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MARCH 24, 2020 2020 NAIC Spring Meeting – Catastrophe Working Group Clearing the way for regulatory approval of catastrophe models Source: US Forest Service Nancy P. Watkins, FCAS, MAAA Principal & Consulting Actuary

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Page 1: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

MARCH 24, 2020

2020 NAIC Spring Meeting – Catastrophe Working Group

Clearing the way for regulatory approval of catastrophe models

Source: US Forest Service

Nancy P. Watkins, FCAS, MAAAPrincipal & Consulting Actuary

Page 2: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Agenda

Background A tale of two markets Florida California Cat model overview and benefits Regulatory challenges Proposal for catastrophe model clearinghouse

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Page 3: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

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BackgroundFacilitating the use of catastrophe models in ratemaking to aid insurance availability, affordability

Current regulatory framework presents challenges to regulators, modelers, and insurers

Historical data from natural catastrophes is sparse and volatile, so past experience may not be a sufficient basis for accurate expectations of the future

Catastrophe ratemaking regulation can have an effect on insurance affordability and availability

Catastrophe simulation models have been widely adopted in private insurance, along with other areas such as emergency management

ChallengeHow can regulators encourage and allow the use of catastrophe models, while maintaining appropriate regulatory oversight to ensure that rates are not excessive, inadequate, or unfairly discriminatory?

Page 4: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

A tale of two markets: Florida

Page 5: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

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Florida hurricane

Insurer insolvencies

Spike in reinsurance costs

Cancellation and nonrenewal of policies

Requests for large rate increases

Availability and affordability crisis

Deterioration in real estate market

Impact

Hurricane Andrew (1992) caused over $27 billion in losses

Insurers learned how seriously they had underestimated exposure

Losses could have been much higher

Situation

Reduction of risk in state

Reduced premiums

More capital, formation of new domestics

More price and product competition

Better consumer choices

Stabilization of real estate market as insurance availability and affordability improved

Results

FRPCJUA established in 1992, 1M policies by 1994

FCHLPM created in 1995 to review/approve hurricane models

Strengthened building codes, mandatory insurance mitigation discounts incentivized home hardening

Response

Page 6: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

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Florida flood

Rate increases shocked the real estate market

Florida particularly impacted, with over 2 million NFIP policies

Biggert Waters partially rolled back in 2014

Concerns over NFIP affordability remained

Impact

NFIP $18 billion in debt in 2012

Biggert Waters (2012) required flood premiums to reflect the true cost of risk

Subsidies and discounts on flood insurance premiums would be phased out

Significant flood rate increases for many NFIP policyholders

Situation

Rapid growth in private flood insurance writers, currently:

32 Primary

6 Excess of NFIP

2 Excess & Surplus

Generally underwritten and/or rated based on cat models

Increased availability, consumer choice

Better coverage options

Often more affordable than NFIP

Closing protection gap

Results

FL SB 542 passed in 2014

Provided private flood alternative to the NFIP

Allowed additional freedom in flood rating

Allowed open use of catastrophe models until FCHLPM developed review standards

Freedom to experiment for multiple years, extended to 2025

Response

Page 7: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

A tale of two markets: California

Page 8: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

California catastrophe ratemakingTotal premium for wildfire must be based on experience and not catastrophe models

According to the California Code of Regulations (2644.5): Catastrophe losses are based on a multi-year long-term average of

catastrophe claims

Minimum 20-year average is required for homeowners multiple peril fire

Adjustments for changes in historical and prospective exposure to catastrophes due to mix of business changes are required

Current ratemaking rules for catastrophe models: Not allowed for setting overall wildfire rate levels (except for Fire

Following Earthquake)

Allowed for setting rate relativities

Allowed for granular territory definitions

Allowed for underwriting and tiering

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Page 9: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Historical experience is not sufficient for wildfire ratemakingRecent wildfire losses have not followed historical experience

Prior to 2017, 1991 Oakland Hills Fire was most destructive event in state history Unprecedented losses occurred in 2017,

followed consecutively by 2018. If past experience is assumed to be the best

basis to predict the future, how could this happen?

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https://www.munichre.com/topics-online/en/climate-change-and-natural-disasters/climate-change/climate-change-has-increased-wildfire-risk.html

Page 10: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Weaknesses of CA reliance on historical data

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YearNon-CAT

Loss CAT Loss

CAT / Non-CAT

Ratio Selected Catastrophe Load1997 101 5 5%1998 123 14 11%1999 131 7 5%2000 179 (0) 0%2001 216 1 1%2002 236 8 3%2003 159 78 49%2004 183 5 3%2005 197 12 6%2006 230 7 3%2007 251 120 48%2008 320 75 23%2009 334 3 1%2010 332 3 1%2011 396 17 4%2012 345 2 1%2013 386 0 0%2014 350 22 6%2015 394 145 37%2016 403 14 4%2017 478 1,243 260%2018 390 2,395 614%

Creates huge volatility in catastrophe rates from year to year Only supports rate changes once events

have been experienced Does not necessarily reflect changes in

exposure Will tend to understate exposure in times

of increasing risk, possibly materially

Actual averages based on filings from three large California insurers

1997-2016 CAT Load: 11%

1998-2017 CAT Load: 23%

1999-2018 CAT Load: 53%

Page 11: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

(1.4)

