NU Online News Service, March 15, 3:08 p.m.EST

A change to a catastrophe model can influence the level ofreinsurance purchased by companies and impinge on the ratingprocess, but the extent to which the latest revision announced byone modeler affects either is not specifically clear.

“If a company relies on only one model, it could have a bigimpact on their balance sheet strength,” said Thomas Mount,assistant vice president at rating agency A.M. Best Co.

Assuming a company buys reinsurance up to the minimum requiredfor a 1-in-100-year wind event, and it used only one model whoseresults changed greatly after revisions, a company’s financialstrength may suffer, he said.

“The affects of a model change vary on a case-by-case basis,”Mr. Mount explained. However, it is not A.M. Best’s intent to“automatically downgrade a company just because of a modelchange.”

Mr. Mount said the rating agency works with a company to asseshow it will address the adverse effects of a model revision, suchas that announced earlier this year by Risk ManagementSolutions (RMS). The company can purchase more reinsurance, orit can outline a plan to cut back on exposure to reduce risk.

A.M. Best does not require the use of one particular modelingcompany, nor does it require the use of multiple models, accordingto a briefing released by the company. Therefore, if significantrevisions are announced for one model, the affect on the overallassessment of risk should not severely impact a company’s capitalposition—or at least the chances of this occurring are reduced.A.M. Best does expect that companies incorporate model updates “assoon as practical.”

“Where there is the potential for significant increases in modelresults due to a model update, and the company has not yet run themodel, A.M. Best will apply a factor to the probable maximum lossto more accurately capture the current view of risk,” the Oldwick,N.J.-based rating agency said.

A.M. Best also specifically advises companies not to rely tooheavily on catastrophe models.

“As was evident in the past, an overreliance on models can beproblematic,” the briefing said. “While catastrophe models providean estimate, they cannot be expected to provide an exact lossfigure.”

Karen Clark, president and chief executive of Karen Clark &Co., a risk and risk management firm in Boston, said ratingagencies "need to stop using a formula based on a point estimatedetermined by a model. This puts insurers in a straightjacket,forcing them to buy reinsurance to the level the rating agencyrequires."

A change in loss results due to a model revision is “notnecessarily a strike against the company,” said Mr. Mount. A.M.Best looks at other factors, such as the company’s track recordwith other storms.

Companies can also attempt to convince A.M. Best that theirin-house PMLs (probable maximum loss) are better than the standardmodel assessments—or that one model fits them better than theother—in which case a weighted average can be used. The basicapproach is to use a straight average of multiple models, A.M. Bestexplained.

Ms. Clark said she is "not sure reinsurance companies willgive as much credibility to the new model; a 100 to 200 percentchange can stop you in your tracks."

Modeler RMS said changes in loss results in the marketportfolios it analyzed typically range between increases of 20percent and 100 percent due to its revisions. In some cases, lossresults can be higher or lower than the average range, said RMS,which revised its model based on new data derived from the 2004 and2005 hurricane seasons as well as Hurricane Ike in 2008.

Reinsurers have the ability to take a look at all three modelsavailable (from RMS, AIR Worldwide and EQECAT). Most primaryinsurers can’t afford all three. Some of the smaller companiesdon’t license any but get access to the model loss results throughbrokers, said Ms. Clark.

Frank Pierson, executive vice president and chief technicalofficer of independent reinsurance brokerage firm HolbornCorporation, said reinsurers may be able to absorb the modelchanges without huge increases because they already thought themodels were coming in low.

“Now that the models incorporate the [2004 and 2005] losses, theimpact on primary insurance could be moderated by the pricesreinsurers were already using.”

Mr. Pierson still cautioned that what he termed the “I Don’tBelieve Factor” among reinsurers may soften as their confidence inmodels grows, resulting in upward pressure on pricing.

Moody’s Investors Service has said revisions in catastrophemodels alone most likely won’t offset the lack of demand inthe reinsurance market. Moody’s said reinsurance demandremains stifled because primary insurers have tighter reinsurancebudgets and lower volumes due to reduced economic activity. This isnot expected to change due to the model revisions, “despite theexpectation of increased modeled losses in certain peril zones,”Moody’s said.

However the model revisions, when combined with catastrophesduring the first quarter, could mean a change in the market, according toRenaissanceRe CEO Neill Currie. Mr. Currie’s comments weremade before the magnitude 9.0 earthquake and tsunami thatrecently struck northern Japan.