Monday, June 28, 2010

Insurance: Is the industry too reliant on models? (BRK.B)

We have A LOT of posts on models and modeling. Financial, climate, high-fashion.
What it all boils down to is a line that Alfred Korzybski used in a different context: "The map is not the territory".
Model designers and model users must always remember that their models are not reality.

This is the second extensive piece that REACTIONS magazine has done on the subject in the last month. The first was an interview with General Re's (Berkshire Hathaway) CEO  in "Insurance: "CEO FORUM: Gen Re's Tad Montross on model dependency" (BRK.A)"

Risk modellers are preparing many updates to their models worldwide, which could have an effect on pricing. But are insurance and reinsurance firms over-reliant on them?
Catastrophe models 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 criticism.
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 they expected.

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 earthquake-exposed business.
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 landfall....MUCH MORE