have become invaluable tools for the insurance and reinsurance
industry, giving underwriters a scientific understanding of
natural perils, in order for them to accurately estimate
potential catastrophe losses to their portfolios and manage
their exposures. The problems arise, however, when large,
unexpected events happen. Real-life events such as September
11, Hurricane Katrina have taught the industry that models only
know what has already been and this has frequently led to
In the past, risk modellers have suffered from the syndrome
of workmen blaming their tools. Following Katrina, for example,
many insurers and reinsurers complained that flood risk was not
included in the models, meaning losses were far higher than
So with forecasters predicting an above average season for
the number of tropical storms and hurricanes forming in the
Atlantic basin this year, how seriously should the industry
take the forecasts and risk model loss calculations and what
influence will the latest risk models have on the market?
What the models offer the industry is the ability to
estimate potential losses for a number of different uncertain
events and a combination of variables. There has been much
advancement in catastrophe models - both in the technology
used to build the models and the data used to feed the
models - that have improved companies' understanding of
risk and loss potential.
According to Karen Clark, president and CEO of risk
modelling consulting firm Karen Clark & Company and founder
of AIR Worldwide, most of the recent risk model developments in
the US have been with earthquake models. New studies by the US
Geological Survey, a source of data for all risk modellers, has
resulted in a "significant decrease in the earthquake risk,
particularly in states such as California," says Clark. She
says, while not decreasing pricing for every reinsurance
treaty, this held down potential price increases for
A new RMS US earthquake model released in 2009 led to a
reduction in US earthquake insured loss estimates and changed
the industry's understanding of the geographical distribution
of exposure. The effects of this have largely been digested by
the market and now companies are waiting to see what the latest
model developments will bring.
Most of the new models in the pipeline relate to wind and
storm risk. In the coming year, Eqecat is releasing a
basin-wide Asia typhoon model, AIR is launching updated models
for US hurricane, European extra-tropical cyclone, and typhoon
models for Asia, and Risk Management Solutions (RMS) is
releasing a new Europe windstorm model and is in the process of
building a new Atlantic hurricane model.
According to Neena Saith, senior catastrophe response
manager at RMS, her firm's new Atlantic hurricane model will
combine a large amount of high resolution data with a great
number of claims forensics. Using historical data of hurricane
activity, Saith says RMS will be able to run advanced numerical
models to understand particular hurricane processes, such as
the interaction between a storm and the surface upon making
Beyond this, RMS is looking to build a US flood model that
will allow risk models to be run at a much higher
In June, AIR's latest US hurricane model was certified by
the Florida Commission on Hurricane Loss Projection
Methodology. The model incorporates "the latest research and
scientific understanding of hurricane structure as well as
detailed modelling for risk differentiation at a high
resolution," Jayanta Guin, senior vice-president of research
and modelling at AIR, told Reactions.
And in Europe, AIR's updated European cyclone fourth
generation model is built upon numerical weather prediction
technology that produces high resolution wind data. The updated
model has been validated against a large database of surface
wind observations and is ideal for use in parametric
transactions. "In addition, the model introduces a novel
approach to modelling clustering behaviour for storm activity
over Europe, which is crucial for a complete view of risk,"
Eqecat's and AIR's development of Asia typhoon models is an
interesting sign of the growing necessity for an awareness of
insured property losses in an area of many fast growing
Eqecat's models previously covered the individual countries
of China, Japan, Philippines, Thailand, South Korea and
Malaysia. "What we are doing now is building a basin-wide event
set that allows our clients to understand the correlation among
the risks that they have in those countries,â€ Bill
Keogh, senior vice-president of Eqecat's strategic initiatives,
told Reactions. "It is giving the market a new perspective on
typhoon risk in Asia that they have never had before."
According to Keogh, Asia typhoon has three components to it.
"It is not just about wind, it is also about storm surge and
typhoon-induced rainfall that creates flooding. So the typhoon
risk in Asia actually presents us with three different hazards,
each of which needs to be modelled and understood, and then
He adds: "We incorporate all three of those in our model and
we believe we are the first ones to do that. What this is
providing to the market now is a full view of risks in
For Eqecat, the exceptional rate of economic growth in Asia
over the past two decades has called for a comprehensive view
of insured risk in Asia.
