S&P report highlights need to understand risk modelling uncertainty

Ratings agency Standard & Poor’s (S&P) has discussed the uncertainty with catastrophe risk modelling and the impact this can have on insurance and reinsurance ratings, underlining the need for companies to take any uncertainties into account.

“Catastrophe modeling is a complex process that is influenced by numerous estimates, assumptions, and subjective judgments.

“We consider that there is a significant modeling uncertainty when estimating cat exposure–that is, the difference between the potential range of losses under extreme events (consistent with a 1-in-250-year loss) and the losses estimated using the catastrophe models at this confidence level,” explains S&P.

S&P states that when assessing the capital adequacy of an insurance or reinsurance company, “the required capital for catastrophe risk (or the “cat charge”) we apply is based on the company’s own estimates of aggregate annual losses at a 1-in-250-year return period.”

However, many reinsurers have different levels of exposures to modelling uncertainty, as some will have greater exposure to perils that have less sophisticated modelling capabilities, some will utilise in-house modelling techniques, while others will rely solely on third-party vendor models.

It’s also important to remember that for some peril regions catastrophe modelling isn’t particularly advanced, so greater uncertainty is to be expected in some cases, although technology and a willingness from the industry to expand its reach is starting to lead to advances in some areas.

“As a consequence, the cat exposure estimates of different reinsurers carry different relative levels of modeling uncertainty,” explains S&P.

The ratings agency explains that modeling uncertainty in relation to catastrophe exposure for re/insurers is taken into account in its ratings analysis, underlining the need for re/insurers to be aware of how uncertainties could impact them and the importance of mitigating this.

Third-party vendor models from firms such as AIR Worldwide and RMS, for example, are widely used by the insurance and reinsurance industry, and despite improving all the time as technology and datasets improve and expand; they should be taken as one view of the risk and not the be all and end all.

S&P explains that these models reflect the vendor’s own view of the risk, and as this can vary slightly or greatly from the risk-view of the reinsurer, some have developed their own modeling tools for certain risks and regions.

This is an important development as it promotes greater scrutiny of exposures and ultimately a greater understanding of the risk, which should filter down the chain and result in more adequate pricing.

“In fact, regulators have encouraged reinsurers not to blindly use the vendor models but to review the workings of the models and identify and address any elements that do not reflect their view of the risk.

“Similarly, when we review reinsurers’ cat risk management capabilities as part of our rating analysis, we take a negative view if a reinsurer does not vet and validate the vendor models to establish their suitability for the reinsurer’s own view of the risk and catastrophe exposure,” explains S&P.

The latter point here from S&P further highlights the need for reinsurers to mitigate potential catastrophe modeling uncertainties via the use of vendor models and their own in-house models, to gain a wider view of the risk and also to see where any differences between the two models may be.

“To capture modeling uncertainty we apply analytic judgment in our assessment of capital and earnings and risk position, supported by benchmarking of qualitative and quantitative metrics,” states S&P.

“Although we understand that no single, “correct” modeling methodology exists and that differences of opinion are thus inevitable, we aim to form a view of whether a reinsurer’s modeling approach is well justified through a rigorous analysis and understanding of the risk,” continued the ratings agency.

Understanding the limitations with catastrophe modelling is an important aspect of a reinsurers risk profile, and the impacts can be minimised through the use of third-party and in-house models in order to gain a broader view of the risks.