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

Outline Background ASOP #38 Pricing Capital Management

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

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.

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

Pricing Overall rate indication typically includes: 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 + 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.

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.

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.

Pricing – Other Applications 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.

Capital Management Scenario 1 Scenario 2 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?

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

Capital Management Modeling is used to monitor growth in PML.

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

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.