2004 CAS RATEMAKING SEMINAR INCORPORATING CATASTROPHE MODELS IN PROPERTY RATEMAKING (PL - 4) PRICING EARTHQUAKE INSURANCE DAVE BORDER, FCAS, MAAA

PRICING EARTHQUAKE INSURANCE Overview l Earthquake Ratemaking l Earthquake Modeling l Uses of Earthquake Models l Whose Fault is it?

EARTHQUAKE RATEMAKING l Earthquake insurance is typically a separate optional coverage l Wide usage of deductibles l Fire Following exposure l Great variation of pricing »Territorial »Construction

EARTHQUAKE MODELING Comparison with Hurricane l Separate coverage vs. package coverage l Historical data – Future reliability l Frequency estimates – Landfall vs. Fault Rupture l Damage estimation – Advances in both areas

EARTHQUAKE MODELING Advantages l Many years of seismological data »Many good sources of geological and seismological data »Paleoseismology – Science of identifying and dating past earthquakes by geological studies l Damageability information by construction type l Current distribution of insured exposure to risk

EARTHQUAKE MODELING Alphabet Soup l Many sources of historical information »USGS – United States Geological Service »CDMG – California Division of Mines and Geology »SSA – Seismological Society of America »EERI – Earthquake Engineering Research Institute »AGU – American Geophysical Union »SCEC – Southern California Earthquake Center

MODELING BASICS l Simulate location and magnitude of earthquake »Gutenberg-Richter Magnitude »Modified Mercalli Intensity (MMI) l Estimate components of earthquake l Estimate event intensity l Damage estimation

EARTHQUAKE MODEL l For each simulated earthquake: »Establishes probability of occurrence »Establishes focal depth and rupture length »Determines shaking intensity and liquefaction »Determines damageability ratios l Calculates expected damageability ratios at a location for all simulated events »Distance from rupture »Soil conditions

REVIEW OF MODEL l Consistent with guidelines in ASOP 38 (Using Models Outside the Actuary’s Area of Expertise) l Level of geographic detail available to run the model l Is current book of business representative of future book?

MODEL OUTPUT l Very similar to hurricane output l Average Annual Losses and Mean Damageability Ratios (MDR’s) by: »Zip code or portion of zip code in a territory »Building / contents / ALE coverage »Construction type »Occupancy type

ADDITIONAL CONSIDERATIONS l Aftershocks l Debris Removal l Demand Surge l Loss Adjustment Expense »More internal damage »Additional adjusters needed

USES OF EARTHQUAKE MODEL l Determination of earthquake rates »Territorial determination »Deductible pricing l Manage catastrophe exposure »Underwriting criteria »Deductible usage »Reinsurance usage l Damage estimation following an event

TERRITORIAL CONSIDERATIONS l Known fault lines l Blind-thrust faults l Cascading faults l Seismic zones with estimated frequency

TERRITORIAL RATEMAKING l Model – AAL’s and MDR’s based on percentage deductible »Select Deductible requirement »Price alternative deductibles as appropriate l Group zip codes into territories »Cluster based on MDR’s »Reasonability check based on known fault configuration l Different loss costs by construction type

EARTHQUAKE RATEMAKING l Convert loss costs into rate »Incorporate provision for expenses –Agent commission –Other variable and fixed expenses »Profit provision –Great variability of results l Determine overall indicated change

SPECIAL CONSIDERATIONS l State facility established (CEA) l Losses impacting primary policy caused by earthquake »Fire Following »Sprinkler Damage

FIRE FOLLOWING EARTHQUAKE l Fire Following losses are typically covered under primary policy »Must provide modeler with full set of exposure data »Broader exposure set than Earthquake policies l Damage ratio should be incorporated into package rate »Replace actual fire following losses »Low significance in most areas

WHOSE FAULT IS IT? l Arguments exist regarding variation of rupture intensity »Smoothing provides good estimate, or »Each fault has a single rupture point l Return time consideration in annual pricing »Price to the average, or »Consider time since last occurrence

RETURN TIME ARGUMENTS l Increasing time since last event decreases time until next occurrence l Increasing time since last event increases time until next occurrence l Appropriate to use average annual loss

ADDITIONAL REFERENCES l Pricing the Earthquake Insurance Using Modeling »Debra Werland and Joseph Pitts »1997 Winter Forum l U.S. Earthquake Frequency Estimation – Ratemaking for Unusual Events »Stuart Mathewson »1999 Winter Forum