Wall Street Journal: Insurers Now Take Grain of Salt With Catastrophe Models

Jun 6, 2012

The following article was published in The Wall Street Journal on June 6, 2012:


Insurers Now Take Grain of Salt with Catastrophe Models


By Erik Holm


Property insurers are beginning to cast a more skeptical eye toward the disaster models that predict potential losses from hurricanes, a major shift prompted in part by changes one modeling firm made to its formulas last year.

The new skepticism is being applauded by risk managers who say insurers had become too willing in recent years to accept without question the work of just a handful of disaster-modeling companies and too reliant on figures the models produce.

“There used to be a relatively monolithic view of hurricane risk,” said Bill Keogh, president of modeling firm Eqecat Inc. “Now, everybody is going off in their own direction to try to understand the risk a whole lot better.”

No matter which analysis insurers use, hurricanes are one of the largest threats facing the U.S. insurance industry. The $41.1 billion in claims from Hurricane Katrina, which struck the Gulf Coast in 2005, remains the largest insured loss in U.S. history, and a major hurricane could cause even more damage if it were to make a direct strike on Miami, Houston or New York.

But such events happen so rarely that insurers have turned to companies like Eqecat or Risk Management Solutions Inc. to determine how much they stand to lose if any of the worst-case scenarios were to occur. The models use information about weather patterns, property values and building codes to provide insurers with an analysis of their probable maximum losses, or PMLs, from hurricanes, earthquakes and other disasters.

If the models reveal potential losses that are more than an insurance company can stomach, it can prompt a shift in strategy. Companies may attempt to raise rates, drop customers or buy additional protection from the reinsurance market, which sells backup coverage against large losses.

Regulators and credit-rating firms that evaluate the financial strength of insurers and reinsurers also use the PML figures in their analyses. Insurers often disclose the figures in their regulatory filings, allowing Wall Street analysts and investors to incorporate them into their models, too.

Karen Clark, who founded modeling company AIR Worldwide more than two decades ago, has argued in recent years that the seemingly exact nature of the PMLs can lull insurers and investors into a false sense of security.

“Models are very valuable tools, but they only give you a rough indication of the risks,” said Ms. Clark, who now runs Karen Clark & Co., where she works with insurers to help them better understand catastrophe risk and how to manage it.

“This isn’t like the financial markets,” she said. “For a Northeast hurricane, we only have a handful of data points. You can’t pretend you have the same level of accuracy or precision as you do watching a stock price move every day for 20 years.”

Historically, most insurers would hire either RMS or AIR Worldwide to analyze their catastrophe risk. RMS and AIR dominate the business-with Mr. Keogh’s Eqecat coming in at a distant third. The results from the models “have not always been transparent, and companies have not always challenged them,” said Christopher Lewis, the chief insurance risk officer for Hartford Financial Services Group Inc.

Now, industry observers say insurers are increasingly hiring two or more of the modeling firms, asking questions about the results, hiring their own experts and reaching their own conclusions.

In response, the modelers are providing increasing amounts of information about their work and being more explicit about aspects of the estimates that are relatively uncertain-such as the Northeast hurricane scenario, said Claire Souch, vice president of model solutions at RMS.

Ms. Souch attributed part of the increased scrutiny to the demands of regulators and ratings firms. Under Solvency II, a new set of European solvency rules, insurers must show regulators they understand the models they’re using. Meanwhile, A.M. Best, a ratings company that specializes in insurers, began asking companies to provide their own view of their catastrophe exposures early this year.

“Models aren’t the be all and end all,” said Richard Attanasio, vice president of property-casualty ratings at A.M. Best. “We want to see them taking ownership of what the models are telling them.”

But many industry observers say a large part of the reason for the more intense scrutiny of the models is a new version of the RMS hurricane model released early last year. The model dramatically boosted some probable maximum losses, doubling the company’s 1-in-100 year estimate for insured hurricane losses in Texas and increasing estimates in the mid-Atlantic by more than 75%.

“It was such a market-impacting event that most of the major companies took a step back,” said Lara Mowery, head of the Property Specialty practice at Guy Carpenter, a reinsurance broker. “We heard loud and clear from the more sophisticated companies that they didn’t want to be held hostage to a model-version change or to an outside influence to their view of risk.”

Ms. Souch of RMS said many clients have “recognized the model is a step forward,” but said there was “no doubt that much of the industry was surprised by the magnitude of change.”

The new model led to “very individualized reinsurer behavior,” Ms. Mowery said. In 2009 and 2010, reinsurers selling coverage in hurricane-prone Florida had rarely offered price quotes that varied significantly from each other, and deviated only about 3% from the average, according to data compiled by Guy Carpenter. In mid-2011, there was “an explosion of volatility” that saw reinsurers competing for the same business offer price quotes that varied by as much as about 15% above or below the average, Ms. Mowery said.

To be sure, there was more at work in the price quotes than a new skepticism about the models, Ms. Mowery and others said. Disasters in the first half of 2011, including the earthquake and tsunami that struck Japan, sapped capital from some reinsurers. And some companies, instead of actively disagreeing with the change in the RMS model, have simply been slow to implement it, said Edward Noonan, the chairman and chief executive of Validus Holdings Ltd., a Bermuda-based insurer and reinsurer.

But Ms. Mowery, Mr. Noonan and others said it is clear that many viewed the changes to the RMS model with skepticism.

“Companies are saying there are particular things they really believe are usable, and there are some things that they don’t believe are necessarily completely accurate that they’re going to apply their own analysis to,” Ms. Mowery said.

It’s a development that is being greeted with applause from many corners of the industry.

“You’re taking away some of the systemic risk,” said Stephen Catlin, CEO of Catlin Group Ltd., a Bermuda-based insurer and reinsurer. “We’re probably not all going to make the same mistake at the same time.”