Incorporating Catastrophe Models in Property Ratemaking Prop-8 Jeffrey F. McCarty, FCAS, MAAA State Farm Fire and Casualty Company 2000 Seminar on Ratemaking March 9-10, 2000 San Diego, California

Use of Models in Property Insurance Ratemaking u General Information u Why Use Hurricane Models u Modeling Overview u Rate Review Analysis u Current Issues Outline

u 1 AIY is $1,000 exposures earned in one calendar year u Proper exposure base for catastrophe ratemaking u Direct compliment with catastrophe modeling output u Other available data can be used instead (e.g. in-force, written, etc.) Amount of Insurance Years (AIY)

Use of Models in Property Insurance Ratemaking u Earthquake u Non-Wind Catastrophes u Non-Hurricane, Wind Catastrophes u Hurricane Catastrophes u Uncertainty Provision/Risk Margin

Calculation of the Hurricane Provision Previous Method ( ) u u Used Historical Companywide Losses u u Statewide provisions determined using relative exposure to loss u u Provision by territory determined using output from computer simulation model Current Method (1997-Present) u u Exclusive use of computer simulation models

Concerns with Use of Historical Loss Data u Limited Hurricane Activity ã Frequency and Severity of hurricane activity has not been constant over time. ã Geographical pattern and physical characteristics of the historical record do not reflect the full range of possible hurricane events.

Concerns with Use of Historical Loss Data (Cont.) u Limited Reflection of Current Conditions ã Changes in Exposure ã Changes in Policy Conditions and Coverages ã Changes in Company Loss Settlement Procedures ã Changes in Company Marketing/Underwriting ã Increased emphasis on Building Code changes and enforcement activity. u Limited Credibility by Territory

Hurricane Computer Simulation Models u Address concerns with use of historical experience ã Simulate full range of possible hurricane events each with associated probabilities of occurrence. ã Use of Company’s current exposure information. u Input Considerations ã ZIP Code versus Geo-Code of exposure location ã Application of hurricane deductibles ã Limits by sub-coverage ã Use of current versus projected exposure distribution

Hurricane Hazard Model u Hazard Analysis u Vulnerability Assessment u Financial Assessment

Hurricane Hazard Model Hazard Analysis - Storm Parameters Storm Parameters Central pressure Radius & maximum winds Forward speed Fill rate Storm track Landfall Site Parameters Site Parameters Distance to the coast Terrain elevation Topology Ultimate outcome is hurricane wind speed.

Hurricane Hazard Model Vulnerability Assessment - Ultimate outcome is an estimated amount of damage for a particular type of building. Structural Characteristics Construction Number of stories Occupancy Roof type

Hurricane Hazard Model u u Measures the relative vulnerability of a structure to the different levels of intensity of a Hurricane. u u For a given intensity and type of structure, damage is expressed as a probability distribution of damage ratios. u u These mean damage ratios express the relative cost of repair for a given structure with respect to its replacement cost. u u They are developed separately for building, contents, additional living expense and business interruption. Damage Function

Hurricane Hazard Model Financial Assessment - Resulting desired output. Insurance Company Data Inputs Line of business/policy form Property location - Geo-Code or ZIP Code Insured values - Coverage A, B, C, D Property replacement cost Deductible Type of construction Number of stories Occupancy Year of construction

Hurricane Model Output u Annual Average Losses and higher moments u Annual Occurrence and Aggregate Loss Distributions u Probable Maximum Loss Scenarios u Effects of higher Deductibles & Coverage changes u Loss Estimates for specific events u “What If” type analysis u Largest Loss Reports

Hurricane Model Output Additional Considerations u Demand Surge u Loss Adjustment Expenses u Other Causes of Loss ã ã Loss Assessment ã ã Flood

Incorporating Hurricane Model Output into Property Ratemaking Loss Ratio Methodology å Calculate Hurricane average annual loss provision/AIY from model output å Add a provision for loss adjustment expense å Add a provision for uncertainty (risk provision) using higher moments of the model output å Convert to a Hurricane Loss Ratio using Earned Premium/AIY factor å Add Hurricane Loss Ratio to Non-Hurricane Loss and Expense Ratio for Total Catastrophe Loss Ratio å Same method for Statewide and Territory Indications

Hurricane Provision by Territory Example Incorporating Hurricane Model Output into Property Ratemaking

Provision for Uncertainty/Risk Provision u Reflect Relative Risk u Use Standard Deviation of modeled hurricane losses as measure of relative risk among states/territories u Determine minimum/maximum profit u Off-balance to target companywide/statewide profit u Selected uncertainty provision related to hurricane exposure u Incorporate into Loss Ratio or Pure Premium Method

Statewide Provision for Uncertainty Example Incorporating Hurricane Model Output into Property Ratemaking

Territory Provision for Uncertainty Example Incorporating Hurricane Model Output into Property Ratemaking

Hurricane Provision by Territory Including Provision for Uncertainty Example Incorporating Hurricane Model Output into Property Ratemaking

Calculation of Total Catastrophe Loss Ratio Example Incorporating Hurricane Model Output into Property Ratemaking

Indicated Rate Level Change Example Incorporating Hurricane Model Output into Property Ratemaking

u Modeling uncertainty u Variability between modelers’ results ã Florida Commission on Hurricane Loss Projection Methodology - (5) models accepted ã Use of multiple models in ratemaking u Regulatory Acceptance ã Before/After an event ã Proprietary/”Black-Box” concerns u Actuarial Standards Board Exposure Draft u Separate Hurricane Rating/Class Plan Current Issues

Separate Non-Hurricane and Hurricane Rating u Florida Statutory Requirement u Interim Approach - Hurricane Factors u Separate Hurricane and Non-Hurricane Ratemaking ã Non-Hurricane - use Loss Ratio Method ã Hurricane - use Pure Premium Method ã Separate Class Plan with appropriate classifications ã Clearly identifies cost of hurricane coverage ã Identifies cost differences for Loss Mitigation efforts ã Incorporate different expense and profit provisions