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Catastrophe Models

December 2, 2010

Richard Bill, FCAS, MAAA


R. A. Bill Consulting
Bill.consulting@frontier.com
Overview

Use of Cat Models in:


• Exposure Management
• Ratemaking

Note: will use Hurricane as example


Cat Models
3
Exposure Management - In old days, pins were used to identify concentration of risk

RABill Consulting 4
Exposure Management – Pins in Map
• Cumbersome practice was eliminated due to expense
considerations
• Billions of Dollars of Exposure is on or near the coast of the
US subject to severe hurricanes
• Likewise, for earthquake, the insurance industry exposure is
tremendous, particularly in California and the New Madrid
Area
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• How do insurance companies judge how much business to
write in catastrophe prone areas such as on the coast of
Florida without exposing the company to bankruptcy????
Catastrophe Ratemaking Problem
• A Hurricane is an unlikely event for a particular
location on the coast
• The experience period for making rates would need
to be very long to reflect the probability of a
Hurricane at a particular location
• Even if past history were available, it would not
reflect the increase in new construction on the coast
--------------------------------------------------------------------
• How do Insurers decide how much to charge for
catastrophe prone areas????
Catastrophe Models evolved as a
solution to the problem
• AIR founded the catastrophe modeling
industry in 1987
• Models were not used much in the beginning
• Hurricane Hugo in 1989 and particularly
Hurricane Andrew in 1992 were wakeup
calls
• Many insurance companies had not realized
the extent of their exposure concentrations.
Cat Model Definition
Catastrophe modeling is the process
of using computer-assisted
calculations to estimate the losses that
could be sustained by a portfolio of
properties due to a catastrophic event
such as a hurricane or earthquake
Property Casualty Insurance Industry
Major Risk Factors
• Hurricanes
• Earthquakes
• Terrorism Losses
• Insufficient Reserves
• Asbestos/Pollution or similar Exposure
• Poor underwriting and/or Inadequate Rates
• Collectibility of Reinsurance
• High Expenses
• Bad Investments
TYPES OF MODELS
• Earthquake
• Fire Following EQ
• Hurricane
• Storm Surge
• Tornado/Hail
• Winter Storm
• Terrorism
Catastrophe Models
• Catastrophe events are simulated for many
years (for example 10,000)
• Company submits detailed information on
their book of business
• Losses are calculated based on the
company’s book of business
• Losses are stated in terms of return time, i.e.
100 year event
Construction of Hurricane Model
• The annual number of occurrences is generated from
the frequency distribution
• Landfall Location of each Hurricane is determined
• Simulation of Storm track after landfall
• Hurricane severity simulation
• Wind Speed
• Size of Hurricane
• The movement of the event across the affected area
is simulated, and dollar damages are calculated based
on insured value, type of building, deductible, etc.
Simplified Example
Simulation of Frequency

• Assume average of 3 Hurricane Landfalls per year


• Assume Poisson Distribution
Probability of X Number of
Hurricanes , Avg Freq = 3 Per Year

# of Percentile # of Simulated
Hurricanes Probability Accumulative F(x) Hurricanes
0 5% 5% 0 - 5% 0
1 15% 20% 5 - 20% 1
2 22% 42% 20 - 42% 2
3 22% 65% 42 - 65% 3
4 17% 82% 65 - 82% 4
5 10% 92% 82 - 92% 5
6 5% 97% 92 - 97% 6

