As the 2010 Atlantic hurricaneseason moves into high gear, concern about catastrophe risk loomslarge in a year that has already featured an unusual level ofactivity, including a massive earthquake in Chile, a powerfulwinter windstorm in Europe, and an oil spill in the Gulf ofMexico.

Munich Re estimates insured losses for global catastrophes at$23 billion for the first six months of 2010, the highest for thattime period since 1994, according to the Insurance InformationInstitute. That far exceeds the 10-year average of $11 billion. Inthe U.S., catastrophe losses have more than doubled over the lastdecade to $193 billion, up 117 percent from the $89 billion fromthe 1990s, according to the III. If this trend continues, the nextdecade is likely to be even more disastrous than this one, with IIIpredicting a year with $100 billion in insured catastrophe lossescertain to come in the future. The rise in U.S. catastrophe lossesis driven in part by dramatic increases in development in placesvulnerable to hurricanes, earthquakes and wildfires.

Related: Read “2010 hurricane season: Keeping the promise.”

In this volatile environment, catastrophe models play animportant role for insurers and for agents and brokers seeking tohelp property owners manage their catastrophe risk.

In the roughly 20 years that they have been in use, catastrophemodels have provided insurers and reinsurers information necessaryto price products more accurately and to manage their exposure toavoid devastating portfolio losses.

Insurance brokers have also put catastrophe models to good use.Through the use of models, brokers have been able to help insuredsand their retail agents, estimate potential losses and identify thedrivers behind those losses; structure more cost-effectiveinsurance programs; and help clients save money even in the hardestmarkets by ensuring that they buy only as much insurance as theyreally need.

To deliver these services, most of the large national brokers,and some wholesale brokers, have invested greatly in licensing riskmodels. By partnering with a wholesale broker, small and mid-sizedagents and brokers can avoid the investment and required expertiseand still deliver top-notch service to their clients.

Development of risk models

The first generation of catastrophe models emerged in the late1980s and focused primarily on earthquake risk. Two of the topcatastrophe modeling firms, AIR Worldwide and Risk ManagementSolutions Inc. (RMS), were founded in 1987 and 1988 respectively,while EQECAT Inc., a third major catastrophe risk modeling firm,was founded in 1994.

The catastrophe risk models they first introduced represented asignificant step forward in the assessment and management ofcatastrophe risk. The models blend earthquake science, structuralengineering and actuarial science. Over the past two decades,catastrophe modeling has continued to evolve and now offers modelsto assess the magnitude of risk of not just earthquakes, but alsoU.S. hurricanes, tornado/hail, and even terrorism. These modelstypically are revised and updated to reflect the new lessons thatare learned after each disaster.

With the help of models, insurers have been able to minimize therisk of mispricing insurance or building up dangerousconcentrations of natural catastrophe risk. Some carriers, insuringhomes in Florida and California, reduced such concentrated riskprior to Hurricane Andrew in 1992 and the Northridge earthquake twoyears later.

20th Century Insurance, for example, was a leading Californiahomeowners' and earthquake insurer with its greatest market sharein California's San Fernando Valley. After the Northridgeearthquake struck in January 1994, 20th Century was unable to payclaims because of its heavy concentration of policies in theaffected area. State insurance regulators removed the company fromthe homeowners' and earthquake markets.

After Northridge, more insurers began using catastrophe models,which had been adjusted to reflect new information about thevulnerability of buildings. In March 1994, just a few months afterthe Northridge earthquake, an estimated 10 percent to 12 percent ofproperty insurers used catastrophe models. By 2009, more than 90percent of insurers were using models, RMS states.

Catastrophe models serve as an important tool for underwritersand risk managers by providing estimates of the probability ofexceeding various levels of loss. Even though the estimates may bebased on the best available science and exposure data, theirprojections necessarily include a degree of uncertainty. It's notsurprising, then, that today's catastrophe models, while the mostsophisticated tools for assessing and managing catastrophe risk,have been subject to criticism when their results significantlyimpact the availability and cost of insurance in the mostvulnerable places.

After a severe hurricane season in2004, and the devastating trio of Hurricanes Katrina, Rita andWilma in 2005, models were revised to reflect the new losses andnew lessons. The new RMS model projected greater potential lossesbased on an increase in Atlantic hurricane activity, newassessments of building performance and a more detailedunderstanding of how a confluence of circumstances amplifies lossesin a severe catastrophe. As a result of the changes, modeled lossesincreased by 25 percent to 40 percent on average for coastalregions of the U.S. In response, reinsurers and primary insurers,in part due to rating agency scrutiny, attempted to reduce theirexposures and increased rates to account for their increased risks.Consequently, many coastal property owners experienced dramaticincreases in their insurance premiums.

While the value of models is unquestionable, they have beensubject to criticism and inspection.

In Florida, RMS had to provide a revised model after stateofficials said it did not meet regulatory standards. RMS, however,continued to recommend that insurance and reinsurance companies useits original version, which had taken a forward-looking,medium-term view of hurricane activity as opposed to the standardhistorical average that was traditionally used.

The reliability of catastrophe models also has been challengedby coastal property owners in Massachusetts, which has experiencedfew severe storms in recent years. AIR Worldwide has estimated thatMassachusetts faces about a 15 percent chance of a catastrophicstorm within the next decade that would cost insurers $5 billion ormore. Property owners are pressing for legislation that wouldsubject the data and assumptions in models to greater scrutiny.

