Rob Jones emphasises the importance of effective risk management tools to a reinsurer's rating

The havoc wreaked by natural catastrophes in 2004 has forced property catastrophe reinsurers to take stock of the methods they use to assess and model multiple events. Although they have made significant improvements in risk management, modelling and underwriting since Hurricane Andrew struck in 1992, catastrophes remain highly unpredictable and difficult to measure. In addition, billions of dollars in potential catastrophe losses remain unmodelled by many in the reinsurance sector.

Some reinsurers use their own tools or rely on their underwriting experience to manage pricing and risk aggregation. These companies might calculate very different prices for the same exposures. The majority of reinsurers, however, use vendor models, which produce similar results. The most sophisticated supplement the vendor models with models of their own.

Standard & Poor's views the ability to manage risk through internal risk management tools and underwriting capabilities as crucial to the rating.

For example, companies that can estimate additional perils that are not captured in vendor models could avoid inefficiently priced layers, programs, or territories entirely. It expects companies that write property catastrophe reinsurance to maintain excess capital to compensate for the volatility and severity inherent in this line of business.

A reinsurer also needs to be able to understand how the input into the vendor models at the primary level affects the results at the reinsurance level. Specifically, if the primary company uses one model and the reinsurer a different model, there can be differing results simply due to model assumptions. In addition, many reinsurers are simply using the primary company's exposure data set as the means toward assessing catastrophe risk, and it may not be all-encompassing. Prospectively, this lack of a complete data set could increase losses to a reinsurance company, unless the company can add additional incremental exposures (and then potential losses) for these missing properties.

Regardless of the success of risk management and modelling, a lack of predictability will remain a feature of this product line. As a result, Standard & Poor's includes an additional exposure-based catastrophe charge for reinsurers in its capital adequacy model - and therefore in its rating expectations - to compensate for the volatility.

The catastrophe charge uses a company's own gross and net modelled exposures on a global basis, based on their respective third-party or proprietary model's probabilistic output - this is known as the exceedence probability (EP) curve. The capital charge for catastrophe risk is based on the company-specific net expected losses at the 1-in-250-year level. Previously, a 1-in-100-year capital charge was applied to some reinsurance companies, but a recent change to the Standard and Poor's criteria means that a 1-in-250-year level charge will be applied to all reinsurers globally. The basis for the 1-in-250-year versus a 1-in-100-year charge is a recognition by Standard & Poor's that catastrophe losses in general are increasing in both frequency and severity.

The severity of property catastrophe risks is increasing through population growth in coastal areas, inflation, and higher building values. In the US, for example, more than 50% of the population now lives within 50 miles of a coastline. According to the US Environmental Protection Agency, there were three times as many natural catastrophes in the 1990s than there were three decades ago. As a result, insured losses from natural disasters are 15 times higher today than they were in the 1960s, even after adjusting for inflation. A case in point is Florida, which, according to ISO, sustained $18.8bn in insured hurricane losses last year - after a 70% increase in the number of state residents between 1980 and 2001.

The Southeast US was not the only area affected by an increase in the frequency of natural catastrophes in 2004. According to the Japan Meteorological Agency, 2.6 typhoons on average make landfall in Japan each year. However, this average was significantly exceeded in 2004, with 10 typhoons. This was well above the previous record of six. Typhoon Songda was the strongest typhoon to hit Japan in 2004, causing $3.6bn in damage. In addition, Standard & Poor's has recognised that although some reinsurers maintain a very large capital base compared with peers, and diversification of exposures is important for managing catastrophe risk, a consistent capital charge approach was the key for these new criteria. Establishing a uniform capital charge is critical, as reinsurers compete on a global basis for the same risks and exposures.

- Rob Jones is managing director of Standard and Poor's.

Catastrophes Reinsurance criteria

The full report, detailing the criteria change, entitled Reinsurance Criteria: Larger Losses And Better Modelling Prompt Changes To Property Catastrophe Criteria is available from Standard and Poor's information services, Ratings Direct - and Classic Direct -" target="_blank">