CL-3: Catastrophe Modeling for

Commercial Lines
David Lalonde, FCAS, FCIA, MAAA
Casualty Actuarial Society, Ratemaking and Product Management Seminar
March 12-13, 2013
Huntington Beach, CA

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 1

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Agenda

• Increasing use of catastrophe models in the commercial

property casualty industry
• Understanding the importance of exposure data quality
and robust financial modeling
• Advances in modeling business interruption insurance
• Understanding industrial facilities
• Modeling severe thunderstorms for commercial exposures

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Increasing Use of Catastrophe
Models in the Commercial Property
Casualty Industry

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Catastrophe Modeling Framework

HAZARD

Event Intensity
Generation Calculation ENGINEERING

Damage FINANCIAL
Estimation
Contract Loss
Exposure Calculations
Information

Policy
Conditions

• Where are future events likely to occur?

• How intense are they likely to be?
• How frequently are they likely to occur?

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 Catastrophe Model Output Provides a Tool for
Probabilistically Assessing and Managing Risk

• Models provide estimates

of loss by event, location
and coverage
• This allows determination
of the full probability
distribution of losses (EP
curves)
• Ability to classify losses by:
– Annual aggregate &
occurrence losses
– Direct, ceded and net retained
loss
– Location, policy, zone,
territory and portfolio levels
– Line of business, construction
type, etc.
• Determination of robust risk
measures such as TVar

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 6

 What is Included in Model Results
Earthquake:
Modeled Perils
• Shake
• Fire following
• Sprinkler leakage
• Liquefaction
Modeled Coverages
• Coverage A - Dwelling
• Coverage B - Other Structures
• Coverage C – Contents /
Personal Property
• Coverage D – Additional Living
Expense / Business Interruption
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Non-Modeled Perils
• Landslide
• Loss from levee or dam failures
• Fire loss following EQ due to arson
• Tsunami
Non-Modeled Loss Components
• Loss adjustment expenses
• Debris removal
• Hazardous waste removal
• Loss inflation due to political
pressure
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An Increasing Number of Commercial Lines Writers
Are Using Catastrophe Models in House

In today’s increasingly
competitive market, the Catastrophe model
development & deployment deployment for
Pricing & Tier
of catastrophe models goes Structure
beyond an actuarial & Assessment Market leaders are those
statistical exercise organizations that take a
End-to-end Technology holistic approach to
catastrophe risk business catastrophe risk
Underwriting
& strategy management & intelligence &
deployment
management. A fully
integration
throughout the integrated solution that
enterprise supports the application of
catastrophe model output at
the point of decision making
Scoring engine helps bridge the gap between
implementation &
business process
the slow adopters & market
redesign leaders

• Models continue to provide an increasingly more accurate view of catastrophe risk and offer
continually expanding functionality.
• Insurers that have successfully integrated catastrophe model output into their risk
management practices are best positioned to leverage the advanced accuracy and expanded
functionality of the models.

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 Integration of Catastrophe Models across the
Organization Support Risk Management Best Practices

• Identify areas to grow
based on model-based
risk metrics
• Perform model-based
analyses to understand
and manage the drivers
of catastrophe risk
• Accumulation/risk-aggregation management
• Manage the impact of catastrophe risk on surplus
Enterprise Risk • Communicate with ratings agencies
Management
• Use models to structure
Portfolio Reinsurance reinsurance treaties
Optimization Structuring • Use models to evaluate
reinsurance purchases

• Use model outputs in • Advance planning, resource

rate filings and in Actuarial
Claims deployment, post-event
pricing of individual Pricing communications
policies or programs

Underwriting • Catastrophe model output used for

risk selection and pricing at the point
of sale

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Catastrophe Models Provide Increased Value to the Risk
Assessment of More Complex Policy Types

Responsible for Similarity of Risks

Variation in terms
writing policies & (across LOB) and
of cover (limits &
setting premiums availability of
deductibles, etc.)
& policy terms exposure data

Personal Typically Highly similar

Lines Standardized automated risks. Data is
Underwriting decision making generally available

Range of
complexity in
the
underwriting
process

Variation of risks.
Commercial May vary by Underwriters
Data may be
Underwriting commercial policy responsibility
sparse

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 10

Companies That Don’t Invest in Analytics, Won’t Be
Able to Maintain the Status Quo

Projected cash stream for

insurers with improved
Competitive investing
Advantage
Assumed cash
Vs. stream resulting
from doing
nothing
Adverse
Selection
Falling behind in pricing and
underwriting effectiveness invites More likely cash stream for
adverse selection Insurers that choose not to
invest in tools