In July, it will also release a new earthquake model that
implements three-dimensional vulnerability.
"We recognise through examining thousands of pieces of
claims data from earthquakes that the way buildings respond to
earthquakes can change during an earthquake," says Keogh.
"After the initial ground motion and damage to a building, the
building becomes more vulnerable to additional ground shaking.
So as an event occurs for a longer duration it has the
potential to be more vulnerable than we thought."
Number of Atlantic hurricanes
|Source: Karen Clark &
Risk of reliance
So how reliant should companies be on these models, and do
they have a tangible effect on the market?
The financial impact of an updated model is hard to quantify
because models are one among several components that determine
pricing. However, as AIR points out, model enhancements do lead
to improved risk differentiation. In the past this has led
insurers to become more aware of exposure, which had a direct
impact on insurance and reinsurance underwriting and portfolio
According to Tatsuhiko Hoshina, director and chief
underwriting officer at Tokio Millennium Re, the Bermudian
reinsurance operation of Japanese insurer Tokio Marine,
companies do react to these models and this presents a threat
to the market.
"It's a strange phenomenon from the cedents' point of view
as the risk exposure is exactly the same, but just because the
models change it has an effect. I think that's one of the
biggest threats that we have in the market," Hoshina told
Reactions. "Also companies are just relying on the output from
these models and not knowing what has actually gone in.
Whatever comes out from the different models they take an
average and that is the threat that we have.
"There is a big uncertainty within the models especially if
you blend it like that â€" you are just adding more
uncertainty by using multiple models," he adds.
Bryon Ehrhart, CEO of Aon Benfield Analytics and chairman of
Aon Benfield Securities, is less convinced that people have
such a knee-jerk response to model changes.
Speaking on a catastrophe management panel at a Standard
& Poor's insurance conference in New York in June, Ehrhart
said: "People still take the models and make a judgement about
what they need to do. Do you see people actively reducing their
PMLs [probable maximum loss] and reducing the amount of cover
because of the earthquake model? Not really."
He pointed out instead that market pressure has a pronounced
effect, using the example of a European wind risk model change
a few years ago. "The estimate of European wind went down
pretty dramatically and people initially held the coverage that
they had, but as pressure mounted in the past year and half
people did start to reduce coverage," he said.
Ehrhart said it is interesting to see how dependent the
industry has become on these models considering that "almost
all of the volatility and vulnerability estimates are made by
people that have zero capital risk."
However, Heike Trilovszky, head of corporate underwriting at
Munich Re, says the industry reaction to models in the US
differs from the rest of the world. "In the other [non-US]
markets it's not that there is one model provider who comes up
with a new version and then everybody uses that model and all
of a sudden has a new view on the risk," Trilovszky told
Reactions. "Some non-US markets don't have models at all, or if
there are models, there are many models. It is not yet as
standardised as in the US.
"RMS has a very strong position in the market and many
people measure their exposure on the basis of that model. That
is why in the US the RMS influence on prices is so
Number of US landfalling hurricanes
|Source: Karen Clark &
An uncertain future
Forecasters are predicting an above-average season in terms
of the number of tropical storms and hurricanes forming in the
Atlantic basin this year.
However, Clark questions the usefulness of the scientific
forecasts that predict the number of tropical storms and
hurricanes that form in the Atlantic each year, calling it a
very "uncertain science".
"There does seem to be a consensus between the forecasters
in that most of the predictions are well above average for the
season; they tend to line up as they are based on the same
indicators. However, predictions are typically wrong," she
"What matters to the insurance industry is: if it makes
landfall, where does it make landfall?" says Clark. "When
it comes to a major hurricane hitting land, no one can predict
that and so you don't know if it will hit a highly populated
Clark points out that when Hurricane Andrew hit in 1992, it
was a low frequency year for hurricanes in the Atlantic. The
same was seen back in 1938 with the Great New England Hurricane
that also occurred in a low frequency year. "Some of the worst
loss years have been in low frequency years," says
Clark. "It's just a random major event hitting a highly
populated area and that is what is important to the industry.
Losses are what are important."
