This article originally appeared in the August 2008 edition of ISO Review.

Feature Story:

Managing Cat Risks More Effectively

by Frank J. Coyne, Chairman, President, and Chief Executive Officer, ISO

In recent years, hurricanes and tornadoes — along with earthquakes, windstorms, wildfires, and flooding — have caused record losses for insurance companies and for society as a whole.

Hurricanes are among the most destructive natural disasters regularly affecting the United States. As the population concentrates more and more of the nation’s wealth in coastal areas subject to hurricanes, property losses and human suffering can only increase.

Companies offering property insurance in hurricane-prone areas face the prospect of devastating catastrophe losses. But an insurer can manage its risk to reduce the likelihood of a major storm impairing its financial stability and preventing the company from meeting its responsibility to pay losses.

The two most important factors affecting insurers’ chances of suffering severe hurricane losses are the location and geographic concentration of properties in their books of business.

Photo courtesy of NOAA

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 insurers with large percentages of their risks in one area are likely to suffer severe losses if a hurricane hits there.

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 catastrophe risk.

Many insurers have turned to geographic information systems (GIS) and computer-based catastrophe models to help measure and manage potential hurricane losses.

Using advanced geocoding technology, geographic information systems associate a property’s address with location-specific information about risk. For example, GIS can help insurers assess the hurricane risk at a particular property by determining how close the property is to the nearest ocean or other large body of water, which can fuel a hurricane and offer a path to landfall.

Insurance companies can use GIS 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. They can also use GIS to analyze a large number of policies — even the company’s entire book of business. Insurers can use such a study to evaluate the geographic distribution of the exposures the company has written.

Catastrophe models have become an essential tool for insurers to gain a thorough understanding of the risk inherent in a book of business and to evaluate potential losses from such perils as hurricanes, earthquakes, severe thunderstorms, winter storms, and wildfires. For example, hurricane models combine information about potential storms with engineering studies about the damage to different types of structures caused by storms of varying intensities. Insurers can use information from such models — together with data about the insurer’s book of business — to estimate potential losses and associated probability distributions. Such information can help insurers more intelligently manage their overall catastrophe risk and make better decisions about reinsurance.

ISO uses modeled losses, as well as historical loss data, in preparing advisory prospective loss costs — estimates of potential losses by coverage, construction class, territory, and other cost 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 catastrophe models, can help an insurer determine fair rates to reflect the risks the company faces.

The breadth and quality of hazard data is at an all-time high. For example, ISO provides address-specific property information — historical and predictive — for natural catastrophes, including hurricanes, earthquakes, and severe thunderstorms. ISO’s natural catastrophe data provides the long-term average annual loss for a typical property at a specific location and for each type of natural disaster.

To assess risk associated with wildfire, ISO and AIR Worldwide have developed models that combine satellite imagery and information about soil, slope, vegetation, road access, and fire response. The models enable insurers to manage wildfire risk both for individual policies and entire portfolios of properties.

The map depicts FireLine wildfire hazard assessment for the 2007 Witch Fire. Note the concentration of burned and damaged homes in areas of high and extreme hazard. The areas of moderate hazard in the northern and southeastern portions of the Witch Fire reflect lower fuel levels due to fires that burned there in 2003. More than one-third of the area consumed by the Witch Fire also burned four years earlier (Cedar and Paradise Fires of 2003).

In addition to probabilistic catastrophe models, ISO provides insurers with additional information on factors contributing to potential earthquake damage, such as soil type, distance to nearest significant fault, and landslide and liquefaction. ISO also contributes data potentially relevant to hurricanes — including storm-surge potential, elevation, and terrain — and tornado, hailstorm, and straight-line windstorm frequencies.

To promote the construction of more catastrophe-resistant buildings and reduce property losses from catastrophes, ISO’s Building Code Effectiveness Grading Schedule (BCEGS®) assesses the building codes in effect in a particular community, as well as how the community enforces its building codes.

Municipalities with effective, well-enforced codes should demonstrate better loss experience, potentially reflected in better insurance rates. The prospect of lessening catastrophe-related damage and ultimately lowering insurance costs provides an incentive for communities to enforce their building codes rigorously — especially as they relate to windstorms and seismic damage.

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