Perfectly Modeled

Copyright 2010 ProQuest Information and LearningAll Rights ReservedCopyright 2010 National Underwriter Company dba Summit Business Media American Agent & Broker

August 2010

COVER STORY: CATASTROPHE MODELS; Pg. 28 Vol. 82 No. 8 ISSN: 0002-7200

18533

2458 words

Perfectly modeled

Pagoumian, David

ABSTRACT

As the 2010 Atlantic hurricane season moves into high gear, concern about catastrophe risk looms large in a year that has already featured an unusual level of activity, including a massive earthquake in Chile, a powerful winter windstorm in Europe, and an oil spill in the Gulf of Mexico. The rise in US catastrophe losses is driven in part by dramatic increases in development in places vulnerable to hurricanes, earthquakes and wildfires. In this volatile environment, catastrophe models play an important role for insurers and for agents and brokers seeking to help property owners manage their catastrophe risk. Brokers today use models to understand clients' exposures; strategically improve the structure of insurance programs; reduce bank loan covenants; and facilitate disaster recovery planning and risk mitigation. Agents and brokers can deliver value to clients and help them achieve their goals by making use of catastrophe models -- whether through in-house capabilities or by partnering with a wholesale broker that has those capabilities. FULL TEXT

THE NORTHRIDGE EARTHQUAKE, HURRICANE KATRINA AND THE DEEPWATER HORIZON OIL SPILL-THERE'S NO QUESTION THAT CATASTROPHIC LOSSES HAVE BEEN RISING, AND 2010 COULD BE THE WORST YEAR YET. FIND OUT HOW CATASTROPHE MODELING HAS COME OF AGE DURING THESE TUMULTUOUS TIMES AND HOW YOU CAN USE SOPHISTICATED NEW TOOLS TO HELP YOUR CUSTOMERS MANAGE PROPERTY EXPOSURES IN AN INCREASINGLY RISKY WORLD.

As the 2010 Atlantic hurricane season moves into high gear, concern about catastrophe risk looms has in a year that has already featured an unusual level of activity, including a massive earthquake in Chile, a powerful winter windstorm in Europe, and an oil spill in the Gulf of Mexico.

Munich Re estimates insured losses for global catastrophes at $23 billion for the first six months of 2010, the highest for that time period since 1994, according to the Insurance Information Institute. That far exceeds the 10-year average of $11 billion. In the U.S., catastrophe losses have more than doubled over the last decade to $193 billion, up 117 percent from the $89 billion from the 1990s, according to the ??. If this trend continues, the next decade is likely to be even more disastrous than this one, with ?? predicting a year with $100 billion in insured catastrophe losses certain to come in the future. The rise in U.S. catastrophe losses is driven in part by dramatic increases in development in places vulnerable to hurricanes, earthquakes and wildfires.

In this volatile environment catastrophe models play an important role for insurers and for agents and brokers seeking to help property owners manage their catastrophe risk.

In the roughly 20 years that they have been in use, catastrophe models have provided insurers and reinsurers information necessary to price products more accurately and to manage their exposure to avoid devastating portfolio losses.

Insurance brokers have also put catastrophe models to good use. Through the use of models, brokers have been able to help insureds and their retail agents, estimate potential losses and identify the drivers behind those losses; structure more cost-effective insurance programs; and help clients save money even in the hardest markets by ensuring that they buy only as much insurance as they really need.

To deliver these services, most of the large national brokers, and some wholesale brokers, have invested greatly in licensing risk models. By partnering with a wholesale broker, small and mid-sized agents and brokers can avoid the investment and required expertise and still deliver top-notch service to their clients.

DEVELOPMENT OF RISK MODELS

The first generation of catastrophe models emerged in the late 1980s and focused primarily on earthquake risk. Two of the top catastrophe modeling firms, AIR Worldwide and Risk Management Solutions Inc. (RMS), were founded in 1987 and 1988 respectively, while EQECAT Inc., a third major catastrophe risk modeling firm, was founded in 1994.

