Catastrophe Modeling Personal Lines Perspective

1. Catastrophe ModelingPersonal Lines Perspective Jodi HealyRatemaking SeminarMarch 28, 2003

2. Outline • Background • ASOP #38 • Pricing • Capital Management

3. Background • 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. • Florida Hurricane Commission • California Earthquake Authority • Rating Agencies • Most State Departments of Insurance

4. Background • Terminology • 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.

5. ASOP #38 • Provides guidance in using models and states that actuaries should: • 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

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

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

8. Pricing – Considerations • Reinsurance Allocation • 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.

9. Pricing – Considerations • Exposure bases • 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.

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

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

12. Capital Management Modeling is used extensively to structure reinsurance contracts. 2,000 Layer 3 @ 90% Layer 3 @ 75% 1,500 Layer 2 @ 75% Layer 2 @ 75% 1,000 Layer 1 @ 50% Layer 1 @ 75% 500 0.0 Scenario 1 Scenario 2 Net PML / Surplus = ? Net PML / Premium = ? Reinstatement Needed?

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

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

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

16. Summary • 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.