RISK MANAGEMENT OF AOG PERILS: RISKS Through ‘CRESTA’ AND ‘CAT MODELS’ By ALL RISK CARRIERS

Acts of God Perils: SEISMIC and WEATHER Perils are usually made INSURABLE through REINSURABILITY as Nat-Cat Events involve enormous accumulations of Liabilities in Natural Catastrophe Prone Zones in various countries of the world. Global Reinsurers bear almost 90% of Total Nat-Cat Insured losses through their participation in all kinds of Reinsurances. Reinsurers have become more ‘Restrictive’ and ‘Prohibitive’ in covering Nat-Cat Risks by Proportional Reinsurance Treaties. Pricing of premiums on Proportional Treaties depends on Direct Insurers Rating and EPI is not quoted by Reinsurers who impose restrictions by various types of measures as under on Proportional Treaties Reinsured Insurers:-

• Loss corridor or loss participation clause.
• Commission of 20% or so on premiums of AOG Perils covered.
• NIL P.C. on AOG Perils Profits.
• Capped Event Limits with Any One Event and/or Annual Aggregates in Proportional Treaties with full premiums given to Reinsurers and Insurers bearing spill overs without premiums.
• Estimated premium income may actually decline and Reinsurers introduce 90% of EPI as MinDep Premiums.

Reinsurer prefer XL Treaties where they Quote XL Treaty Premiums by Rate On Line % method applied on limits of each layer of multi-layered Cat XL Treaty Programs with Min & Deposit Premiums @90% of XL Premiums. However, Reinsurers follow certain norms to have overall pay-back period 10 years by 10% R.O.L. Rate On Line XL Premium is converted into Adjusted Rate % on EGNPI. Again with each reinstatement of limits exhausted by Cat Event Losses, there is 100% Additional Reinstatement Premium. Even Hours Clauses are corrected as in the case of Thai Floods losses. The 188 consecutive hours of 7 days was also replaced by 504 consecutive hours of 21 days as One Event of flood loss. Yet, despite all corrective measures with increasing frequencies and severities of Nat- Cat Events of losses, Reinsurers prefer to cover Nat-Cat Loss Events of AOG Perils by the creation of Market NAT CAT Pools. Now, let us understand how to underwrite AOG Perils Risks by CRESTA Zonal Assessments and Cat Models. CRESTA- Catastrophe Risk Evaluationand Standardizing Target Accumulations– was the creation of a Joint Project global reinsurers Swiss Re, Munich Re and Gerling- Konzern in the decade of 1970’s. The aim of CRESTA has been to establish a globally uniform system to control accumulations of risks arising out of NAT-CAT Events especially AOG Perils of Earthquakes, Various kinds of Storms and Floods. CRESTA member countries Maps of Zonal Aggregates of Natural Hazards region-wise has been accepted by Insurers and Reinsurers globally. ‘CRESTA ZONES’ have been of Universal Standard internationally famous amongall players of Insurance and Reinsurance Industries. CRESTA:

• Determine country-wise specific zones for assessment of accumulations of risks in the events of Natural Catastrophes according to geological exposures to specific Natural Hazards in a country.
• Drawing up Zonal Accumulation to assess aggregate exposures.
• Electronic Transmission of NAT-CAT Accumulation Data.
• Data to Insurers and Reinsurers out of past recorded data especially of Earthquakes and Hurricanes with revaluation of Loss Amounts.
• It may be practically difficult to implement but guidelines are created for Rating Norms for covering Earthquake Risks and Hurricane Risks in particular also including Storms, Floods etc.
• Seismological maps of various countriesare created which are helpful to insurers of these countries to assess and control exposure but the aggregate exposures keep on changing due to Climatic Changes, Demographic Changes and Urbanization Patterns.For example, Japan’s earthquake exposures are donewith about eleven zones and possible accumulation between aggregates of zone 4 & 5 or Zone 5 & 6.