The catastrophe risk models they first introduced represented a significant step forward in the assessment and management of catastrophe risk. The models blend earthquake science, structural engineering and actuarial science. Over the past two decades, catastrophe modeling has continued to evolve and now offers models to assess the magnitude of risk of not just earthquakes, but also U.S. hurricanes, tornado/hail, and even terrorism. These models typically are revised and updated to reflect the new lessons that are learned after each disaster.

With the help of models, insurers have been able to minimize the risk of mispricing insurance or building up dangerous concentrations of natural catastrophe risk. Some carriers, insuring homes in Florida and California, reduced such concentrated risk prior to Hurricane Andrew in 1992 and the Northridge earthquake two years later.

20th Century Insurance, for example, was a leading California homeowners' and earthquake insurer with its greatest market share in California's San Fernando Valley. After the Northridge earthquake struck in January 1994, 20th Century was unable to pay claims because of its heavy concentration of policies in the affected area. State insurance regulators removed the company from the homeowners' and earthquake markets.

After Northridge, more insurers began using catastrophe models, which had been adjusted to reflect new information about the vulnerability of buildings. In March 1994, just a few months after the Northridge earthquake, an estimated 10 percent to 12 percent of property insurers used catastrophe models. By 2009, more than 90 percent of insurers were using models, RMS states.

Catastrophe models serve as an important tool for underwriters and risk managers by providing estimates of the probability of exceeding various levels of loss. Even though the estimates may be based on the best available science and exposure data, their projections necessarily include a degree of uncertainty. It's not surprising, then, that today's catastrophe models, while the most sophisticated tools for assessing and managing catastrophe risk, have been subject to criticism when their results significantly impact the availability and cost of insurance in the most vulnerable places.

After a severe hurricane season in 2004, and the devastating trio of Hurricanes Katrina, Rita and Wilma in 2005, models were revised to reflect the new losses and new lessons. The new RMS model projected greater potential losses based on an increase in Atlantic hurricane activity, new assessments of building performance and a more detailed understanding of how a confluence of circumstances amplifies losses in a severe catastrophe. As a result of the changes, modeled losses increased by 25 percent to 40 percent on average for coastal regions of the U.S. In response, reinsurers and primary insurers, in part due to rating agency scrutiny, attempted to reduce their exposures and increased rates to account for thetr increased risks. Consequently, many coastal property owners experienced dramatic increases in their insurance premiums.

While the value of models is unquestionable, they have been subject to criticism and inspection.

In Florida, RMS had to provide a revised model after state officials said it did not meet regulatory standards. RMS, however, continued to recommend that insurance and reinsurance companies use its original version, which had taken a forward-looking, medium-term view of hurricane activity as opposed to the standard historical average that was traditionally used.

The reliability of catastrophe models also has been challenged by coastal property owners in Massachusetts, which has experienced few severe storms in recent years. AIR Worldwide has estimated that Massachusetts faces about a 15 percent chance of a catastrophic storm within the next decade that would cost insurers $5 billion or more. Property owners are pressing for legislation that would subject the data and assumptions in models to greater scrutiny.

USE OF MODELS

It wasn't long after insurers began using models that brokers also began using them to understand how insurers were selecting risks and be in a better position to negotiate with underwriters.

Brokers found that the use of models allowed them to deliver value to clients in a number of ways and serve as a terrific sales tool. Brokers today use models to understand clients' exposures; strategically improve the structure of insurance programs; reduce bank loan covenants; and facilitate disaster recovery planning and risk mitigation.

UNDERSTAND CLIENTS' EXPOSURES

Businesses have a responsibility to protect the value of their assets by buying insurance, but without the help of models, they may be spending more than necessary by buying too much catastrophe insurance.

Wholesale brokers who use catastrophe models can help the clients of retail agents identify their potential catastrophe risks and understand the possible scope of the losses. In this way, brokers also can suggest appropriate levels of catastrophe protection.

Consider the case of a large real estate firm with heavy California and Pacific Northwest earthquake exposure. One earthquake catastrophe model estimated its potential loss at $137 million, while another model estimated it at $160 million. Without the information from those two models, the firm would have likely purchased insurance based on the value of its largest location, which was about $230 million. But because of the models, the firm bought a lower level of catastrophe insurance instead, saving $100,000.

