NAIC Catastrophe Computer Modeling Handbook

Purpose of the Handbook “What on Earth do we need this for?” n The purpose of the Catastrophe Modeling Handbook is to explore in some detail catastrophe computer models and to discuss issues that have arisen or can be expected to arise from their use. n Used by insurance regulators to review models primarily used in underwriting, rate-making and solvency procedures.

n Insurers’ Perspective: –Old rate making methods underestimate the cost of insuring catastrophe prone areas. n Consumers’ Perspective: –Modelers must disclose input and output so independent tests can be run to assure that results are reasonable. User Perspectives of Models “Well here’s what we think...”

User Perspectives of Models (continued) n Regulators’ Perspective: –Must learn to replace traditional models with a methodology that is in its relative infancy in terms of producing consistently reliable results. –Must work with modelers to provide enough disclosure to make informed decisions while preserving the confidentiality of proprietary details.

Components of the Model “The whole is greater than the sum of its parts.” n Science Module: –Physical characteristics about the catastrophe (factors include: wind speeds, landfall location, magnitude, location of fault, liquefaction potential). n Engineering Module: –Estimates the effect of catastrophic events on different types of structures (factors include: age of structure, construction type, attachment anchoring). n Insurance Module: –Estimates the insured damage at a location (factors include: guaranteed replacement cost multiplier, deductible, reinsurance limits).

Considerations of Model Inputs “Whatever goes in...” n Models use expected future exposures as the basis for analysis whereas more traditional techniques use historical data. n Models can be modified to utilize exposure data maintained by companies and statistical agents. n Currently, exposure data is not collected specifically to be used in catastrophe modeling which can significantly impact a model’s results.

Model Output “…must come out.” n Average Annual Losses: –Provides an estimate of the amount a company needs to collect from policyholders each year to fund long- run catastrophe losses. n Loss Costs: –Defined as Average Annual Losses divided by the number of exposure units giving rise to those losses.

Model Output (continued) n Distribution of Losses: –The probability distribution that a company will experience losses less than or equal to a specified amount, used to: n estimate parameters when the form of the distribution has been assumed n create an empirical loss distribution. n Exceeding Probability Distribution: –Represents the probability that a client company’s portfolio of risks will experience losses greater than a given amount.

Model Output (continued) n Individual Event Losses: –Shows the event characteristics as well as detailed estimates on the losses for a specific simulated catastrophic event for a specified portfolio or risks. n Historical Event Losses: –Characteristics of a particular historical event are used to simulate the loss experience for a specific exposure distribution, typically the client’s current distribution.

Model Validation, Updating and Evaluation “Because you can never be too sure.” n Accuracy and Comparison to Historical Data: –Compare modeled results to actual results for a historic event. n Convergence: –Confirm the model was calculated using sufficient iterations.

Model Validation, Updating and Evaluation (continued) n Expert Opinion/Peer Review: –Confirm that modelers disclose the extent to which the model has been verified or substantiated by independent expert opinion. n Input Data Provided by Company: –Modelers should perform validation checks on provided data and disclose how invalid data is treated in their model.

Model Validation, Updating and Evaluation (continued) n Logical Relationship to Risk: –Verify that modeled loss costs increase as exposure to potential loss is assumed to increase and should decrease as exposures decrease. n Model Updates: –Verify that modelers update zip code databases on a regular basis.

Model Validation, Updating and Evaluation (continued) n Probabilistic Range: –Verify that models produce results over ranges that can be reasonably expected. n Sensitivity: –Test to see how a change in input or in a model parameter affects the outputs. n Stability: –Verify that sampling and aggregation have a negligible contribution to error.

Model Validation, Updating and Evaluation (continued) n Questions to Ask About: –Company data input to models –Computer simulation models –Model output

Proprietary Information “Everything is Sacred.” n Two Conflicting Sides of the Coin: –Catastrophe modelers are dependent upon keeping their model assumptions and parameters out of the hands of competitors. –Regulators are governed by Freedom of Information of Sunshine laws concerning what information must be disclosed to the general public.

Proprietary Information (continued) n Three Regulator Options to the Dilemma: –These laws occasionally contain a waiver from disclosing data if it considered to be a trade secret. –Modelers may allow regulators to perform an on-site visit and assist regulators in reviewing and understanding a specific model and its application to insurer data. –Regulators may ask state seismologists and geologists to assist them in understanding scientific aspects of the modeling process.

Education and Outreach n Explanation of how computer models are used in rate- making or portfolio management. n An overview of the technical information that the models contain should be supplied. n Educational materials should be prepared to increase public awareness of catastrophe risk. n Educational materials should be developed and distributed through the mail and the Internet. n Establish speakers’ bureaus for cities, towns, civic/business/religious organizations and educational institutions to identify available resources.

Other Suggestions “Let us not forget the kitchen sink!” n Related Activities: –Actuarial Standards for Model Use n ‘Using Models Outside the Actuary’s Area of Expertise (Property and Casualty)’ –Pre-Tax Loss Reserves for Companies n NAIC has been working on a proposal for a statutory tax deductible pre-event catastrophe reserve.

Contact Information For a copy of the NAIC’s Catastrophe Computer Modeling Handbook, contact Davin Cermak at : 2301 McGee, Suite 800 Kansas City, MO “As if this isn’t more than you wanted to know!”