(2.0) (2.7)(3.1) (3.7) (3.4) (3.1) (3.0) (2.6) (2.4) (2.7) (2.8) (3.7)

(2.0)

(0.3) 1.5 1.0 1.4 3.0

4.3 5.5

6.8 8.1

9.1 9.5 10.2

(0.7)

(10.1)

($20)

($15)

($10)

($5)

$0

$5

$10

$15

$20

'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18

Prof

its ($

Billio

ns)

CA Homeowner Estimated Industry Underwriting Profits Since 1991Yearly Profit Cumulative Profit

Homeowners insurance profitability

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Source: Milliman Estimates, based on P&C Combined Industry Annual Statement data from SNL and data from the California Department of Insurance

1991-2016 Cumulative profits: $10.2 billion

Loss for 2017 and 2018 combined equals $20 billion

Drought from 2011-2017 reduced water and wind losses

Page 12: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Potential prognosis for California under status quo

Reduction in admitted insurance availability, especially in most risky markets

Fewer options for consumers in admitted market, transfer of risk to residual and E&S markets

Reduced ability to promote affordability through risk mitigation

Adverse impact on real estate market

Potentially severe

economic consequences

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Page 13: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Disadvantages of E&S and residual market solutions

E&S and residual market (FAIR plan) growing rapidly Residual and E&S insurers permitted to

use catastrophe models Implications for consumers: Higher costs Potentially reduced coverage Less guarantee fund protection Lack of regulatory oversight of rates, market

conduct, solvency monitoring

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Source: LA Times: https://www.latimes.com/business/story/2019-08-28/hiltzik-california-fire-insurance-crisis

Page 14: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Cat model overview and benefits

Page 15: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

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Models separate catastrophe risk into component parts

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Paths of hurricanes from 1851 through 2015 (NOAA)

Individual exposed risks (e.g. homes, businesses)

Insurance purchased (e.g. limits, deductibles, coverages)

Range of events (e.g. hurricanes, floods, wildfires)

Intensity (physical hazard to specific geography at risk)

Vulnerability (damage to exposed risks)

Financial (monetary loss from the damage)

Page 16: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Limitations of historical experience vs. catastrophe models

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Historical experience Catastrophe models

Possible events Reflects only events that actually occurred

Reflect the range of possible events and their likelihood; calibrated to

reproduce historical events

Time horizon Choice of years to include can result in materially different outcomes

Not sensitive to choice of years

Exposure catalog Reflect historical exposures (location, home materials, building codes)

Reflect current or prospective exposures as inputs to model

Mitigation Difficult to adjust data in a meaningful way to show effects of mitigation

Can be built to show change in outcomes under mitigation scenarios

Scenario testing Difficult to adjust data in a meaningful way to show effects of climate change

Can be built to show range of outcomes under climate change

scenarios

Page 17: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Regulatory challenges

Page 18: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Catastrophe model treatment varies widely among states

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Statewide body for scientific and technical review of catastrophe models

Regulations piggybacking on other state reviews

Questionnaires and case-by-case model validation

Silent on the use of catastrophe models

Prohibition of the use of catastrophe models for some or all purposes in establishing rates

Page 19: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Challenges for regulators

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Lack of appropriate expertise and/or resources to review models comprehensively

Balancing needs of affordability, availability, insurance company solvency and consumer protection

Inability to protect proprietary information of modelers and insurers

Page 20: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Proposal for catastrophe model clearinghouse

Page 21: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

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Proposal for catastrophe model clearinghouse

Multi-disciplinary panel to develop standards, select expert reviewers and manage model review process

Third-party experts chosen by panel to perform confidential reviews Consistent professional review team for

all models for a given peril

Expert team would depend on nature of model but could include engineers, scientists, technologists, actuaries, claims experts, other professionals

Potential clearinghouse deliverables Standardized modeler disclosures

Market basket output for state level regulatory analysis, comparison

Third-party expert reports reviewing model compliance with standards

Model acceptability for specific purposes

Voluntary participation by states who wish to rely on expert model review

Page 22: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Key considerations

Ownership/structure: What organizational/control structure will be mutually acceptable to regulators, insurers and cat modelers? Needs to be able to administer an independent, centralized, rigorous review process One idea: Insurance Institute for Business & Home Safety (independent, nonprofit, scientific research

and communications organization funded by the insurance industry)

Funding: How should costs of the clearinghouse reviews be shared among the parties that benefit (states, insurers, cat modelers, others)? Trade secret protection: How will the clearinghouse ensure intellectual property and proprietary

information of modelers and insurers will be protected?

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Page 23: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Vision

Rigorous, sound framework to evaluate complex and constantly evolving models Better information from clearinghouse improving ability of state regulators to fulfill oversight

responsibilities without expending significant cost and resources Stabilization of rate indications by reducing impact of large events Catastrophic risk priced at actuarially sound rates that are not excessive, inadequate or unfairly

discriminatory Competition and investment in science, data, modeling related to catastrophic risk Integration of community and home mitigation impacts allowing better cost-benefit analysis,

incentives to reduce risk Greater insurance availability improving consumer choice Risk reduction and competition leading to more affordable insurance premiums

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Page 24: Clearing the way for regulatory approval of catastrophe models Cat... · California catastrophe ratemaking Total premium for wildfire must be based on experience and not catastrophe

Nancy Watkins, FCAS, MAAAPrincipal & Consulting Actuary

Thank you!

[email protected](415) 394 3733