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Karachi Sheraton 11 April 2012 Pakistan Insurance Institute International Insurance Conference on Catastrophe Events – A Challenge ________________________________________________ Some actuarial aspects by Samee - ul -Hasan FIA, FPSA, FCII, FLMI, ASA Consulting Actuary

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slide1

Karachi Sheraton

11 April 2012

Pakistan Insurance Institute

International Insurance Conference on

Catastrophe Events – A Challenge

________________________________________________

Some actuarial aspects

by

Samee-ul-Hasan

FIA, FPSA, FCII, FLMI, ASA

Consulting Actuary

Akhtar & Hasan (Pvt) Ltd, Actuaries, Karachi

slide2

IAA’s Solvency Working Party’s list of Risks to insurers

(only risks relevant to this conference are stated below)

Underwriting risks: “Risks that product design and/or underwriting process were flawed, premiums charged proved inadequate, retention and reinsurance arrangements were unable to with-stand events, technical reserves proved to be insufficient. Risks from random fluctuations in claims.

Event Risks: These include major disasters like earthquakes and floods.

“Random fluctuations” are included in Underwriting Risks. But “Major disasters like earthquakes and floods”, i.e. catastrophes are included in “Event Risks.”

slide3

Solvency II requires Life and Non-Life entities to include catastrophe component in Solvency Capital

“Solvency II” requires the solvency capital of Life and Non-Life insurers to include a component to deal with catastrophe risks. Solvency II relates to Europe. But this requirement seems sensible, irrespective of regulatory laws.

Framework of today’s discussion

These statements lead up to catastrophe risks, in the following steps:

Law of Large Numbers

Random fluctuations

Catastrophes

Mega Catastrophes

slide4

Law of Large Numbers

  • Suppose we toss a coin once. We don’t know which way it will fall. It could be heads or tails. But suppose we toss a million times. Then almost exactly 50% will be heads.
  • This illustrates the Law of Large Numbers, which Barron’s Insurance Dictionary states as follows:
  • “The greater the number of exposures,
    • (a) the more accurate the prediction;
    • (b) the less the deviation of the actual losses from the expected losses; and
    • (c) the greater the credibility of the prediction”
slide5

Example of Law of Large Numbers at work

Pakistan’ National Accidental Death Insurance (NADI) Scheme operated from 1 Jul 1986 to 30 June 1989.

If a bread-winner aged 20 to 60 died by an accident, his/her family got Rs 15,000. Premium paid by Federal Government.

Tens of millions of individuals were covered. Law of Large Numbers operated for “normal” accidents. Random fluctuations in the amount of claims could be ignored.

But actuaries who designed the scheme were aware of catastrophe risk, especially earthquakes. So deaths from any event which caused more than 5,000 fatalities excluded.

Thus even large portfolios cannot operate solely on Law of Large Numbers. Almost all portfolios are exposed to catastrophes.

slide6

Portfolios where Law of Large Numbers does not operate, and random fluctuations are important

Portfolio of Fire Policies in Pakistancannot rely on the Law of Large Numbers to any substantial extent, because:

(a) The number of policies is relatively small.

(b) Multiple risks are covered, including Fire, Earthquake, Atmospheric Disturbance and others.

(c) Sums insured vary greatly.

(d) Most claims are partial claims, and the ratio of claim to sum insured varies greatly.

(e) Accumulation of risks.

In such portfolios, random fluctuations are important.

slide7

1978 study of Pakistan Fire Claims from claim events in 1974-78

In 1978, a study was done of gross amount of all claims paid by all insurers under Pakistani Fire policies, in respect of claim events during the 4 years 1973 to 1976 inclusive. Payments on different dates in respect of same event, and payments by different co-insurers, were aggregated. After this aggregation, the number of claim events was 3,218.

This was the first actuarial study carried out for Pakistani non-life insurance. The results proved useful for the business.

Probability Density Functions (pdf’s) based on past claim data can be used to study random variations. For the above study, the log-normal pdf function gave the best fit, but not a perfect fit. A conceptual graph is shown below.

slide9

There are many small claims. As claim size increases, frequency reduces. Even if no actual claim occurred in a certain claim range, curve will generate a number. This enables us to handle random fluctuations.

The upper limit to claims from a single event was the total sum insured in the location where there was maximum Accumulation or Concentration of risk. Suppose this total sum insured was Rs x billion. If we follow the log normal tail to the right, we will come to a point where the claim amount is Rs x billion. This could result only from a catastrophe. But the probability of a random fluctuation at that point in the pdf curve will be so low as to be outside practical possibility.

Unfortunately, catastrophes are practical possibilities. So we cannot rely on pdf curves based on non-catastrophic losses to study catastrophes.

slide10

Catastrophes

Classification of Catastrophes

Ms Jane Lockett submitted a comprehensive paper in 1980 on “Catastrophes and Catastrophe Insurances” to the UK Institute of Actuaries Students’ Society. Her paper is well worth reading. This is how she classified catastrophes:

“(a) Natural hazards. Storm, particularly windstorm, including hurricane and tornado; flood; bush fire; volcanic eruption; earthquake, both shock and ensuing fire damage.

(b) Man-made hazards. Riot; some cases of aviation or marine losses; pollution, particularly of the seas, or generally by chemical accident or explosion etc.; some types of product liability; nuclear accidents.”

slide11

Law of Large Numbers, and Pdf curves, do not apply to catastrophes

The Law of Large Numbers does not operate for catastrophes.