Predicting if and where hurricanes might make landfall is a
very challenging task that involves much higher levels of
uncertainty than the predictions of storm and hurricane counts.
As a result, only a few of the organisations that provide
seasonal forecasts include landfall forecasts.
Clark believes there is too much uncertainty around
year-to-year hurricane activity and insured losses to make
credible short-term predictions.
According to a Karen Clark & Company report on the
performance of the near-term models that have been designed to
project insured losses in the US from Atlantic hurricanes for
the five-year period ending in 2010, the losses for the
cumulative 2006 through 2009 seasons have often been
overestimated. As such, Clark recommends insurers, reinsurers
and regulators evaluate the efficacy of the near-term models in
light of this uncertainty.
Keogh says Eqecat's initiatives for education and training
related to uncertainty remains the single most important
resource that Eqecat has for its clients. "For many people when
they think about uncertainty they think about the mathematical
expression of uncertainty and numbers part of it," says
Eqecat tries to hammer home the message that similarly built
structures, subject to same peak gust wind speed or same ground
motion, can have very different responses and experience
dissimilar damage profiles.
"What we call that is real physical uncertainty and it's a
way for people to understand that the uncertainty isn't just
about mathematics. The uncertainty of the model is about the
physical uncertainly about how buildings respond to different
physical responses and to external forces. We have a lot of
information about that and we use that information to inform
how our models treat uncertainly," he says.
US insured losses from hurricanes
|Source: Karen Clark &
Keogh says with risk modelling, it is vital to understand
that models are tools and should be used as such. He does not
claim that Eqecat holds a crystal ball and urges practitioners
to have a high appreciation for the underlying uncertainly in
So what does Keogh say models have to offer? "Our models, at
best, will provide our clients with realistic expectations
about risk," says Keogh.
Looking ahead, Keogh expects that models will become more
accurate with regards to knowing what the uncertainties
involved are. Although he notes: "Accuracy is not a word we
tend to use in modelling. The underlying sciences, physics and
engineering that go into the model get better, but at the end
of the day the output you are getting will always have
uncertainly in it.
"That is something that we want practitioners to embrace and
understand so they are able to use them as tools as opposed to
thinking that they have the answer when they get the
By Annabelle Palmer - firstname.lastname@example.org
Risk models could help reduce poverty
The use of catastrophe models is not just about protection for
the beach house owner in Florida or a homeowner on a fault line
in California. Recently, insurance concepts of extreme risk
modelling and risk sharing across finance, development and
other industries have been extended to help development and aid
organisations look for new solutions help poorer nations and
emerging economies cope with catastrophes.
According to Rowan Douglas, chairman of the Willis Research
Network (WRN), an academic and the insurance industry
collaboration project funded by the reinsurance arm of Willis,
the use of catastrophe models and the management of extreme
risks are vital to sustainability, financial security and
The methods employed by insurers to model extreme risks can
be important in helping the world's most vulnerable communities
cope with the social and economic impacts of floods, droughts
and other climate-related threats.
Speaking at the World Bank's inaugural 'Understanding Risk'
conference, held in Washington, DC in June, Douglas noted that
the scientific models used by the insurance industry to assess
the financial risks of extreme weather events could help
governments and aid agencies develop new approaches for
sustainable development and poverty alleviation.
During a keynote speech, Douglas illustrated how the tools,
models and techniques used to help insurance companies sustain
1-in-200-year shocks could help deliver sustainability and
financial security, and combat poverty in those regions most at
risk to extreme weather.
According to research conducted by the World Bank, it is the
poorest regions in areas such as south-east Asia that will be
most affected by extreme weather events, including floods,
cyclones and drought. India alone could see a 30% to 40%
decline in agriculture productivity as a direct result of more
"We tend to manage for normality, but it is the extreme
events that often matter most," said Douglas. "Whether it's in
our financial institutions, societies or environment,
sustainability is achieved by avoiding or managing the impacts
of undesirable extremes within tolerable parameters. Therefore,
we are proposing a new lens through which we look at the issue
of sustainability, one which repositions the fundamental
concepts and roles of insurance at the heart of delivering
sustainability, financial security and poverty reduction."