Tuesday, November 30, 2010

Insurance/Reinsurance: "COMMENT: Risk modellers take flak"

We've been following the Florida insurance series for the last six weeks, links below.
Here's the article in question: "UPDATED: The Bogus Hurricane Models that Cost Florida Billions"
Here's a comment on it from the editor of Reactions magazine:
A scathing article that appeared in a Florida newspaper recently underlines that the market needs to stop taking risk models’ output as gospel, says Reactions' editor Michael Loney.

Read more: [risk management solutions] [rms karen clark] [karen clark & company]

Risk modelling firm Risk Management Solutions (RMS) was the subject of a scathing article in Florida’s Herald Tribune in November. The article said that following Hurricane Katrina in 2005 RMS aggressively pushed a new short-term model.

The lurid article, headlined “Florida insurers rely on dubious storm model”, stated: “RMS, a multimillion-dollar company that helps insurers estimate hurricane losses and other risks, brought four-hand picked scientists together in a Bermuda hotel room. There, on a Saturday in October 2005, the company gathered the justification it needed to rewrite hurricane risk. Instead of using 120 years of history to calculate the average number of storms each year, RMS used the scientists’ work as the basis for a new crystal ball, a computer model that would estimate storms for the next five years. The change created an $82bn gap between the money insurers had and what they needed, a hole they spent the next five years trying to fill with rate increases and policy cancellations.”

The article goes on to say that some hurricane specialists are now sceptical of RMS’ claimed “scientific consensus” for its new model. “Today, two of the four scientists present that day no longer support the hurricane estimates they helped generate,” the article says. “Neither do two other scientists involved in later revisions. One says that monkeys could do as well.”
The article adds that as a result of RMS’s model change the cost to insure a home in parts of Florida hit world-record levels.

(Full disclosure – Reactions and RMS share an ultimate parent in the Daily Mail & General Trust).
A number of points should be made in response to this article. Firstly, it is not risk modellers that set rates – insurance and reinsurance firms do that. Secondly, no one is forcing the reinsurance and reinsurance firms to use the RMS model. It is only one of several modelling firms. Thirdly, all the models were way off on Katrina, so the loss estimates were always going to increase (the question was by how much). Lastly, it is ludicrous to blame all of the rate increases after hurricane Katrina on a model change. Capital was depleted – the laws of demand and supply kicked in, pushing up pricing. The effects of model changes came on top of that.
The problem for RMS is the higher losses its new model predicted never came, making it look like the near-term model was not needed.

RMS responded in a letter to the editor of the Herald Tribune. It, not unreasonably, pointed out that the models merely deliver probabilistic forecasts not deterministic predictions. It also said that there is a widespread agreement among scientists that the number of North Atlantic hurricanes has increased since the 1970s and that since 1995 activity has been “significantly higher than the long-term average since 1900”. The question, RMS said, is how much higher is the frequency and how will it impact hurricanes making landfall in the US?

RMS said: “The scientists were deliberately kept at a distance from the commercial implications of the recommendations. In our annual review of medium-term activity rates (the next five years), we have worked with a total of 17 leading experts, representing a broad spectrum of opinions.”
It added: “There is no commercial advantage for us to overstate the risk.”

But the article does raise an important issue – the over-reliance of the industry on models. The Herald Tribune article stated: “RMS continues to promote its short-term model as the preferred option for its customers. A survey by Bermuda officials shows it is the dominant model for Bermuda reinsurers, the most crucial source of private hurricane protection for Florida.”
This is further evidence that insurers and reinsurers need to question what the models tell them. This is not the modellers’ fault. The models will never be perfect and they will always be wrong. Ironically, the models normally come in too low.
But equally, modellers should be careful not to overstate the accuracy of their models also. Karen Clark, CEO of risk modelling consulting firm Karen Clark & Company and founder of AIR Worldwide, an RMS rival, believes this is a problem. “I thought it was a pretty good article,” Clark told me after the Herald Tribune article came out. “I agree with the gist of what it was saying.”

Clark says three things were on the minds of insurance companies after Katrina: the industry had just had two years in a row of big cat losses; there was a sense that all models had been too low on Katrina; and there was a tremendous amount of press around Katrina, some even saying Katrina was caused by climate change.
“There was pressure to come out with models,” says Clark. “What happened is RMS came out with a near-term model that said over the next five years hurricane frequency would increase by 40%. That is fine if there is some science behind it to support an increase in frequency but quite another thing to say, OK, we throw out the model we have been using and move to the near-term one.”

Clark says too much emphasis was placed on the near-term model by RMS.

“They were kind of oversold,” says Clark. “It was money to real people. A small insurer may have to buy a lot more reinsurance and not be able to afford it. So the question is: is the science enough to justify it? A handful of scientists came up with that number and they never really had that use in mind for it.”
Clark says modellers overemphase the outcomes of their models, which can give answers down to the cent. She says the data behind the models is simply too uncertain to be that precise, and that a range should be provided instead....MORE
"Florida's Hurricane Insurance Premiums Largely Determined Overseas" 
"How Bermuda rigs insurance rates in Florida"