Best Practices for Managing Catastrophe Risk

by Bill Churney, Vice President, AIR Worldwide

Natural catastrophes such as earthquakes, hurricanes, tornadoes, wildfires, and winter storms can jeopardize the financial well-being of an otherwise stable, profitable company. Catastrophe models are tools that help risk managers effectively assess catastrophe risk and make informed risk management decisions. Working together with their brokers, corporate risk managers can explore various risk transfer strategies, including appropriate levels of insurance purchase. By incorporating the results of catastrophe models, the following best practices can enable risk managers to take greater control of the risk transfer process and make the best and most cost-effective decisions for their enterprises.

Quantify Insurance Coverage Needs

Catastrophe modeling is the best way to identify the extreme events that can threaten an enterprise and to quantify the insurance coverage needed to protect the organization from the financial impacts. Catastrophe models simulate thousands of years of earthquakes, hurricanes, severe thunderstorms, wildfires, winter storms, terrorist acts, and other natural and man-made events. Modelers can then superimpose the simulated events over property exposures to determine the likelihood of one or more of events causing a loss. The output of the models provides the full range of potential losses, which an organization can then analyze.

Fortunately, natural and man-made events capable of derailing a company’s operations are rare. However, risk managers must understand the likelihood of these low-frequency, high-impact occurrences so that they can determine how much coverage to buy, what deductible level to choose, and at what cost.

The primary benefit of catastrophe modeling is that it provides a statistical measure of potential losses, so risk managers can align their insurance coverage more closely with their organization’s risk tolerance level. Additionally, by avoiding unnecessary coverage and customizing their corporate risk management program to reflect the realistic probabilities of loss from specific perils, risk managers can allocate risk transfer dollars more effectively.

Models also enable side-by-side comparisons of various scenarios — such as the probable cost of certain risk transfer/retention strategies — that can help risk managers and their brokers decide the amount of the deductible as well as the optimal way to apply it. Risk managers can more confidently determine whether the deductible should be a percentage of site replacement cost, a percentage of the aggregate loss, or a fixed sum and whether they should apply the deductible per occurrence (single event) or cap it.

Understand the Potential Magnitude and Frequency of Large Losses

Knowing how big potential catastrophes can be and how often they are likely to occur will help risk managers avoid either overbuying or underbuying insurance. Many companies insure to the probable maximum loss (PML), but a PML does not provide information about the probability that an event will occur. A better way to manage catastrophe risk is to understand the likelihood of various levels of potential losses and insure against those probabilities. In addition, knowing where the large losses (and business interruptions) are most likely to occur is useful for disaster recovery and operations planning.

Negotiate with Underwriters during Renewal Time

The acceptance and use of catastrophe modeling within the insurance industry is widespread today and nearly universal for large organizations. Thus, underwriters’ recognition of the technology works in favor of the insurance buyers who include model results with their submissions. Sharing model results with underwriters — particularly results that include a level of detail the underwriter doesn’t normally see — can be a powerful and persuasive negotiating tool during renewal time.

Improve Decision Making within the Organization

Catastrophe models can improve the quality of the information on which critical business decisions are based, such as:

Marginal impact of acquisition or sale — When dealing with a large portfolio of properties or multiple-location policies, the risk manager should be aware of how the sale or acquisition of a property may affect the organization’s risk profile. The location, value, and construction type of the properties in question, and their relation to the existing portfolio, can significantly alter the organization’s overall exposure. A catastrophe loss analysis is the best method to determine if a deal warrants a renegotiation and to quantify the appropriate rebate or preferred additional coverage.

Geographical consolidation or dispersion of operations — Catastrophe modeling can provide insight into more effective ways of managing exposure to catastrophe risk. Model results provide a clear picture of a company’s geographical distribution of exposures and the key drivers of a company’s catastrophe risk, including which perils, regions, and businesses have the greatest marginal impact on losses. Such information can help businesses fine-tune growth strategies to manage future catastrophe loss potential. The analyses can help determine where business can expand without increasing loss potential, as well as areas in which a company is already overexposed to catastrophe losses.

Allocation of insurance costs among business units — In addition to identifying the contribution of each location to an enterprise’s overall catastrophe risk, you can use a model-based analysis to allocate the cost of insurance back to individual locations or business units. This type of analysis allows organizations to assess fully the net benefit of geographically diverse operations or assets.

Conclusion

Catastrophe modeling offers enormous value to risk managers — value that continues to increase as the technology evolves and as property values increase in catastrophe-prone areas. Catastrophe modeling enables proactive decision making and strategic planning. As modeling analyses become more accessible — whether in-house, as a service through brokers, or directly from modelers — risk managers are embracing the technology to further their companies’ competitive advantage and make scientifically sound decisions about catastrophe risk management.