Optimizing the Management of Natural Disaster Exposure
June 2002
Many companies feel their approach to managing
their overall aggregate exposure to natural disasters is deficient. Rick Clinton
examines some software and consulting options for handling the earthquake exposure.
by Rick Clinton
EQECAT, Inc., an ABS Consulting company
The events of September 11, 2001, have forced insurance companies to take
a new look at how they are managing not only their exposure to man-made hazards,
but also their exposure to natural disasters, such as earthquakes and hurricanes.
What many companies have found is that their present approach to managing their
overall aggregate exposure is deficient in many ways.
What can companies do to become more aggressive and effective in managing
their exposure to earthquake and other natural disasters? In the past, most
companies have concentrated their efforts on controlling their overall accumulations
within some (usually fairly large) geographic area and, to a lesser extent,
underwriting new business. Their ability to do this has been greatly enhanced
through the development of catastrophe modeling software.
New Catastrophe Modeling Software
Most primary and reinsurance companies are now using catastrophe modeling
software to manage their accumulations. In addition, many of the reinsurers
and some of the primary companies are also using the models to underwrite business.
Based on the number of companies using software, it would appear on the surface
that the insurance industry is being very aggressive in managing this exposure.
However, as demonstrated by the September 11 losses, managing the accumulation
over a larger geographic area is not sufficient if the risks are concentrated
in a very small area.
The problem is that many companies are not using software to underwrite business,
and those that do are not coordinating it well with their accumulation programs.
The net result is that they are not selectively screening business to optimize
the use of their available capacity and avoiding concentrations of risks in
a small area.
Improving Catastrophe Management Programs
How can companies improve their catastrophe management programs? First, the
objective of every catastrophe management program should be to optimize the
risk/return relationship. Insurance 101 will tell you that the way to achieve
this objective is to identify properly which accounts should be written or declined
(new and renewal), to price accounts appropriately, and maintain a geographically
diversified portfolio. Fortunately, the catastrophe modeling software products
currently being introduced are providing the tools needed to underwrite and
price accounts, while maintaining a diversified portfolio.
Some software products, such as EQECAT's WorldCat EnterpriseTM software,
provide underwriters with the ability to look at the key underwriting and pricing
factors for an individual account fulfilling the basic underwriting requirements.
However, this alone does not achieve the overall objective of optimizing the
risk/return relationship. To do this, a company needs to determine the impact
of the individual risk on the overall book of business.
Fortunately, the more advanced software products can also provide this information
by accounting for the correlation between risks. Highly correlated risks by
definition are similar in nature and in close proximity to one another. This
is very important since risks that are highly correlated with the overall portfolio
will contribute significantly more to the portfolio's exposure and/or volatility
than one that is not highly correlated. Therefore, this correlation needs to
be reflected in the underwriting and pricing of the individual risk, as well
as the accumulation of exposure. Since correlation is very important to the
management of accumulations, it is essential that every company clearly understand
how it is being accounted for since a very robust model is required to do so
properly.
Risk Measures
The risk measures used to underwrite the individual risk and analyze the
accumulations are the same. They include the expected annual loss, standard
deviation, coefficient of variance (COV), calculated rate on line, the 100-,
250-, and 500-year loss estimates, and others. Most of these risk measures are
the same ones currently being used by most reinsurers and some primary companies
to underwrite and price accounts (e.g., annual loss, standard deviation, and
100-year loss). However, some of them, such as COV and Calculated Rate on Line,
are newer and provide unique insights into the exposure.
The COV is a relative measure of the volatility of the risk (the more volatile
it is, the riskier it is). The Calculated Rate on Line is the technical price
for the exposure, which takes into account the loss cost, volatility, and expense
factor. Using this type of information, a company can effectively underwrite
and price any risk, taking into consideration its individual merits as well
as its impact on the overall portfolio.
The Consultant Option
While the above approach is a vast improvement over prior underwriting accumulation
management approaches, there are still more advanced portfolio optimization
techniques that are available to companies on a consulting basis. As an example
using EQECAT's Exceedance Probability Leverage Analysis (EPLA) methodology,
the goal is to enable companies to achieve their overall objective by evaluating
each account on both its own individual characteristics and its relative impact
on the overall portfolio similar to what was discussed above.
The difference with this approach is that it enables companies to include
more variables in the analysis such as risk/reward (potential loss versus premium)
measures. The methodology produces an Exceedance Probability Leverage Curve
(EPLC) for each account. The EPLC provides the account's leverage quotient at
the different level of exceedance probability. A high leverage quotient means
that the risk-adjusted return for the account is low.
Using tools like EPLA, companies can determine:
- Appropriate pricing for an account
- Which accounts to remove from a portfolio to maximize risk-adjusted
return
- Where to grow or shrink business geographically to achieve maximum diversification
benefits
- How to swap parts of two different portfolios to optimize the risk/return
relationship.
The key element to keep in mind when using one of the advanced portfolio
optimization techniques currently available is the robustness of the underlying
model, which cannot be emphasized enough. To be truly effective in achieving
the intended result requires the use of a very technically advanced catastrophe
model.
A Case Study
The following is an actual analysis that was conducted using the EPLA methodology.
For the purpose of this analysis, the corporate portfolio optimization objectives
were defined as follows:
- Minimize 100-year to 500-year loss
- Maximize premium
- Constraints
> Expected return on capital not less than 15 percent
> 100-year loss to premium ration not more than 10 percent
> 250-year loss to premium ratio not more than 20 percent
> 500-year loss to premium ratio not more than 30 percent
The analysis looked at each risk to determine how much it was leveraging
the overall portfolio, if the revenue were appropriate given the leverage factor
for the account, and whether or not it should be eliminated, reviewed, or retained
in order to achieve the stated objectives. The methodology employed in the analysis
essentially made a value judgment on the relative merits of each account to
determine which ones should be retained and eliminated. The analysis also identified
areas where additional exposure could be written with minimal impact on the
overall exposure.
The following table contains the results of the analysis:
| # of Account/Risks |
315 |
293 |
.7% |
| Premium |
$14.6 |
$13.8 |
-6% |
| 100-year loss |
$80.1 |
$44.3 |
_45% |
| 250-year loss |
$145.3 |
$73.7 |
-52% |
| 500-year loss |
13.8% |
$157.1 |
-51% |
| Return on Capital |
320.90 |
27.3% |
+98% |
Conclusion
Obviously, every company will not achieve results as dramatic as those shown
above. However, every company incorporating one or more of the portfolio optimization
techniques should benefit and move closer to achieving the ultimate objective
of optimizing the risk/return relationship.
Richard L. Clinton is president of
EQECAT, Inc., an ABS Consulting company. Mr. Clinton has been with EQECAT since
1993 and has been instrumental in its development as one of the leading catastrophe
management modeling and consulting companies. Prior to this position, he directed
EQECAT's product management and client support activities, setting the strategic
direction for all future software development. Mr. Clinton is a leading consultant
to insurance companies and risk managers helping to assess catastrophic exposure
and improve catastrophe management programs through the use of software and
engineering services.
Before joining EQECAT, Mr. Clinton worked for Fireman's Fund
in their Corporate Underwriting department, reviewing new underwriting initiatives
or strategies for all lines of insurance, providing underwriting insight, oversight
on political issues affecting the industry and the management of catastrophic
exposure. In addition, he was Fireman's Fund representative on several insurance
industry committees' addressing property and casualty underwriting issues. Overall,
Mr. Clinton has 30 years of insurance and catastrophe modeling experience. He
is a Chartered Property and Casualty Underwriter, with a BA degree in Mathematics
and experience as an instructor for the Insurance Educational Association.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
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