Clark Williams explains how the emergence of scientific engineering models for natural catastrophes is generating new and more precise applications.

The 1999 hurricane season begins on 1 June and, according to the latest projections by the National Hurricane Conference (Orlando, Fla.), it is expected to comprise 14 named storms and nine hurricanes, four of them major. These daunting reports heighten the challenge that insurers and reinsurers face to establish appropriate premium rates and reserve properly in a notoriously soft market environment. In the past, insurers and reinsurers have relied heavily on the historical data approach to catastrophe modelling to make these critical decisions. Today, advances in modelling technology mean that companies no longer have to settle for antiquated approaches to risk assessment.

Advanced weather technologies are forecasting that global weather conditions will result in more severe and more frequent natural disasters. The marketplace anticipates a storm with the ferocity of Hurricane Andrew soon. Insurers remember watching the course of Hurricane Andrew for fear it would shift just a few miles to the north, devastating the city of Miami and taking many well established, but under-reserved insurance companies with it.Unfortunately for the United States, the nation's coastal areas - where population and business growth demonstrate that most people want to live and work - are the same locations where hurricanes, tropical storms and earthquakes have the most dramatic impact.The reality is that every year thousands of businesses are destroyed and hundreds of lives are lost from natural disasters. Less than 50% of all businesses reopen their doors following a major disaster. Half the US population lives, and half of all US businesses are located, within 100 miles of the nation's coastlines. Commercial exposure of covered properties in high-risk natural disaster zones has grown at an unprecedented rate in the US, and this growth is forecasted to continue over the next 10 years. The confluence of these factors presents increased challenges for insurers and reinsurers in the midst of a soft market environment.

The wake-up call
The Northridge, Calif. earthquake surprised many established insurers and reinsurers because the available models were seriously under-predicting the potential losses. This event triggered significant changes in the modelling industry, as confidence in then-available methods of cat modelling diminished and the demand for better, more accurate products expanded.

One approach was to re-calibrate models based on the occurrence at Northridge - which amounted merely to multiplying loss predictions by another historical factor. The alternative was emerging scientific engineering models, not necessarily based on calibrated numbers, but rather on advanced technology from other disciplines that could analyse any possible type of weather or earthquake event. These models are based on the laws of nature, rather than the calibrated expert opinion approach traditionally utilised, and they meld science, engineering and mathematical data.Once burned, companies have become very inquisitive about the inner workings and hidden mechanisms of the “black box” approach to cat modelling. Technology now enables (re)insurers to know exactly what causes varying levels of catastrophic loss - providing new insights into details such as structural response to impact, the reaction of soil following an earthquake, the effect of the fires that often follow serious quakes and the damage caused at different proximities to actual or potential storms.

Rather than offering only a statistical approach, new technology provides a logical methodology for revealing likely impacts based on what is known about structural engineering and weather effects. This collection of more detailed underwriting information on properties was not available 15 to 20 years ago.

The insurance information age
Following the volume of catastrophes in the early 1990s, insurers and reinsurers began to recognise the need to create their own information age by taking advantage of the data warehousing and computational capabilities that had become available. Technology, in the form of next generation catastrophe risk assessment, has now advanced to the point where exposure to potential losses can be better understood and assessed.

Companies are armed with the necessary information to plan accurately and prevent losses. Reliable assessments of catastrophic risk for large property owners have facilitated the development of innovative mechanisms for transferring risk, whether through traditional insurance products, financial reinsurance or capital market solutions. Access to better information is opening new lines of business for reinsurers for risks that were once considered out of their domain. Corporate leaders and innovators also seek this type of information to examine the effect of varied scenarios on business continuity and the corresponding impact on market share.

On the mitigation front, insurers and reinsurers can utilise advanced science and engineering technology applied to sophisticated actuarial approaches to examine closely individual properties, as well as total business operations. This new technology allows breakthrough levels of precision and flexibility for testing single assets or total portfolios for varying types of actual and potential weather events.With an unprecedented level of detailed information, ceding companies and reinsurers can conduct far more sophisticated cost/benefit analyses to determine appropriate risk mitigation techniques and appropriate pricing. Particularly for earthquakes and hurricanes, construction reinforcements can be incorporated into models that more accurately measure multi-level structural reactions and provide precise formulae for effective risk reduction.

Unprecedented levels of risk information
While historical and actuarial data continue to hold an integral role in catastrophe modelling, technological advances dictate that companies need no longer be satisfied with limited aggregate levels of information. This capability is particularly important for (re)insurers who need to execute portfolio analyses on large numbers of properties down to the most detailed asset level with a high fidelity decision making tool. In fact, companies that recognise this transition in cat modelling capabilities are seeking advanced technology which will allow them to examine individual assets on the most fundamental basis before making underwriting and pricing decisions. Reliance on catastrophe models has grown, particularly among insurers who want to assess and manage aggregate exposure in the portfolio and optimise their reinsurance programmes.

Innovative risk transfer products, including both facultative and treaty reinsurance, can be applied alone or in combination to a portfolio. Catastrophe excess treaties could be applied to the entire portfolio or specific lines of business. An insurer can apply new cat modelling technology approaches to its existing book of business to assess accurately the impact of its existing reinsurance programme and select the optimum strategy to update the programme or suite of reinsurance products.

Impact for the future

Looking ahead, cat models are becoming increasingly important in the capital markets both because they allow the risk to be quantified to structure a bond or a security and because they are also an extremely effective pricing tool. In addition to premium and risk transfer, cat models are being utilised to price cat bonds, establish weather derivatives, examine possible mergers/acquisitions, conduct due diligence on transactions and determine credit worthiness.

At Impact Forecasting, for example, we recently conducted a risk assessment on behalf of financiers to determine the advisability of building a baseball stadium on a particular location in San Francisco. In addition to performing engineering tests on the framework, we were able to model for monetary losses due to damage repair and business interruption, including accounting for the different times of the year that an earthquake might occur.

For example, if an earthquake occurs during the off-season, there is a probability that the structure will be repaired before the new baseball season begins. Conversely, if the earthquake occurs in the middle of the baseball season, major business interruption losses could occur. The information enables the financiers to move forward on the project with appropriate risk mitigation and transfer programmes in place.

We expect to see more creative uses of cat modelling as the technology's scope becomes more comprehensive, yet more focused and flexible in terms of its ability to probe a broad range of catastrophe effects and test the mitigation of specific engineering enhancements. For insurers and reinsurers, the net benefit will be greatly enhanced information that will drive decisions about coverage and pricing to new levels of precision and reliability.

Clark Williams is president and ceo, Impact Forecasting. Impact Forecasting provides next generation catastrophe modelling and risk assessment services. It is a limited liability company, using proprietary technology provided by Aon Risk Technologies and ISEC, Inc. Tel: +1 (312) 456 1315; fax: +1 (312) 456 8647; e-mail: clark_williams@aon.com