Based on Poisson Distribution


Industry Simulated Hurricane Frequency
Average Frequency = 3 Per Year

Year Percentile # of Events


2012 17% 1
2013 36% 2
2014 85% 5
2015 97% 7
2016 14% 1
2017 2% 0
2018 15% 1
2019 52% 3
2020 78% 4
2021 34% 2
Landfall Location 1st Hurricane
Number of Percentile
Segment Landfalls Probability Accumulative F(x) Segment
1 3 2% 2% 0 - 2% 1
2 3 2% 5% 2 - 5% 2
3 4 3% 8% 5 - 8% 3
4 10 8% 15% 8 - 15% 4
5 4 3% 18% 15 - 18% 5
6 3 2% 20% 18 - 20% 6
7 5 4% 24% 20 - 24% 7
8 6 5% 29% 24 - 29% 8
9 6 5% 33% 29 - 33% 9
10 3 2% 35% 33 - 35% 10
11 2 2% 37% 35 - 37% 11
12 4 3% 40% 37 - 40% 12
13 3 2% 42% 40 - 42% 13
14 19 14% 56% 42 - 56% 14
15 17 13% 69% 56 - 69% 15
16 3 2% 71% 69 - 71% 16
17 2 2% 73% 71 - 73% 17
18 1 1% 74% 73 - 74% 18
19 5 4% 77% 74 - 77% 19
20 2 2% 79% 77 - 79% 20
21 3 2% 81% 79 - 81% 21
22 10 8% 89% 81 - 89% 22
23 1 1% 89% 89 - 89% 23
24 2 2% 91% 89 - 91% 24
25 1 1% 92% 91 - 92% 25
26 5 4% 95% 92 - 95% 26
27 1 1% 96% 95 - 96% 27
28 5 4% 100% 96 - 100% 28
Total 133 100%
Industry Simulated Hurricane Location

Random (0,1)
Hurricane Percentile Segment #
1 17% 5
2 36% 11
3 85% 22
4 97% 28
5 14% 4
6 2% 2
7 15% 4
8 52% 14
9 78% 20
10 34% 10
Industry Simulated Hurricane Events
Based on 10,000 Years of Simulated Events

Simulates Precise
Location within Segment

Year EventID Event Lat/Long Landfall


1 11814 FL Hurricane Cat 1 26.1949/-80.0354
2 13602 LA Hurricane Cat 3 29.5352/-92.3730
2 22355 NC Hurricane Cat 5 35.2994/-76.1572
3 19188 MS Hurricane Cat 2 28.4666/-92.4352
3 34955 FL Hurricane Cat 3 26.2549/-90.3445
3 38175 FL Hurricane Cat 5 26.3555/-90.5553
3 3421 AL Hurricane Cat 4 27.3322/-92.5543
3 23037 SC Hurricane Cat 4 34.3335/-78.5555
~ ~ ~ ~
~ ~ ~ ~
9999 17044 GA Hurricane Cat 3 33.4444/-87.2225
10000 38889 FL Hurricane Cat 5 26.4444/-90.5555
Company XYZ Simulated Hurricane Losses
Based on 10,000 Years of Simulated Events

Replacement Average Annual


Policy # Type Address Lat/Long Location Value Loss
1000 Dwelling 1234 Washington 26.1949/-80.0354 $ 100,000 $ 100
1001 Apartment 1235 Washington 26.1950/-80.0360 15,000,000 10,000
~ ~ ~ ~ ~ ~
~ ~ ~ ~ ~ ~
1050 Dwelling 1500 Ash 26.1951/-80.0374 300,000 400
1051 Dwelling 1505 Ash 26.1953/-80.0380 400,000 550

Total $ 3,000,000
Model Output
Company XYZ Simulated Hurricane Losses From Largest
In Thousands

Accumulated Gross Loss Gross Loss Net Loss


Probability Year EventID Event Amount Amount
0.0001 7779 16970 LA Hurricane 100,120 80,120
0.0002 3851 17065 NC Hurricane 99,500 79,500
0.0003 5447 40855 MS Hurricane 98,000 78,000
~
Richard:
~
1000 Year Event
0.0009 3354 35241 FL Hurricane 76,443 56,443
0.0010 1418 8130 FL Hurricane 75,150 55,150
0.0011 9004 34930 AL Hurricane 74,300 54,300
~ Richard:
~ 100 Year Event
0.0099 621 1617 SC Hurricane 40,253 37,752
0.0100 8782 13220 GA Hurricane 40,100 37,599
0.0101 4560 1172 FL Hurricane 39,980 37,479
Company XYZ Cat Model Results
In Millions
Return
Period Probability Direct Losses Net Losses*

25 4.00% 18 17
50 2.00% 27 25
100 1.00% 40 37
250 0.40% 51 46
500 0.20% 65 47
1,000 0.10% 75 55
10,000 0.01% 100 80

