Managing Location and Geographic Concentration
The business of insurance is about accepting risk. Companies that sell property insurance in areas subject to hurricanes face the prospect of devastating catastrophe losses. But an insurer can manage its risk to reduce the likelihood that a major storm will impair the company's financial stability and prevent the company from meeting its responsibility to pay losses.
ISO's 1996 study Managing Catastrophe Risk showed that the two most important factors affecting an insurer's chance of suffering severe hurricane losses are the location and geographic concentration of properties in the insurer's book of business.
Location matters because hurricanes are far more likely to strike certain areas — the East and Gulf Coasts of the United States, for example — than other areas, such as the Midwest.
Geographic concentration matters because an insurer with a large percentage of its risks in one area is likely to suffer severe losses if a hurricane hits that area.
An insurer with policies spread over many areas has a relatively high chance of suffering hurricane losses in any given year. Wherever a hurricane comes ashore, it's likely to hit some of the properties on which the insurer has written policies. But, in any one year, the insurer faces a relatively low likelihood of suffering losses on a substantial proportion of its geographically dispersed policies.
An insurer with policies concentrated in one geographic area has a relatively low chance of experiencing any hurricane losses at all in a given year. The chance of a hurricane hitting any one place is low. But if a storm does strike the area where the insurer has concentrated exposures, the insurer faces a higher chance of suffering losses on a substantial proportion of its book of business than does an insurer with more geographically dispersed exposures.
Recent advances in computer technology and data analysis, as well as better scientific understanding of hurricanes, have greatly expanded the tools available to help insurance companies understand and manage their hurricane risk.
Many insurers have turned to geographic information systems (GIS) and computer-based catastrophe models to help measure and manage potential hurricane losses. [11]11. Governments and self-insured companies and organizations can use the same tools to assess, manage, and mitigate catastrophe losses.
Geographic Information Systems
To help manage the locations and geographic distribution of properties they cover, many insurers are using computerized geographic information systems. ISO's Geographic Underwriting System (GUS®) is one such information system.
Using advanced geocoding technology, GUS associates a property's address with location-specific information about risk. For example, GUS can help an insurer assess the hurricane risk at a particular property by determining how close the property is to the nearest ocean, gulf, or other large body of water. [12]12. GIS systems can also help insurers with a variety of other tasks, including many not related to catastrophes. For example, ISO's GUS product provides information about public fire protection, vulnerability to crime, and other underwriting and rating variables.
An insurer can use GUS or a similar system when evaluating individual applications for insurance to determine whether properties meet company underwriting criteria and to calculate correct premiums based on the insurer's own rating plan.
An insurer can also use GUS to analyze a large number of policies — even the company's entire book of business. An insurer can use such a study to evaluate the geographic distribution of the exposures the company has written.
Catastrophe Modeling
Using a GIS system by itself can help an insurer understand and manage the location and geographic distribution of risks in a book of business. But to gain a thorough understanding of the risk inherent in that book of business, an insurer needs a way of evaluating potential losses. Formerly, to assess potential losses, insurers generally had to rely on historical data. That information had serious limitations.
For any one location, hurricanes are infrequent events that can cause very severe losses. Therefore, developing a reliable estimate of potential losses in a particular place requires a long experience period — perhaps hundreds of years. Insurance records do not contain enough experience to provide actuarially credible information about potential hurricane losses.
However, if hundreds of years of insurance records were available, the information would not reflect current conditions. Changes in land use, population densities, construction techniques and materials, building codes, and a variety of other conditions would make the old loss experience almost useless for predicting future losses.
Computer-based catastrophe modeling enables insurers to resolve this dilemma. Modeling can provide a substitute for hundreds of years of experience, all based on the current set of insured properties.
A catastrophe model is a set of databases and computer programs designed to analyze information about the frequency and severity of catastrophes and to produce estimates of potential losses under various scenarios. A typical hurricane model uses publicly available information and proprietary research to estimate the probabilities of hurricanes of given intensities at given locations and the amount of damage those storms might do.
Based on meteorological data for the past century or more, a model can simulate all the possible hurricanes that could hit a location. Such a model can also estimate the likelihood of each hurricane striking in a one-year period.
Hurricane models combine information about potential storms with engineering studies about the damage that storms of various intensities cause to different types of structures. An insurer might use information from a hurricane model — together with data about the insurer's book of business — to estimate potential losses and the associated probability distributions. Such information could help the insurer more intelligently manage its overall hurricane risk and make better decisions about reinsurance. [13]13. Reinsurance is simply a contract under which one insurer pays a premium to another company — the reinsurer — in exchange for the reinsurer's agreement to pay some of the first insurer's losses. The reinsurance contract specifies what losses and under what conditions the reinsurer will pay.
ISO uses modeled hurricane losses, as well as historical loss data, in preparing advisory prospective loss costs — estimates of potential losses by coverage, construction class, territory, and other rating variables. Insurers can use ISO's estimates of potential losses in determining their own rates.
The availability of ISO's loss costs, including information from hurricane models, can help an insurer determine rates that fairly reflect the risks the company faces.
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