Hurricanes, Risk Models, and Insurance

Roger Pielke Jr has an interesting post Are We Seeing the End of Hurricane Insurability? on the Prometheus weblog. The insurance industry uses models of expected losses to set rates for catastrophic losses – from things such as huricanes. However, the models that are properitarity and not open to public evaluation. Now consumer groups are attacking the providers of “catastrophe models” arguing that these models main purpose is to justify increases in insurance rates.

In the past consumer groups have argued:

Consumers were told that, after the big price increases in the wake of Hurricane Andrew, they would see price stability. This was because the projections were not based on short-term weather history, as they had been in the past, but on very long-term data from 10,000 to 100,000 years of projected experience. The rate requests at the time were based upon the average of these long-range projections. Decades with no hurricane activity were assessed in the projections as were decades of severe hurricane activity, as most weather experts agree we are experiencing now. Small storms predominated, but there were projections of huge, category 5 hurricanes hitting Miami or New York as well, causing hundreds of billions of dollars in damage. Consumers were assured that, although hurricane activity was cyclical, they would not see significant price decreases during periods of little or no hurricane activity, nor price increases during periods of frequent activity. That promise has now been broken.

While the catastrophe modelling firms argue:

Given a constant climatological state (or if annual variations from that state are short lived and unpredictable) the activity rate in a catastrophe model can best be represented as the average of long-term history. In this situation there is no need to characterize the period over which the activity is considered to apply because, with current knowledge, it is expected that rate will continue indefinitely. The assumption that activity remains consistent breaks down, however, where there are either multi-year fluctuations in activity or persistent trends. It then becomes necessary to characterize the time period over which the activity in the Cat model is intended to apply.

Pielke argues that the disaster modellers are implying

…that the historical climatology of hurricane activity is no longer a valid basis for estimating future risks. This means that the catastrophe models that they provide are untethered from experience. Imagine if you are playing a game of poker, and the dealer tells you that the composition of the deck has been completely changed – now you don’t know whether there are 4 aces in the deck or 20. It would make gambling based on probabilities a pretty dodgy exercise. If RMS [Risk Management Solutions - a catastrophe modelling company] is correct, then it has planted the seed that has potential to completely transform its business and the modern insurance and reinsurance industries.

What happens if history is no longer a guide to the future? One answer is that you set your expectations about the future based on factors other than experience. One such approach is to ask the relevant experts what they expect. This is what RMS did last fall, convening Kerry Emanuel, Tom Knutson, Jim Elsner, and Mark Saunders in order to conduct an “expert elicitation”.

… RMS conducted its elicitation October, 2005 with the intent that it will shape its risk estimates for the next 5 years. This is wholly unrealistic in such a fast moving area of science. It is unlikely that the perspectives elicited from these 4 scientists will characterize the views of the relevant community (or even their own views!) over the next five years as further research is published and hurricane seasons unfold. Because RMS has changed from a historical approach to defining risk, which changes very, very slowly, if at all over time, to an expert-focused approach, it should fully expect to see very large changes in expert views as science evolves. This is a recipe for price instability, exactly the opposite from what the consumer groups, and insurance commissioners, want.

From the perspective of the basic functioning of the insurance and reinsurance industries, the change in approach by RMS is an admission that the future is far more uncertain than has been the norm for this community. Such uncertainty may call into question the very basis of hurricane insurance and reinsurance which lies in an ability to quantify and anticipate risks. If the industry can’t anticipate risks, or simply come to a consensus on how to calculate risks (even if inaccurate), then this removes one of the key characteristics of successful insurance. Debate on this issue has only just begun.

Hedging ones bets with insurance is a good strategy to deal with risk – where known outcomes are expected to occur with some known probability. However, when confronting more uncertain situations other approaches such as building resilience to potential classes of shock, engaging in experimental management to decrease uncertainty, and accelerating learning by integrating sources of knowledge across a wider variety of domains (e.g. meterology, ecology, and urban planning) and different regions (e.g. Sri Lanka, the Netherlands, and New Orleans).

2 thoughts on “Hurricanes, Risk Models, and Insurance”

  1. The historical atmospheric CO2 volume was ~ 280ppm. Now it is ~33% higher than that, with concurrent LU/LC (albedo) changes as well. So it may be safe to say that the “historical climatology of hurricane activity is no longer a valid basis for estimating future risks”.

    And although I’m absolutely in line with the responses outlined in your last paragraph, I don’t see the political will on the ground to engage in this social learning.

    DS

  2. Whilst we don’t experience hurricane’s here in the UK (yet), we had unprecedented storms and flooding in 2007 (see here http://www.uk-insurance-index.co.uk/article-246.html). Insurance premiums have risen for most residents as a result with some areas getting close to being uninsurable. I think we are going to have to get creative with our insurance policies and look for new ways to understand and mitigate risk.

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