  Global Reinsurers and Domestic Insurers of various countries worldwide have been using the CRESTA made data as Underwriting Risks with controls and proper levels of Rating Risks. Still there always have been compromises between IDEAL Rating Levels and REAL Rating Levels. However, in Risk Management Technologies of writing and underwriting Acts of God Perils of Natural Catastrophes, a closer co-operation is always ideal to be followed among Insurance Underwriters, Reinsurance Underwriters and Reinsurance Brokers. Hurricane Betsy (1965), Hurricane Camile (1969), Hurricane Hugo (1989), Hurricane Andrew (1992), Hurricane Georges (1998), Hurricane Floyd (1999) and then in 21^st century Hurricanes Katrina (2005), Rita (2005) and Wilma (2005) revealed increasing frequencies and severities of NAT-CAT Events arising out of AOG Perils. In 2008 Hurricane Ike, in 2011 Thai Floods, in 2011 Japanese Tsunamis caused by Tohoku earthquake and a series of Floods in India since 2010-11 to 2018 have all revealed practical TRUTH that all attempts to generalize norms of CAT Modelling and understanding the underwriting principles behind insuring and reinsuring AOG Perils have been a practical challenge to underwriting expertise with enriching experience of actual events. The ‘TRUTH’ is Cat- Modelling can become useful only as guidelines based on past experience. They are probabilistic assumptions to understand and underwrite ever increasing exposures.Exposure and experience both remain alluring in spite of all attempts of Cat Modelling. Acts of Men Cat Perils of Terrorism, Sabotage, Risks, Malicious Damage are even greater challenges. While Acts of God Perils cause destructions, yet there is Concern of Nature behind all destructions. Whereas Men destroy intelligently with all moral hazards and no humanitarian concern. The worst example is the WTC Attack loss of 11^th September, 2001. Terrorism has been a greater challenge with increasing frequencies and severities. Can we have a Cat Modelling to cover Terrorism? Countries shown in red are covered by zones in the CRESTA 2013 standard Cat Models for Earthquakes and Hurricanes are probabilistic and reliable when these are based on CRESTA Zones.  CAT MODELLING:Cat modelling is at once an Art and Science. It is a process of using computer assisted calculations to estimate NAT CAT Losses arising out of specified perils of earthquakes and Hurricanes. Experts of Actuarial Science, Meteorology, Seismology and Engineers apply their technologies and visions behind Cat Modelling of Risks. Insurance Company’s Team of Underwriters monitor exposures of their NAT CAT Portfolio of Risks and also generalize whether Rating Levels of NAT CAT Risks are ADEQUATE. It has never been ADEQUATE in practice due to Free Competition. Cat Modelling centersaround exposures of specific perils of earthquakes, Hurricanes, rainstorms. Actual experience of Hurricane Katrina (2005) revealed Non-Modelled Cat Perils role in causing unexpected Insured Losses. The 11^th March, 2011 losses of Tohoku Earthquake in Japan and resultant Tsunamis further revealed role of Non-Modelled Cat Risks. Same things happened in respect of Thai floods of June- July 2011. These events revealed the facts that ‘Cat Modelling’ are not and cannot be perfect guidelines because climate changes have been unpredictable. However climate changes and AOG Perils causingNAT-CAT Events have been full of uncertainties in frequencies and severities, Man-made catastrophes of Sabotage and Terrorism are even worse. Terrorists have been getting weapons of destruction. Even weapons of mass destructions are dangerously getting within their reach! On July 16^th, 2008, the insurance journal of New York contained an interesting article ‘Insurance Industry is Rethinking Cat Modelling After Last Year’s Disasters’ by Elizabeth Bolsfield. After Hurricane Katrina in July 2005, the Hurricane Harvey caused highest Hurricane Losses amounting to US$ 125 Billions. In June 2018, S&P Insurance conference in New York panelists discussed the Cat Modelling Process which raised serious concerns after the Hurricane Harvey losses.  Rainfall of 50 inches in some areas caused damages which were never considered as serious exposures in the zones affected by the Rainstorms and Floods causing enormous property damages. Mr. Steven Kelner, the M.D. and head of US/Canada Analytics at Guy Carpenter & Co. LLC, as a panelist on S&P Conference observed: “You can run the models all day. But when you go down to Houston and look at neighborhoods, the whole neighborhood was deemed not flood exposed because the maps weren’t accurate and the data wasn’t up to date. There is a lot of complexity in getting a Cat Model to run accurately.” Another panelist John Langione, Chief Risk officer of QBE North America, has observed: “Cat Models are great, but they are the part of the process.” The challenge for the Insurance Industry consists in recognizing the importance of using Cat Modelling software for pricing but not becoming ‘overly reliant’ on the Cat Models. The historical elements behind Cat Models are helpful to understand actual exposures of risks. Underwriters Team in an insurance company must use a ‘Sixth Sense’ and a strong common sense after using Cat Models as guidelines to write and underwrite AOG Perils both Modelled and Non-Modelled. ‘Expect The Unexpected’ is the lesson to be learned from available Cat Models. Cat Models are means to an end but not end in themselves. Life Cycles of the process of actual Cat Events are to be understood in details of exposures location-wise and number of past loss events. In fact, actual loss events behind the Cat Models are to be lessons for real modelling efforts. This is a continuous process to be followed. However, in Western World of USA/Canada, Western Europe, Australia, New Zealand and Japan, Cat Modelling Processes are revised realistically. But other Afro-Asian and Latin American Markets have to follow Risk Management techniques by CRESTA Zonal Assessments and Cat Modelling. All these facts reveal basic facts to appreciate practical use of Cat Models:

