# Catastrophe modeling

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This article refers to the use of computers to estimate losses caused by disasters. For other meanings of the word catastrophe, including catastrophe theory in mathematics, see catastrophe (disambiguation).

Catastrophe modeling [1] (also known as cat modeling) is the process of using computer-assisted calculations to estimate the losses that could be sustained due to a catastrophic event such as a hurricane or earthquake. Cat modeling is especially applicable to analyzing risks in the insurance industry and is at the confluence of actuarial science, engineering, meteorology, and seismology.

A computer is a machine that can be instructed to carry out sequences of arithmetic or logical operations automatically via computer programming. Modern computers have the ability to follow generalized sets of operations, called programs. These programs enable computers to perform an extremely wide range of tasks. A "complete" computer including the hardware, the operating system, and peripheral equipment required and used for "full" operation can be referred to as a computer system. This term may as well be used for a group of computers that are connected and work together, in particular a computer network or computer cluster.

Insurance is a means of protection from financial loss. It is a form of risk management, primarily used to hedge against the risk of a contingent or uncertain loss

Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in insurance, finance and other industries and professions. Actuaries are professionals trained in this discipline. In many countries, actuaries must demonstrate their competence by passing a series of rigorous professional examinations.

## Perils analyzed

Natural catastrophes (sometimes referred to as "nat cat") include:

An earthquake is the shaking of the surface of the Earth, resulting from the sudden release of energy in the Earth's lithosphere that creates seismic waves. Earthquakes can range in size from those that are so weak that they cannot be felt to those violent enough to toss people around and destroy whole cities. The seismicity, or seismic activity, of an area is the frequency, type and size of earthquakes experienced over a period of time. The word tremor is also used for non-earthquake seismic rumbling.

A tsunami or tidal wave,, also known as a seismic sea wave, is a series of waves in a water body caused by the displacement of a large volume of water, generally in an ocean or a large lake. Earthquakes, volcanic eruptions and other underwater explosions above or below water all have the potential to generate a tsunami. Unlike normal ocean waves, which are generated by wind, or tides, which are generated by the gravitational pull of the Moon and the Sun, a tsunami is generated by the displacement of water.

A thunderstorm, also known as an electrical storm or a lightning storm, is a storm characterized by the presence of lightning and its acoustic effect on the Earth's atmosphere, known as thunder. Relatively weak thunderstorms are sometimes called thundershowers. Thunderstorms occur in a type of cloud known as a cumulonimbus. They are usually accompanied by strong winds, and often produce heavy rain and sometimes snow, sleet, or hail, but some thunderstorms produce little precipitation or no precipitation at all. Thunderstorms may line up in a series or become a rainband, known as a squall line. Strong or severe thunderstorms include some of the most dangerous weather phenomena, including large hail, strong winds, and tornadoes. Some of the most persistent severe thunderstorms, known as supercells, rotate as do cyclones. While most thunderstorms move with the mean wind flow through the layer of the troposphere that they occupy, vertical wind shear sometimes causes a deviation in their course at a right angle to the wind shear direction.

Human catastrophes include:

Terrorism is, in the broadest sense, the use of intentionally indiscriminate violence as a means to create terror among masses of people; or fear to achieve a religious or political aim. It is used in this regard primarily to refer to violence during peacetime or in war against non-combatants. The terms "terrorist" and "terrorism" originated during the French Revolution of the late 18th century but gained mainstream popularity in the 1970s in news reports and books covering the conflicts in Northern Ireland, the Basque Country and Palestine. The increased use of suicide attacks from the 1980s onwards was typified by the September 11 attacks in New York City and Washington, D.C. in 2001.

War is a state of armed conflict between states, governments, societies and informal paramilitary groups, such as mercenaries, insurgents and militias. It is generally characterized by extreme violence, aggression, destruction, and mortality, using regular or irregular military forces. Warfare refers to the common activities and characteristics of types of war, or of wars in general. Total war is warfare that is not restricted to purely legitimate military targets, and can result in massive civilian or other non-combatant suffering and casualties.

• Personal property
• Commercial property
• Workers' compensation
• Automobile physical damage
• Limited liabilities
• Product liability

## Input

The input into a typical cat modeling software package is information on the exposures being analyzed that are vulnerable to catastrophe risk. The exposure data can be categorized into three basic groups:

• information on the site locations, referred to as geocoding data (street address, postal code, county/CRESTA zone, et cetera)
• information on the physical characteristics of the exposures (construction, occupation/occupancy, year built, number of stories, number of employees, et cetera)
• information on the financial terms of the insurance coverage (coverage value, limit, deductible, et cetera)

## Output

The output is an estimate of the losses that the model predicts would be associated with a particular event or set of events. When running a probabilistic model, the output is either a probabilistic loss distribution or a set of events that could be used to create a loss distribution; probable maximum losses (PMLs) and average annual losses (AALs) are calculated from the loss distribution. When running a deterministic model, losses caused by a specific event are calculated; for example, Hurricane Katrina or "a magnitude 8.0 earthquake in downtown San Francisco" could be analyzed against the portfolio of exposures.

