KCC Introduces Characteristic Events

BOSTON, MA, January 31, 2012

Karen Clark & Company (KCC), independent experts in catastrophe risk, catastrophe models and catastrophe risk management, today announced the introduction of Characteristic Events (CEs), a new tool to assist insurance companies in assessing and managing catastrophe risk.

CEs are defined-probability events created for specific peril regions that provide a wealth of information to insurance companies. The events are developed for the return periods of most interest to insurers, such as 1-in-100 and 1-in-250. In light of the inherent limitations of the catastrophe models, KCC developed CEs as an additional tool offering a more consistent and effective framework, and a robust scientific approach, to catastrophe risk management.

"After working with dozens of companies over the past several years, we found the fundamental requirements for effective catastrophe risk management are stable sets of events to represent large loss potential and consistent yardsticks for measuring and monitoring risk," said Karen Clark, President and CEO, KCC. "This is what companies are looking for because, while catastrophe models perform many functions and provide a lot of numbers, the models can be problematic for risk management decision-making when the loss estimates swing widely from model to model and update to update. By remaining constant year to year, CEs provide more stable risk metrics for day-to-day underwriting and pricing decisions and monitoring the effectiveness of risk management strategies over time. They can be used on their own or as a perfect complement to the models."

How the CE Approach Works

Using the same scientific data underlying the catastrophe models, the CE intensity "footprints" are created to represent the event characteristic of the selected return periods and for specific regions. For example, in Florida, the 100 year CE will be representative of a Category 5 hurricane while in the Northeast, the 100 year CE will be representative of a Category 3 storm. These fully transparent footprints are superimposed on company exposures, and damage functions by occupancy and construction are applied to estimate the losses.

For each exposed region, the CE footprints are "floated" to make sure that all exposed properties are covered and the resulting patterns of risk are smooth and logical, particularly at high resolution. Because the catastrophe models generate random events, the underlying pattern of risk at high resolution can be erratic and anomalous. Model-generated ZIP code and location level losses are particularly volatile.

Much of the volatility in the model-generated loss estimates is due to noise from uncertainty and changing assumptions in the hazard component of the models. CEs eliminate this volatility by keeping the events constant. The CE footprints change only if there is tangible scientific evidence that significantly alters the consensus view of risk in a particular peril region. Because CEs remain constant and are the same across companies, they provide a "common currency" for comparing and monitoring catastrophe risk. Because they are transparent, the CE footprints can be easily peer reviewed by internal and external experts.

CEs illustrate clearly the types of events that can impact an insurer, highlight areas of exposure concentrations, and provide an effective exposure management tool. While probabilistic loss estimates are very valuable, insurance companies still want to monitor exposure concentrations. While concentric circles are reasonable for monitoring terrorism exposures, the CE footprints provide more realistic intensity contours for monitoring exposures to hurricanes and earthquakes.

How Companies are Using CEs

Insurers can use CEs to accomplish multiple objectives. CEs provide a transparent view of the risk so companies can better understand their exposures, and they are model-independent scientific benchmarks for testing the model loss estimates. By comparing the CE estimates to the model-generated estimates, insurance companies can determine if any models are outliers for their books of business and which models are more credible in various peril regions. In addition, the model estimates can be compared to those of the CEs by region to determine appropriate model-blending weights.

Rating agencies and regulators have growing expectations with respect to how well companies understand and can explain their catastrophe loss potential. CEs provide additional information companies can use to support their risk management decisions to external stakeholders as well as for effective internal communication.

CEs can be used on their own or in conjunction with the models as consistent yardsticks for monitoring risk and the effectiveness of risk mitigation strategies. The events underlying PMLs and even TVaRs change as exposures change so these risk metrics are not operational for managing risk, particularly across large, complex companies. Since event losses are additive, the CE losses can be monitored at the corporate level and drilled down to individual business units, lines of business, policies and locations. Because CE loss estimates can be estimated at a location level the marginal impact of individual policies can be calculated and used for underwriting and pricing decisions.

"The industry response to CEs has been overwhelmingly positive because companies now have an additional scientific method for assessing and managing catastrophe risk which is healthy for a competitive market," , said Ms. Clark. "Catastrophe losses now dominate many of the property lines, and will continue to grow, so the more credible scientific information that can be brought to bear on risk management decisions, the better. We are excited to be introducing a new paradigm of transparency and stability as part of the industry transition to an advanced level of catastrophe risk understanding and management."

Currently available for US hurricane, future versions of CEs will address earthquakes and other perils.