• Cat models have variable forms according to exposures of risks in countries as markets of Insurance and Reinsurance.
• All Models cannot be equal.
• Without a Model, underwriters have to grope in the dark.
• Cat Models are used on guidelines to realistically understand exposures of risks underwritten by each Insurer in the same market.
• Cat Models provide a historical link to current exposures of risks.
• Modelled and Non-Modelled Nat-Cat Risks are to be combined to arrange Reinsurance Protections of each Insurers’ portfolio of class-wise risks in General Insurances.
• Cat Models are a continuous process to give the insurance and Reinsurance Industries more confidence to grow with strength, stability and adequate Reinsurance Protection.

CAT MODELS ARE USED BY:

• Risk Management Team of Insurers use a Cat Model to assess their Nat- Cat Exposures and monitor their own portfolios’ overall exposures to specific AOG Perils of their own domestic market. This helps them to decide necessary Reinsurance Protection.
• State Regulators promote use of Cat Models for Insurers to charge correct levels of rating to catastrophe prime areas insureds covering AOG Perils in Property Risks as well as CAR/EAR Risks and Motor Own Damage coverage.
• Rating agencies like S&P, AM Best use Cat Models to assess financial strength of Insurers and Reinsurers to analyze their premium rates and overall Returns on Capital cash.
• Reinsurance brokers and Reinsurers use Cat Models in structuring Reinsurance Programs for Insurers with sufficient range to cover full exposure and also fix prices for protection especially on Cat XL Treaties.
• European Unions Insurers use Cat Models to satisfy requirements to maintain capital baseunder solvency II. These are internal Cat Models developed by each Insurer.
• In the Alternative Reinsurance Technology of Securitizationof RisksthroughCat Bonds, the capital market Cat Bond investors and investment banks use Cat bonds for pricing and structuring Trigger Point of Earthquakes’ magnitude.
• Insurance industry is working with ACORD- Association for Co-operative Operations Research and Development for sharing exposure data made available through Cat-Models.
• International Society of Catastrophe Managers (ISCM) also promotes professionalism within Insurance Industry through Cat-Modelling processes.
• Cat-Models are probabilistic models to assess Loss Patterns on set of events such as what happens when Category IV windstorm occurs, what happens when magnitude of earthquake is more than 8 on Richter Scale in California or towns and cities in Japan’s specific Earthquake Zones.

In short, Cat Models are created with reliable probabilities of Nat-Cat Events.  MARKET NAT-CAT POOLS AND CAT MODELS: Instead of covering AOG Perils by Proportional Reinsurance Treaties, Reinsurers prefer Cat XL Treaty Programs and most preferred method is The Creation of Market Nat-Cat Pools where all insurers become members and AOG Perils are covered with uniform and better levels of rating AOG Perils Risks as prescribed by the Underwriting Committee of the Market Pool. Similarly, Market Terrorism Pools are created. Market Cat Exposures are then adequately rated and covered by market Insurers as members of the Pool. Rating Levels are adequate as all insurers have to follow Uniform Rates as prescribed by the Underwriting Committee of the Market Pools. The Pool is then protected by Cat XL Treaty Programs priced suitably according to Nat-Cat exposures.   CONCLUSIONS: It is interesting to take note of Analysis of AM Best’s truthful observations on 19^th June, 2019: The Insurance Industry is experiencing a period of historic unprofitability as the gap between cost of capital and returns on equity remain at highest levels currently. Reinsurers have to become Restrictive- Prohibitive and have to act with Caution and Conservatism. CRESTA Zone-wise exposure data is to be updated continuously. Cat Models are to be used as guidelines of Probability of Nat Cat Events in specific zones. Risk Management of Natural Cat Perils are Man-Made Cat Perils of RSMDST- Riots, Strikes, Malicious Damage, Sabotage and Terrorism and Civil Commotion, Confiscation as well as War or War like conditions- are all to be considered as political risks and covered according to guidelines of the Market Pools’ Underwriting Committee. The usual Political Risks Exclusion Clause need not be included if political risks are to be covered. Corrective Measures are easy to implement for all when all insurers are members of the Market Pool. Insureds, Insurers, Brokers, Agents, Reinsurers and Reinsurance Intermediaries with Risk Management Team of Underwriters- all collectively act to introduce ORDER despite many uncertainties and in this task, CRESTA Zonal Assessments and Cat Modelling are the best methods of Risk Management in respect of AOG Perils Risks. Authored By: K. L. Naik Director Naik Consultancy & Advisors L.L.P Mumbai