Pdf curves based on non-catastrophic losses are not useful for catastrophes.

Non-catastrophic losses under different insurance policies are usually independent of each other. But catastrophic losses are generally not independent of each other, because a catastrophe is likely to hit many policies.

So how do we handle the catastrophe risk?

slide12

Exclusions

Exclusions constitute our first line of defence. We all know about exclusions of wars, radioactivity, nuclear weapons, and other catastrophic perils. The exclusion in Pakistan’s NADI scheme of events which result in more than 5,000 deaths is another example.

Retentions, Reinsurance, Capital adequacy

The second line of defence is always to keep catastrophes in mind in Retentions, Reinsurance, Capital adequacy. Particular attention should be paid to under-writing and retentions where there is a large risk Accumulation or Concentration.

The worst case is usually much worse than we think!

slide13

Historical approach to estimating the catastrophe risk

Study catastrophe losses in the past 10 years or more. Problem with this method is that the future ain’t what it used to be1.

Ms Lockett’s paper says: “…earthquake records in Japan from 1498 are used in rating. 480 years may seem to be a very long period, but few large earthquakes will have affected any one location. It may be unwise to attach full credibility to any estimate of return periods for severe events, even based on such long past records. There is no way of knowing whether the activity indicated over the available data period can be considered representative of levels of activity which may occur in any future period. Similar problems affect any data available for other hazards in other parts of the world.”

Nevertheless, the historical method may be useful for some cases.

_______________________________

1 Yogi Berra, a famous US baseball person

slide14

Catastrophe modelling

Past catastrophe data is used to generate catastrophic scenarios, by mathematical modelling and/or computer simulation. These models draw on the skills of “seismologists, meteorologists, other physical scientists, engineers, mathematicians, statisticians, actuaries, and computer technology specialists”2.

Such models can generate a range of results.

The Catastrophe Management Work Group of the American Academy of Actuaries refers to the increasing use of such models for hurricanes and earthquakes.

The results of such modelling deserve attention and respect.

______________________________

2 Quotation from June 10, 2001, report of Catastrophe Working Group of American Academy of Actuaries

slide15

However, a British actuary, the late F.M. Redington, said:

“I am very conscious of the fact that if you manipulate any statistics for long enough you can always find patterns in them. Only time will tell if these patterns are reflections of the truth or a transient trick of the light. In the meantime the only test is commonsense.”

“We must be cautious because the data is scanty, and because all these figures are measurements at the tip of the waving bough.”

These remarks apply to estimates of costs of future catastrophes.

We have to make estimates of catastrophe risks, through a logical procedure. But only time will tell how good our estimates were. We have to revise them periodically.

slide16

Internally consistent system to use estimates of catastrophe risk

Step 1: Use the estimates to calculate the catastrophe risk component of Solvency Capital. (Solvency II requires other components to be included, in addition to the catastrophe risk.)

Step 2: Include following components in the premium:

Cost of “usual risks” including random fluctuations + Contribution to yly cost of remunerating Solvency Capital.

(There will be other components, e.g commission, expenses).

It would comply with Solvency II. It would be consistent with the IAA’s Solvency Party’s listing of insurers’ risks.

slide17

Mega Catastrophes

Kill and injure very many people, cause enormous property damage. They may result from hazards listed in Ms Lockett’s paper. Or they may be Wars, which caused vastly more deaths and property damage than Ms Lockett’s hazards.

Examples

slide18

WWII’s effect on Germany

WWII killed 3,350,000 combatants and 3,269,000 non-combatants, a total of 6,619,000.3“The whole country [was] smashed to powdered rubble by a juggernaut.4”

West Germany’s reconstruction was due to: The Reconstruction Loan Corporation’s activities; Marshall Plan aid of $1.45 billion (= approx $15 billion in today’s money); a tax of 50% on property not destroyed by the War, payable over 30 years; the spending of pay of Allied military personnel stationed in West Germany; bold economic policies of Finance Minister Ludwig Erhard; technical skills and hard work of Germans.

________________________

3 Source: www.worldwar–2.net

4 From Lee Child’s novel “The Enemy”. The novel is a good read

slide19

Pakistan’s 2005 earthquake

Earthquake Reconstruction & Rehabilitation Authority set up, to provide housing, livelihood, health, education, water, sanitation.

Mega-catastrophes require Government intervention

Insurance industry cannot cope with mega-catastrophes. They cannot maintain solvency capital large enough.

Wars are un-foreseeable. The risks are un-insurable and the question of insuring them does not arise5.

Even where insurance is available, people may not buy it. Ms Lockett mentioned heavy under-insurance in the USA and other highly developed countries.

So the State has to intervene.

_______________________

5 War risk may be insurable in some cases.

slide20

Way forward for Pakistan

PII and PSoA joint study group:

Pakistan is exposed to earthquake and flood risks. The Pakistan Insurance Institute and the Pakistan Society of Actuaries should set up a joint study group, to study the following:

# How Catastrophe Modelling can be applied to Pakistan

# System to meet reconstruction costs of future mega catastrophes

A “flood surcharge” on income tax was imposed after the 2010 floods in Pakistan. Instead of such ad hoc measures, it would be better to formulate a plan in advance. We already have a statutory War Risk Insurance scheme, which was invoked and implemented in the past. The Study Group should consider a system to meet the reconstruction costs of future mega catastrophes. It need not be on the War Risk scheme’s pattern.