Model Behavior: Assessing Catastrophe Risk

The widespread devastation from the recent earthquake and tsunami in Japan follows a string of major natural and manmade disasters -- including the New Zealand and Haitian earthquakes, severe winter storms across the continental U.S., flooding in Australia and even the BP oil spill -- that have presented insurers with unprecedented tests of their catastrophe risk analysis and management capabilities. What have these disasters revealed about the insurance industry's ability to forecast, analyze and underwrite catastrophe risks? What tools and technologies do insurers need to manage these risks and respond to policyholders when catastrophe strikes? --Peggy Bresnick Kendler

Fortunately, catastrophes such as the recent earthquakes in Japan and New Zealand are rare. But it is exactly their rarity that makes estimating losses for future catastrophes so difficult. Furthermore, the increase in the number and value of exposed properties in areas of high risk has and will continue to contribute to increasing losses for insurers.

The recent events in Japan, coupled with the country's long history of damaging earthquakes, highlights the vulnerability of Japan's heavily concentrated urban areas and serves as a reminder that large-scale loss of life and widespread repercussions to the insurance industry -- and the global economy -- are real. It is critical that companies have the tools they need to make an appropriate assessment of their risk exposure and to develop risk management strategies that will prepare them for the next large-scale event.

The purpose of catastrophe modeling is to help companies anticipate the likelihood and severity of potential future catastrophes before they occur so that they can adequately prepare for their financial impact. The insurance industry has embraced catastrophe models to estimate the loss potential to their books of business and to give them the tools and information they need to choose between alternative strategies for managing that risk. These recent events further demonstrate the importance of using catastrophe models to manage catastrophe risk.

Today, catastrophe modeling technology is used by reinsurers and insurers around the world. But it is no longer only the insurance industry that relies on risk modeling. Applications of the technology have since broadened to serve corporate risk managers, investors, mortgage underwriters, government officials and a wide variety of other stakeholders exposed to catastrophe risk.

Jayanta Guin is SVP of research and modeling for Boston-based AIR Worldwide.