Report: Reinsurers View On Risk Models
Reinsurers need to stop viewing risk models’ predictions as infallible, says a leading financial intelligence magazine.
In a commentary published on November 24, Michael Loney, editor of the internationally respected “Reactions”, responded to a withering report which recently appeared in a Sarasota newspaper chastising Bermuda reinsurers for uncritically accepting the output of a new short-term hurricane model and adjusting prices charged to Florida insurers accordingly.
Headlined “Florida insurers rely on dubious storm model”, the article — described by Mr. Loney as “lurid” — stated: “RMS, a multimillion-dollar company that helps insurers estimate hurricane losses and other risks, brought four-hand picked scientists together in a Bermuda hotel room. There, on a Saturday in October 2005, the company gathered the justification it needed to rewrite hurricane risk.
Instead of using 120 years of history to calculate the average number of storms each year, RMS used the scientists’ work as the basis for a new crystal ball, a computer model that would estimate storms for the next five years. The change created an $82bn gap between the money insurers had and what they needed, a hole they spent the next five years trying to fill with rate increases and policy cancellations.”
The article went on to say some hurricane experts are now dubious of RMS’ claimed “scientific consensus” for its new model. “Today, two of the four scientists present that day no longer support the hurricane estimates they helped generate,” the “Sarasota Herald-Tribuner” reported. “Neither do two other scientists involved in later revisions. One says that monkeys could do as well.”
The article adds that as a result of RMS’s model change the cost to insure a home in parts of hurricane-battered Florida hit world-record levels. The RMS method of hurricane risk analysis, reported the newspaper, ”remains dominant model for Bermuda reinsurers — the most crucial source of private hurricane protection for Florida.”
“A number of points should be made in response to this article,” said Mr. Loney. “Firstly, it is not risk modellers that set rates – insurance and reinsurance firms do that. Secondly, no one is forcing the reinsurance and reinsurance firms to use the RMS model. It is only one of several modelling firms. Thirdly, all the models were way off on Katrina, so the loss estimates were always going to increase (the question was by how much). Lastly, it is ludicrous to blame all of the rate increases after hurricane Katrina on a model change. Capital was depleted –- the laws of demand and supply kicked in, pushing up pricing. The effects of model changes came on top of that.
“The problem for RMS is that no big events have struck since Katrina. The higher losses its new model predicted never came, making it look like the near-term model was not needed.”
But Mr. Loney said the article did raise an important issue – the over-reliance of reinsurers on risk modelling.
“This is further evidence that insurers and reinsurers need to question what the models tell them,” he said. “This is not the modellers’ fault. The models will never be perfect and they will always be wrong. Ironically, the models normally come in too low. In short, the market needs to stop taking the models’ output as gospel and modellers need to stop acting as if their models are more than an educated guess.”
Mr. Loney said reinsurance executives have also urged caution when using the models. He said Wilhelm Zeller, former CEO of Bermuda-based Hannover Re, was fond of using the phrase “A fool with a tool is still a fool” in reference to risk models.
