Karen Clark & Co says figures are not credible; study examines ‘Hurricane Frequency Paradox’
Karen Clark & Company, independent experts in catastrophe risk, catastrophe models, and catastrophe risk management, has released its second annual report on the performance of near-term hurricane models.
The report finds the models, designed to project insured losses in the United States from Atlantic hurricanes for the five-year period ending in 2010, have significantly overestimated losses for the cumulative 2006 through 2009 seasons. Last year’s report found the same for the 2006 through 2008 seasons.
Near term models were introduced by the three major catastrophe modellers in 2006, following the destructive 2004 and 2005 hurricane seasons. Each of the companies, AIR Worldwide (AIR), EQECAT and Risk Management Solutions (RMS), initially projected insured loss levels at least 35% above the long-term average for the period 2006 through 2010. AIR lowered its figure to approximately 16% in 2007. EQECAT has made only minor adjustments to its original estimate of loss increases of between 35 and 37%. RMS introduced modifications to its model in 2009, but still predicted losses at 25 percent above the long-term average.
Assuming long-term average annual insured hurricane losses of $10bn per year, these figures translate into cumulative insured losses for 2006 through 2009 of $48.8bn, $54.5bn, and $54.6bn respectively, for the AIR, EQECAT and RMS models. The actual cumulative losses were $13.3bn, far lower than the model predictions, and only one third the long-term cumulative average of $40bn. The 2009 Atlantic hurricane season was below average in the number of named storms, hurricanes and major hurricanes, and was the lowest frequency year since 1997.
“This latest study further supports our previous findings that a short time horizon is not sufficient for credibly estimating insured losses from hurricanes,” said Karen Clark, President and CEO, Karen Clark & Company. “Hurricane activity changes markedly year to year, and the 2004 and 2005 seasons have proven not to be harbingers of a continuing trend. Given all the uncertainties, near term projections do not have sufficient credibility to be used for important insurance applications such as product pricing and establishing solvency standards.”
Catastrophe models were introduced to the insurance industry in the late 1980s. By utilising many decades of historical data, the models gave insurance companies better estimates of what could happen and more specifically, the probabilities of losses of different sizes on specific portfolios of insured properties. Use of the near term models by insurance and reinsurance companies, which are based on short term assessments of the frequencies of hurricanes, was a radical departure from the way in which catastrophe average annual losses (AALs) and probable maximum losses (PMLs) are typically derived.
The report notes that hurricane activity is influenced by many climatological factors, many of which are known, but some unknown, by scientists. There are complicated feedback mechanisms in the atmosphere that cannot be quantified precisely even by the most sophisticated and powerful climate models. The report recommends that insurers, reinsurers and regulators evaluate the efficacy of the near term hurricane models in light of this uncertainty.
“Catastrophe models are powerful, broad based tools that are very good for particular applications,” said Clark. “However, model users must recognise that there can be a very wide range of estimates associated with a given model metric, such as average annual loss. Model users should be ‘thinking outside the black box,’ focusing more on understanding the range of estimates rather than automatically relying on one or two highly uncertain point estimates. This will facilitate more transparent and robust catastrophe risk management decision making.”
The Hurricane Frequency Paradox
The Karen Clark & Company report also addresses what has been termed the Hurricane Frequency Paradox.
Some scientists suggest there has been an increase in Atlantic tropical activity, based on growth in the tropical cyclone counts since data was first compiled in the late 19th century. Paradoxically, this apparent increase has not resulted in an increase in hurricane landfalls in the United States. If in fact there are more Atlantic tropical cyclones, then over the past four decades the percentage of storms making landfall has declined to about 60 percent, compared to an average of about 75 percent prior to 1965.
Researchers at the National Oceanic and Atmospheric Administration (NOAA) have now concluded that the increase in annual storm frequency is in large part attributable to improvements in observational technology leading to the increased detection of tropical storms and hurricanes. This is particularly true for short duration storms originating in the Eastern Atlantic, far removed from potential landfall. Prior to the introduction of satellite technology, such storms were dependent upon oceangoing ships for detection.
“According to the most recent NOAA study, the occurrence of short-lived Atlantic tropical storms and hurricanes, those surviving no more than two days, has increased dramatically over time, while the number of longer-duration storms has not,” said Clark. “If one estimates the number of storms prior to 1970 that were not detected, there appears to actually be a slight decreasing trend in storm frequency. In addition, we have not seen an increasing trend in hurricane losses when historical losses are normalised to current exposure values.”