Catastrophe Modeling Personal Lines Perspective Jodi Healy Ratemaking

Catastrophe Modeling Personal Lines Perspective Jodi Healy Ratemaking Seminar March 28, 2003 1

Outline l l 2 Background ASOP #38 Pricing Capital Management

Background l l Use of catastrophe models provides credible, scientific loss estimates based on the simulation of thousands of potential scenarios. Hurricane and earthquake catastrophe models are commonly used and widely accepted. – – 3 Florida Hurricane Commission California Earthquake Authority Rating Agencies Most State Departments of Insurance

Background l Terminology – – 4 AAL = Average Annual Loss or long-term average loss; typically used in pricing. PML = Probable Maximum Loss or the estimate of a catastrophic loss that will be met or exceeded a given percentage of the time; typically used in capital management.

ASOP #38 l Provides guidance in using models and states that actuaries should: – – – 5 Determine appropriate reliance on experts Have a basic understanding of the model Evaluate whether the model is appropriate for the intended application Determine that appropriate validation has occurred Determine the appropriate use of the model

Pricing l Overall rate indication typically includes: – – – 6 Modeled AAL for hurricane and/or earthquake Less any applicable reinsurance recoverables Plus cost of reinsurance

Pricing – Overall Indication Indicated State Rate Change = Non-Cat Loss Ratio + Fixed Expense Ratio - 1 Variable Permissible Loss Ratio Cat Loss Ratio = Average Annual Loss – Reinsurance Recoveries + Reinsurance Premium at Present Rates Notes: 7 Loss ratios include loss adjustment expenses. Cat loss ratio may include non-modeled losses if state has exposure to non-modeled perils.

Pricing – Considerations l Reinsurance Allocation – – 8 Recoveries can be calculated by applying reinsurance program directly to modeled losses. Reinsurance premium can be allocated using recoveries as a base. Allocate premium by layer if at all possible.

Pricing – Considerations l Exposure bases – – 9 Exposure bases for modeled loss data, reinsurance recoveries and reinsurance premium may not be consistent; they should be trended to a common exposure date. Total Insured Value is a good estimate of exposure covered in contract and can be used to adjust data to appropriate base.

Pricing – Other Applications l l l 10 Territory Relativities Deductible Relativities – Wind/Hail or Hurricane – Earthquake Wind/Hail Ceding Credits Wind/Hail Ceding Assessments Risk loads

Capital Management Modeling is used to estimate size of PML. 11

Capital Management Modeling is used extensively to structure reinsurance contracts. 2, 000 Layer 3 @ 90% 1, 500 1, 000 500 Layer 3 @ 75% Layer 2 @ 75% Layer 1 @ 50% Layer 1 @ 75% 0. 0 Scenario 1 Net PML / Surplus = ? 12 Net PML / Premium = ? Reinstatement Needed? Scenario 2

Capital Management Modeling is used to estimate cost and efficiency of reinsurance contracts. 13 Cost of risk load = Estimated Premium – Expected Recoveries

Capital Management Modeling is used to monitor growth in PML. 14

Capital Management l Modeling results used to assess PML impact of: – – 15 Increasing amounts of insurance Ceding to windpools Adding new policies Changing deductibles

Summary l l l 16 Catastrophe models are an integral component of personal lines pricing and capital management. They are widely accepted and used within the industry. ASOP #38 provides guidance to actuaries using models.