Hurricane Models Wrong For Past Three Years, Report Says

Model forecasts for 2006 through 2008 hurricane seasons significantly overestimated U.S. insured losses, according to a catastrophe risk management firm study announced today.

The report, “Near Term Hurricane Models—How Have They Performed?,” was issued by Boston-based Karen Clark & Company and is available at www.karenclarkandco.com.

The firm said it looked at models designed to predict insured losses in the United States from Atlantic storms for the five-year period ending in 2010.

Ms. Clark developed the first hurricane catastrophe model, and in 1987 founded the first catastrophe modeling company, Applied Insurance Research (AIR) in Boston, which she left last year. AIR was among the companies critiqued in the report.

Besides AIR the study looked at near-term models produced by Oakland, Calif.-based Eqecat and Risk Management Solutions (RMS) in Newark, Calif.

It said AIR had initially predicted an overall annualized increase in hurricane losses of 40 percent above the long-term average but later lowered that figure to 16 percent in 2007.

Eqecat said the report had predicted increases of between 35- and 37 percent, and RMS consistently predicted an overall increase of 40 percent above the long-term average.

Assuming long-term average annual hurricane losses of $10 billion for each year, these figures translate into cumulative insured losses for 2006 through 2008 of $37.2 billion, $40.8 billion and $42 billion, respectively, for the AIR, Eqecat and RMS models.

But Karen Clark & Company said the actual cumulative losses were $13.3 billion, far lower than the model predictions, and more than 50 percent below the long-term cumulative average of $30 billion.

“With the close of the 2008 hurricane season, and three years into the application of near-term hurricane models, it is a good time to evaluate the models’ performance,” said Ms. Clark, the president and chief executive officer of her firm.

“While it is still too early to make definitive conclusions about the near-term models, with insured losses significantly below average for the cumulative 2006 through 2008 seasons, initial indications are there is too much uncertainty around year-to-year hurricane activity and insured losses to make credible short-term predictions,” she advised.

Catastrophe models were introduced to the insurance industry in the late 1980s. By utilizing many decades of historical data, the models gave insurance companies better estimates of what could happen and, more specifically, the probabilities of losses of different sizes on specific portfolios of insured properties, Karen Clark & Company said.

According to the firm, the destructive 2004 and 2005 hurricane seasons were catalysts for introducing the near-term models, which are based on short-term assessments of the frequencies of hurricanes. Use of these models by insurance and reinsurance companies was a radical departure from the way in which catastrophe average annual losses (AALs) and probable maximum losses (PMLs) are typically derived.

The report said in order for insured losses to reach 40 percent above average for the five-year period, in line with the highest model predictions, the next two years will have to be similar to 2004, or there will have to be another Hurricane Katrina.

The report noted that hurricane activity is influenced by climate factors, many of which are known, but some unknown, by scientists.

The study said there are complicated feedback mechanisms in the atmosphere that cannot be quantified precisely even by the most sophisticated and powerful climate models, and it recommended that insurers, reinsurers and regulators evaluate the efficacy of the near-term hurricane models in light of this uncertainty.

“Standard, long-term catastrophe models are characterized by a high degree of uncertainty, and short-term assumptions on frequency and severity only magnify this uncertainty and the volatility in the loss estimates,” said Ms. Clark.

“While computer models are valuable decision-making tools, they can lead to bad business decisions when not used correctly. Model users frequently forget that all models are based on simplifying assumptions, and therefore all models are wrong. Models attempt to replicate reality, but they are not reality,” she warned.

Karen Clark & Company is an independent provider of catastrophe risk management products and services. The company works with senior executives and boards of directors to help ensure their companies have in place effective risk management processes that conform to best practices.

The company also provides executive briefings to inform senior management and company boards on specific information they need to know on catastrophe risk, catastrophe models and using model results to manage risk.