Avg Annual Loss 3

* After Reinsurance Recoveries


Return Period Perspective
• 250 Years-20 years before the Declaration of
Independence - 1756
• 500 Years- 14 years after Christopher Columbus
discovers America - 1506
• 1,000 Years-Leif Erickson discovers “Vinland”
(possibly New England - 1006?)
• 10,000 Years – 8000 B.C. - ??????
Industry % of Insured Value
in Coastal Counties

• 79% in Florida
• 63% in Connecticut
• 61% in New York
• 54% in Massachusetts
• 16% Nationwide
Top 10 Most Costly Hurricanes in US History, (Insured
Losses, $2005)

$45 Seven of the 10 most expensive


$40.0
$40 hurricanes in US history
$35 occurred in the 14 months from
$30 Aug. 2004 – Oct. 2005:
$ Billions

$25
Katrina, Rita, Wilma, Charley, $21.6
$20
Ivan, Frances & Jeanne
$15
$10 $7.4 $7.7 $8.4
$6.6
$3.8 $4.8 $5.0
$5 $3.5

$0
Georges Jeanne Frances Rita Hugo Ivan Charley Wilma Andrew Katrina
(1998) (2004) (2004) (2005) (1989) (2004) (2004) (2005) (1992) (2005)

From III Presentation on Hurricanes


Sources: ISO/PCS; Insurance Information Institute.
Exposure Management
• Component of Insurance Company’s
Enterprise Risk Management (ERM)
• Make sure that a catastrophe does not wipe
out the company
• Maintain financial strength after an event
• Maintain financial ratings
• Smooth earnings (publicly held companies)
Accumulation Management

• Manage accumulation during


underwriting process
• Limit new business
• Non renewals
• Increase business in lower risk
areas
Exposure Management (cont.)
• Rating Agencies are placing a lot more
reliance on cat management since the
hurricanes of 2004 and 2005
• A Company can either purchase more
reinsurance or reduce exposure or raise
prices or a combination
Industry Reaction
• More demand for reinsurance
• Many companies are pulling back from
coastal areas particularly, the gulf states
• Insurance Rates for coastal properties have
skyrocketed
Ratemaking
Pricing for Hurricane
“When hurricane rating analyses were first
expanded from five to 30 years of storm
experience, the technique was applauded as a
vast improvement, which is was. The 30 years
were replaced by 100,000 years and real life
events were replaced by silcon-prompted
simulations. “
Company XYZ Simulated Hurricane Losses
Based on 10,000 Years of Simulated Events
In Thousands

Gross Loss Net Loss


Year EventID Event Lat/Long Location Amount Amount
1 11814 FL Hurricane 26.1949/-80.0354 283 283
2 13602 LA Hurricane 29.5352/-92.3730 400 400
2 22355 NC Hurricane 35.2994/-76.1572 40 40
3 19188 MS Hurricane 28.4666/-92.4352 300 300
3 34955 FL Hurricane 26.2549/-90.3445 10,000 9,500
3 38175 FL Hurricane 26.3555/-90.5553 640 640
3 3421 AL Hurricane 27.3322/-92.5543 100 100
3 23037 SC Hurricane 34.3335/-78.5555 829 829
4 17044 GA Hurricane 33.4444/-87.2225 214 214
4 38889 FL Hurricane 26.4444/-90.5555 589 589
~ ~ ~
~ ~ ~
Total 30,000,000

Average Annual Loss (Divide by 10,000) $ 3,000


Average Annual Loss
• Indicates what needs to be charged each year
to cover hurricane losses over the long run
• Can be calculated for each individual building-
useful for pricing large commercial buildings
• Can be calculated at a zip code level or even
finer to be used in pricing – example, all
dwellings within 1 mile of the coast
• Risk charge can be calculated as an additional
charge
How Models Are Used
Underwriting
Establish guidelines
Differentiate risks
Develop pricing

Portfolio Management
Determine risk drivers
Evaluate capital adequacy
Allocate capital
Estimate post-event losses
Accumulation Management

Risk Transfer
Determine reinsurance needs
Structure and price of reinsurance