IMPROVE STRUCTURE OF INSURANCE PROGRAMS

Brokers with strong underwriter relationships have a nuanced understanding of each carrier's risk appetite. One insurer may want to expand in a certain area or class of business, while another might be reducing its exposure.

Effective use of catastrophe models can provide a much more refined understanding of a client's exposures, and this insight allows the broker to tailor an underwriting submission to match the appetites of particular carriers. From the client's perspective, modeling results also may influence advice about retentions and deductibles.

For example, the use of catastrophe models has had a significant impact on the insurance program of a national retail chain with 700 locations across the country. After running its information through catastrophe models, the wholesale broker was able to inform the agent and risk manager that the company had only five locations with any significant catastrophe risk. With this information, those high-risk locations were placed with specialty insurers separate from the overall property insurance program, achieving a much lower cost program the bulk of the account.

REDUCE BANK LOAN COVENANTS

Brokers have used catastrophe models to help reduce the amount of insurance clients are required to buy under their bank loan covenants. Lenders typically will require businesses to buy full-value property catastrophe insurance as a condition of their mortgage.

A Florida entertainment center property, for instance, was required by its bank to buy $400 million in windstorm insurance. Models, however, showed that the building would sustain a probable maximum loss of only $50 million. The bank agreed to reduce the requirement from $400 million to $50 million, saving the client $700,000 in insurance premiums.

Presented with estimates from catastrophe models, banks are often willing to reduce their insurance requirements. As the mortgagee, the bank wants to protect itself from a loss in case of a catastrophe, but it gains nothing from forcing a client to buy more insurance than it needs.

IMPROVE DISASTER RECOVERY PLANNING

The disaster on BP's Deepwater Horizon drilling rig in the Gulf of Mexico has reminded companies and local governmental organizations about the importance of having good disaster recovery plans in place. Insureds can use catastrophe models to pinpoint and enhance understanding of potential disaster scenarios and implement plans at vulnerable locations to manage those risks and mitigate losses.

One large manufacturer of polymers and plastics, for instance, is seeking to work with a catastrophe modeling company and engineering firms to assess its properties in California to determine its vulnerability to damage from an earthquake and to help it assess how quickly its operations could be brought back online after a disaster.

QUALITY DATA IS KEY

Catastrophe models have opened the door for much more accurate assessments of catastrophe risk by basing estimates and scenarios on a mix of structural engineering and meteorological and earthquake science. Quantitative measurements of hazard have made it possible to more accurately project potential losses instead of relying so heavily on historical loss experience.

But the models' results are only as good as the data that goes into them. The more accurate and detailed the information that is available about each property, the more reliable the modeling results and the greater the opportunity to achieve premium savings.

Among the data points that can make a significant difference in the accuracy of modeling outputs include address, occupancy type, year built, number of stories, construction type as well as replacement value.

Agents should work with their clients to obtain the most detailed and up-to-date engineering and empirical data possible. Since missing data will default to the worst case, clients that take the time to provide good data will be rewarded as that gives underwriters more clarity about the risk, increasing their ability to offer coverage at more favorable terms and conditions.

The last 20 years have been marked by a number of devastating catastrophes. The list includes the Loma Prieta earthquake and Hurricane Hugo in 1989, Hurricane Andrew in 1992, the Northridge earthquake in 1994, the attacks on the World Trade Center and the Pentagon in 2001, and Hurricane Katrina in 2005.

As global catastrophe losses have risen over the last two decades, insurance underwriters have taken significant steps to more accurately assess and carefully manage their accumulations of catastrophe exposure. Clients who have a clear idea of their potential exposure will be in the best position to minimize their losses and protect their assets while keeping insurance costs under control.

Agents and brokers can deliver value to clients and help them achieve their goals by making use of catastrophe models - whether through in-house capabilities or by partnering with a wholesale broker that has those capabilities.

By DAVID PAGOUMIAN, chief executive officer, NAPCO

David Pagoumian is CEO of NAPCO (www.NAPCOLLC. com), a leading wholesale broker of commercial property insurance coverage.

Photographs

August 25, 2010