-Kerjan, Beverly Porter 10.1 Introduction 209 10.2 September 11, 2001: Impacts on Terrorism Insurance 210 10.3 The Nature of Terrorism Coverage 211 10.3.1 Insurability Issues 212 10.3.2 Expanding Capacity Through Catastrophe Bonds 212 10.3.3 Potential Role of Catastrophe Bonds 213 10.4 Comparison of Terrorism Risk with Natural Disaster 215 Risk 10.5 Terrorism Risk Insurance Act of 2002 216 10.5.1 Public-Private Risk Sharing Under TRIA 216 10.5.2 Challenge for Insurers and Firms: Quantifying the 218 Residual Risk x 10.6 Catastrophe Models for Terrorism Risk 218 10.6.1 Terrorism Hazard