Catastrophe model gaps an opportunity for reinsurance and ILS: Karen Clark

For those in management tasked with risk analysis, risk strategy implementation and long-term views of risk, the probable maximum loss (PML) “is not a useful number,” stressed Karen Clark during a speech at the SIFMA event in the U.S. last week.

The original founder of AIR Worldwide and now Chief Executive Officer (CEO) at Karen Clark & Company (KCC), Karen Clark, took the opportunity to address issues with catastrophe modelling and the use of the PML and exceedance probability (EP) curve, during a speech to attendees of the SIFMA IRLS 2015 event, in New York.

“The PMLs, in particular, are highly volatile. Even for U.S. hurricane where we have the most data and the least uncertainty, those numbers can change by multiples with one model update,” explained Clark.

Clark continued to note the increased acceptance and importance of the 1-in-100 and 1-in-250 year PMLs, as these figures are now the guidelines for “solvency and capital requirement formulas, determining reinsurance purchasing” and so on.

The problem, Clark states, is that a vast array of unknowns contribute to model uncertainty and inaccuracy, the latter an inherent element of risk modelling, according to Clark.

Using Florida as an example, she explained that due to the EP curve methodology risk analysers would only need to account for the 100 year PML, which is just over $100 billion but, in reality, if a category five hurricane struck downtown Miami today, the costs would be closer to $250 billion.

And it’s the gap of $150 billion that Clark urges the reinsurance, insurance-linked securities (ILS) and insurance world to fill, especially where the gap is difficult to narrow through advancements in catastrophe modelling.

“Now that gap can be an opportunity or a threat. The opportunity is obvious, get out there and sell more coverage to help close the gap,” Clark advised.

The threat, Clark warns, is that should an event of significant magnitude occur before the gap is bridged, it could close the door on the opportunity for the private reinsurance and ILS market, as instead of looking for private market solutions the Government would likely establish its own reinsurance programme.

“Why take a chance, let’s start innovating and close that $150 billion gap. It’s a huge opportunity,” urged Clark.

Today, companies are more than aware that losses could surpass their PMLs but there’s a tendency to simply regard it as a very unlikely occurrence, a dangerous method considering wide belief that the severity and frequency of large loss events is on a steady rise.

Opposing this, by offering the “flip side” of the EP curve technology she created nearly three decades ago, Clark described the benefits of KCC’s Characteristic Event (CE) methodology.

The CE method produces probabilities based on hazard versus the loss, which unlike traditional models shows exactly where the company has exposure concentrations.

The results here being that companies can better assess their exposure areas to large events, and take action to reduce risk areas they’re not satisfied with.

“Or you the reinsurers and ILS investors can offer new products to cover these spikes for your clients,” Clark advised the audience.

And now is arguably as good a time as ever for insurers, reinsurers, catastrophe bond players and the wider risk-financing world to start looking at ways of narrowing the gap highlighted by Clark.

As the market sits awash with excess capital in traditional and alternative forms, adding pressure to firms’ balance sheets and sparking a wave of market consolidation, companies are eager to deploy capital through innovative solutions.

Although Clark doesn’t see the abundance of capital in quite the same light as others; “We don’t have an over capacity problem, we have an under demand problem,” she said.

Concluding; “So you can see it’s an exciting new world with new models, new tools, and new opportunities. The future is bright for the ILS market.”