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Mother Nature commands fresh respect from risk modelers

Posted On: Oct. 15, 2006 12:00 AM CST

MONTE CARLO, Monaco¬óCatastrophe modeling came under a storm of criticism after the record insured losses of 2005, but underwriters have learned important lessons about the limitations of modeling, insurance industry executives said at the recent Rendez-Vous de Septembre in Monte Carlo.

"Catastrophe risk has metastasized in the psyche of senior management," said Hemant Shah, president and CEO of Newark, Calif.-based Risk Management Solutions Inc. "It had been seen as a specialized problem, delegated to specialists, such as RMS. Now senior executives realize they need to internalize it and think strategically outwardly. They need to understand what models do and don't do."

While RMS was the target of "a lot of incrimination and anger," the modeling firm was "the first to say, 'We've got a lot to learn. The reason you pay us is to learn from experience,"' Mr. Shah said. "Probabilistic models had some gaps. We acknowledge that we didn't anticipate secondary effects from a catastrophe, for example demand surge and delays in rebuilding" affected areas, he said.

lessons learned

Modelers learned three key lessons in 2005, Mr. Shah said.

One was that cat models had gaps, which RMS and others have closed through new versions released earlier this year. Second was that "insurers and reinsurers needed to understand what models do and don't do and they can't make default decisions," he said. "The model didn't tell you to write the business." The third lesson was that models must be integrated with underwriting processes. "The operating infrastructure needs to be suited to understanding insureds and their risks," Mr. Shah said.

In some ways, modeling has made underwriters' jobs more difficult, Mr. Shah said. "The postmodern challenge for insurance underwriters is that the world has changed. Use of objective analytics and models is the way of the future," he said. As a result, "the underwriter needs to be able to understand the tools' capabilities and ask, 'Does the model describe the reality that I see?' The underwriter also has to take appropriate judgment and make sure that the modeled output fits the underwriter's understanding of the risk."

Despite a light hurricane season so far this year, "the industry's balance sheet is fragile enough that people aren't going to lose respect for Mother Nature," said Bryon Ehrhart, CEO of Aon Re Services Inc. in Chicago.

"The industry had a rough outcome the last two years" in catastrophe losses, Mr. Ehrhart noted. Underwriters that "had a nice fusion of fieldwork and knowledge, added to by models--those people tended to do well," he said.

"The inherent weakness is that models model what they've been asked to model," Mr. Ehrhart said. "More sophisticated clients have a process to supplement models" and broaden their view of risk. "In modeling, everything you ever learned is important to remember," he said. "People who kept those (lessons) in the core all came out better. True underwriting talent is still worth a lot; it's a good time to be an underwriter."

Ken LeStrange, CEO of Pembroke, Bermuda-based Endurance Specialty Holdings Ltd., acknowledged that his company, like many others, absorbed a lot of loss in 2005 that modeling did not reflect. "Our Katrina loss on a modeled basis was about 20% of what our actual loss was," he said. "We discovered weaknesses in our application of modeling technology that we hadn't quantified, but we found that parts of our portfolio performed really well."

The key lesson for Endurance and all underwriters, he said, is to ensure quality of data about the risks in the portfolio. "The math works when you have high-quality data and can factor that in.... The technology and experience of our underwriting team allows us to see relative value" in the risks Endurance writes, he said, adding that a dynamic mix of business and ability to evolve are very helpful. "We were tested as a young company in a serious way and we survived it. It makes me really optimistic for the future," Mr. LeStrange said.