Source: Christensen, Kaufmann, Shih, “Innovation Killers: How Financial Tools Destroy
Your Capacity to Do New Things,” Harvard Business Review, Jan. 2008.
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Understanding the Importance of
Exposure Data Quality and Robust
Financial Modeling

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Integration of Catastrophe Model Output into Commercial
Underwriting Workflows

Submit Fill gaps in

Perform Fire
Proposed Pricing, Policy Exposure Data
Underwriting
Policy Terms and Quality &
Checks
Parameters conditions Collection

Perform Cat
Hazard Check

Portfolio
Obtain
Replacement Cost Management and
Determine Optimization
Pricing

Integration of Catastrophe Model

Ultimate UW Decline allows risk analyses to be
Bind Decision performed iteratively at all stages
of the underwriting process

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 13

Identifying the Appropriate Construction and
Occupancy Class Can Impact Loss Analyses

Underwriter receives submission with limited information:

• General commercial occupancy
• Unknown construction
• Replacement cost: $100 million
Example: ratio of loss for a contrived portfolio, when classifying portfolio as a
particular construction class vs. identifying as “unknown”
Relative Vulnerability

Wood Frame Masonry Unreinforced Masonry Light Metal

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Lack of Detailed Data Can Lead to an Incomplete
View of Risk

• Underwriter might collect additional

information through available resources:
– Commercial occupancy: Hotel (Temporary
lodging)
– Construction type: Steel

Relative Vulnerability of Steel Construction Types for General

Commercial Occupancy
Relative Vulnerabilities for the
Earthquake Peril

Variation within sub-

classes of construction
types highlights the need
to accurately capturing
detailed data

Steel Light Metal Braced Steel Steel MRF Steel MRF

Frame Perimeter Distributed

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Robust Exposure Data Tools Provide the Underwriter
with the Most Complete View of Risk

• AIR’s Touchstone™ enables the underwriter to validate and fill gaps in exposure
data:
– Validate replacement value and collect data on other primary risk characteristics such
as year built, building height, etc.
– Determine appropriate construction and occupancy classes
– Identify secondary risk characteristics such as presence of a soft story

Effect of Soft-Story on Modeled Losses for a Contrived

Portfolio of Steel Buildings
No Soft Story
Soft Story Present
Loss

AAL
AAL 10%
10% 5%
5% 2%
2% 1%
1% .4%
0.40% .2%
0.20%
Exceedance Probability

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Commercial Policies can Have Complex Terms and
Conditions
Deductibles Reinsurance
• At location level • Facultative reinsurance
– By site: $, %, % of loss – Proportional
– By coverage: $ and % – Non-proportional
– Combined (Building, Other Structures,
Contents): $ and % – Available at policy or individual locations
– CEA Mini Policy: $ and % • Risk-based treaty reinsurance
– Franchise – Quota share
• At policy level – Surplus share
– Attachment point – Per risk excess of loss
– Blanket, Minimum, Maximum – Includes special conditions
– % of loss • Line of business and region specific
– Franchise • Occurrence limits
Limits • Aggregate limits
• At location level • Portfolio (CAT) treaty reinsurance
– By site or by coverage – Occurrence
• At policy level – Aggregate (stop loss)
– Blanket, Excess, By coverage,
Sublimits, First loss

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A Probabilistic Approach is Required to Accurately
Capture Policy Terms

• Commercial policy terms can

be complex
• Defining and incorporating
Policy 1 policy terms into catastrophe
risk analyses improves the
accuracy of modeled losses
• For instance, policy terms
Location Location Location covering multiple coverages
1 Location 3 4 and location
2
– Individual distributions need to
be combined to arrive at the
joint probability distribution of
loss across
Building Contents Time • Coverages
• Locations

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 18

Quality Exposure Data Captured at the Point of Underwriting
Improves the Portfolio-level View of Exposure and Informs
Underwriting Rules & Strategy

Underwriting Rules / Strategy

Portfolio
Underwriting
Management
• Simple issue/decline decisions • Exposure concentration
• Pricing • Growth planning
• Policy terms • Reporting (statutory)
• Feed into rate-scoring models • Ratemaking
• Impact on loss ratios • Reinsurance
• Exposure concentration limits

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Advances in Modeling Business
Interruption Insurance

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Discussion on Business Interruption (BI)

• BI from an underwriting perspective

– Estimation of an insured's business income requirement
– Complexity and variation in policy forms and coverages
– Challenges in BI claims settlement
• BI exposure data
– Data requirements
– Exposure data analysis
• Modeling
– Model variables
– Model framework