Use of models

It wasn't long after insurers began using models that brokersalso began using them to understand how insurers were selectingrisks and be in a better position to negotiate withunderwriters.

Brokers found that the use of models allowed them to delivervalue to clients in a number of ways and serve as a terrific salestool. Brokers today use models to understand clients' exposures;strategically improve the structure of insurance programs; reducebank loan covenants; and facilitate disaster recovery planning andrisk mitigation.

Understand clients' exposures

Businesses have a responsibility to protect the value of theirassets by buying insurance, but without the help of
models, they may be spending more than necessary by buying too muchcatastrophe insurance.

Wholesale brokers who use catastrophe models can help theclients of retail agents identify their potential catastrophe risksand understand the possible scope of the losses. In this way,brokers also can suggest appropriate levels of catastropheprotection.

Consider the case of a large real estate firm with heavyCalifornia and Pacific Northwest earthquake exposure. Oneearthquake catastrophe model estimated its potential loss at $137million, while another model estimated it at $160 million. Withoutthe information from those two models, the firm would have likelypurchased insurance based on the value of its largest location,which was about $230 million. But because of the models, the firmbought a lower level of catastrophe insurance instead,

Improve structure of insurance programs

Brokers with strong underwriter relationships have a nuancedunderstanding of each carrier's risk appetite. One insurer may wantto expand in a certain area or class of business, while anothermight be reducing its exposure.

Effective use of catastrophe models can provide a much morerefined understanding of a client's exposures, and this insightallows the broker to tailor an underwriting submission to match theappetites of particular carriers. From the client's perspective,modeling results also may influence advice about retentions anddeductibles.

For example, the use of catastrophe models has had a significantimpact on the insurance program of a national retail chain with 700locations across the country. After running its information throughcatastrophe models, the wholesale broker was able to inform theagent and risk manager that the company had only five locationswith any significant catastrophe risk. With this information, thosehigh-risk locations were placed with specialty insurers separatefrom the overall property insurance program, achieving a much lowercost program the bulk of the account.

Reduce bank loan covenants

Brokers have used catastrophe models to help reduce the amountof insurance clients are required to buy under their bank loancovenants. Lenders typically will require businesses to buyfull-value property catastrophe insurance as a condition of theirmortgage.

A Florida entertainment center property, for instance, wasrequired by its bank to buy $400 million in windstorm insurance.Models, however, showed that the building would sustain a probablemaximum loss of only $50 million. The bank agreed to reduce therequirement from $400 million to $50 million, saving the client$700,000 in insurance premiums.

Presented with estimates from catastrophe models, banks areoften willing to reduce their insurance requirements. As themortgagee, the bank wants to protect itself from a loss in case ofa catastrophe, but it gains nothing from forcing a client to buymore insurance than it needs.

Improve disaster recovery planning

The disaster on BP's Deepwater Horizon drilling rig in the Gulfof Mexico has reminded companies and local governmentalorganizations about the importance of having good disaster recoveryplans in place. Insureds can use catastrophe models to pinpoint andenhance understanding of potential disaster scenarios and implementplans at vulnerable locations to manage those risks and mitigatelosses.

One large manufacturer of polymers and plastics, for instance,is seeking to work with a catastrophe modeling company andengineering firms to assess its properties in California todetermine its vulnerability to damage from an earthquake and tohelp it assess how quickly its operations could be brought backonline after a disaster.

Quality data is key

Catastrophe models have opened the door for much more accurateassessments of catastrophe risk by basing estimates and scenarioson a mix of structural engineering and meteorological andearthquake science. Quantitative measurements of hazard have madeit possible to more accurately project potential losses instead ofrelying so heavily on historical loss experience.

But the models' results are only as good as the data that goesinto them. The more accurate and detailed the information that isavailable about each property, the more reliable the modelingresults and the greater the opportunity to achieve premiumsavings.

Among the data points that can make a significant difference inthe accuracy of modeling outputs include address, occupancy type,year built, number of stories, construction type as well asreplacement value.

Agents should work with their clients to obtain the mostdetailed and up-to-date engineering and empirical data possible.Since missing data will default to the worst case, clients thattake the time to provide good data will be rewarded as that givesunderwriters more clarity about the risk, increasing their abilityto offer coverage at more favorable terms and conditions.

The last 20 years have been marked by a number of devastatingcatastrophes. The list includes the Loma Prieta earthquake andHurricane Hugo in 1989, Hurricane Andrew in 1992, the Northridgeearthquake in 1994, the attacks on the World Trade Center and thePentagon in 2001, and Hurricane Katrina in 2005.

As global catastrophe losses have risen over the last twodecades, insurance underwriters have taken significant steps tomore accurately assess and carefully manage their accumulations ofcatastrophe exposure. Clients who have a clear idea of theirpotential exposure will be in the best position to minimize theirlosses and protect their assets while keeping insurance costs undercontrol.

Agents and brokers can deliver value to clients and help themachieve their goals by making use of catastrophe models–whetherthrough in-house capabilities or by partnering with a wholesalebroker that has those capabilities.