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Factors Contributing to Underinsurance in BI

• Use of business interruption limits for annual BI exposure

• Use of rules of thumb to determine BI limit rather than using BI
worksheet for each location
• Underestimation of number of locations that can be damaged in a
catastrophe
• BI findings from independent insurance studies
− Businesses either do not have BI coverage or do not have the
information to estimate BI exposure
− Significant underestimation of business downtime (<3 months) to
determine BI limits

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Robust Approach to Modeling BI Captures Insured
Downtime Following a Loss

Total Equivalent BI “Downtime”

Dependent Building Damage

Indirect BI
Utility Failure
Sub - Events

Civil Authority

Post – Repair /
Relocation

Direct BI
Repair and Reconstruction /
Relocation
Pre-Repair /
Relocation

Time after Event

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AIR’s Models Use an Event Tree Approach to
Handle BI

• Event tree approach

• Function of building damage and occupancy class

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 Key Factors Used in Determining BI Downtime

• Downtime is influenced by both building complexity and

content types

BUSINESS INTERRUPTION DOWNTIME

Building Characteristics Business Resiliency Other Factors

− Building Damage
− Building Occupancy
− Building Size
− Building Complexity
− Operation Likelihood − Extended Period
− Relocation Likelihood − Extra Expense
− Contingent BI
− Civil Authority
− Utility Failure

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 25

 A Robust BI Model Should Incorporate the Impact of
Various Factors by Occupancy500

Indirect Operation Relocation

BI
Hotels
Mean Business Interruption Days
400

Offices
Hospitals
300

Hotel
200
100

Office

0% 25% 50% 75% 100%

Mean Building Damage Ratio
©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 26
Advances in Modeling BI Insurance

• Business interruption accounts of downtime

• Modeling can capture both direct & contingent BI
• AIR’s modeling framework allows for the development of
separate downtime functions for different types of
businesses (occupancies)
• Quality of exposure data varies significantly across the
industry: detailed business interruption policy conditions
and property conditions are often not available
– AIR’s methodology to modeling business interruption losses
employs logical assumptions about the occupancy and building
characteristics of “typical” BI policy

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Understanding Industrial Facilities

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 Identifying Major Component Classes within
Industrial Facilities
HV Circuit Breakers Process Towers
(Example: Chemical Plant)
Building
Transmission Towers Flare Tower Tanks
Open Frame Conveyor Pipe Rack

ransmission Towers Flare Tower Tanks

Open Frame Conveyor Pipe Rack
Transformer Cooling Towers Vertical Vessels

Open Frame Conveyor Pipe Rack

Transformer Cooling Towers Vertical Vessels

Transformer Cooling Towers Vertical Vessels

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Complexity and Diversity of Industrial Facilities Creates
Additional Challenges to the Underwriting Process

• A site can be very large with very different industrial plants in its interior
• Examples of industrial facility classes
– Chemical plants
– Petrochemical plants
– Power generation and distribution systems
– Manufacturing plants
• In addition, plants may be comprised of many different components - each of
very different vulnerability

Catastrophe Risk Engineering (CRE)

Analysis of a facility's
catastrophe risk exposure can Defined distribution of components – to
depend on the carrier’s more accurately reflect a facility’s
vulnerability
sophistication & experience in
underwriting industrial facilities
Industrial facility type

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Defining the Component-Mix of a Facility Helps to Ensure the
Most Accurate Assessment of Vulnerability

• A component-based approach to modeling a facility’s damageability

should consider the vulnerability of assets comprising the facility
• Underwriters can input the facility’s distribution of components to
accurately assess vulnerability or select standard industrial facility type

Chemical Plant Ethanol Plant

Transportation Transportation
Tanks Assets Silos Assets
15% 5% 11% 4%

Cooling Plant
Towers Equipment
27% Plant
5% Tanks Equipment
17% 29%

Process Cooling
Towers Towers
20% 0%
Process
Buildings Towers Buildings
Open 12% 15% 20%
Frame Open Frame
Structures Pipe Racks Structures Pipe Racks
8% 8% 2% 2%

©2013 AIR WORLDWIDE CAS Ratemaking & Product Management Seminar 31

Summary

• Leading companies are integrating catastrophe modeling

into their underwriting process for better decisions
• A range of data and techniques are available to provide
increasing precision in risk differentiation
• Catastrophe risk is influenced by factors other than simple
hazard metrics
• Proper capture of building characteristics and business
interruption risk can significantly impact loss estimates
• Component approach improves modeling of Industrial
Facilities

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