Hurricane Katrina was an extremely destructive and deadly Category 5 hurricane that made landfall on Florida and Louisiana in August 2005, causing catastrophic damage; particularly in the city of New Orleans and the surrounding areas. Subsequent flooding, caused largely as a result of fatal engineering flaws in the flood protection system known as levees around the city of New Orleans, precipitated most of the loss of lives. The storm was the third major hurricane of the record-breaking 2005 Atlantic hurricane season, as well as the fourth-most intense Atlantic hurricane on record to make landfall in the contiguous United States, behind only the 1935 Labor Day hurricane, Hurricane Camille in 1969, and Hurricane Michael in 2018.

## Uses

• Insurers and risk managers use cat modeling to assess the risk in a portfolio of exposures. This might help guide an insurer's underwriting strategy or help them decide how much reinsurance to purchase.
• Some state departments of insurance allow insurers to use cat modeling in their rate filings to help determine how much premium their policyholders are charged in catastrophe-prone areas.
• Insurance rating agencies such as A. M. Best and Standard & Poor's use cat modeling to assess the financial strength of insurers that take on catastrophe risk.
• Reinsurers and reinsurance brokers use cat modeling in the pricing and structuring of reinsurance treaties.
• European insurers use cat models to derive the required regulatory capital under the Solvency II regime. Cat models are used to derive catastrophe loss probability distributions which are components of many Solvency II internal capital models.
• Likewise, cat bond investors, investment banks, and bond rating agencies use cat modeling in the pricing and structuring of catastrophe bond.

Reinsurance is insurance that is purchased by an insurance company, in which some part of its own insurance liabilities is passed on ("ceded") to another insurance company. The company that purchases the reinsurance policy is called a "ceding company" or "cedent" or "cedant" under most arrangements. The company issuing the reinsurance policy is referred simply as the "reinsurer". In the classic case, reinsurance allows insurance companies to remain solvent after major claims events, such as major disasters like hurricanes and wildfires. In addition to its basic role in risk management, reinsurance is sometimes used to reduce the ceding company's capital requirements, or for tax mitigation or other purposes.

Standard & Poor's Financial Services LLC (S&P) is an American financial services company. It is a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is known for its stock market indices such as the U.S.-based S&P 500, the Canadian S&P/TSX, and the Australian S&P/ASX 200. S&P is considered one of the Big Three credit-rating agencies, which also include Moody's Investors Service and Fitch Ratings. Its head office is located on 55 Water Street in Lower Manhattan, New York City.

Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.

## Open catastrophe modeling

Recently, an effort to create and disseminate open multi-hazard cat risk modeling tools was initiated by the Alliance for Global Open Risk Analysis (AGORA).

Also, Oasis Loss Modelling Framework (LMF) has been created. It has been founded as a not for profit organisation funded and owned by the Insurance Industry to promote open access to models and to promote transparency. Open source code for the framework is available at http://github.com/oasislmf .

Additionally, the insurance industry is currently working with the Association for Cooperative Operations Research and Development (ACORD) to develop an industry standard for collecting and sharing exposure data. To date, the industry has been operating on closed, proprietary data formats.

## Related Research Articles

Terrorism insurance is insurance purchased by property owners to cover their potential losses and liabilities that might occur due to terrorist activities.

General insurance or non-life insurance policies, including automobile and homeowners policies, provide payments depending on the loss from a particular financial event. General insurance is typically defined as any insurance that is not determined to be life insurance. It is called property and casualty insurance in the United States and Canada and non-life insurance in Continental Europe.

A risk pool is one of the forms of risk management mostly practiced by insurance companies. Under this system, insurance companies come together to form a pool, which can provide protection to insurance companies against catastrophic risks such as floods or earthquakes. The term is also used to describe the pooling of similar risks that underlies the concept of insurance. While risk pooling is necessary for insurance to work, not all risks can be effectively pooled. In particular, it is difficult to pool dissimilar risks in a voluntary insurance bracket, unless there is a subsidy available to encourage participation.

Financial Reinsurance, is a form of reinsurance which is focused more on capital management than on risk transfer. In the non-life segment of the insurance industry this class of transactions is often referred to as finite reinsurance.

Parametric insurance is a type of insurance that does not indemnify the pure loss, but ex ante agrees to make a payment upon the occurrence of a triggering event. The triggering event is often a catastrophic natural event which may ordinarily precipitate a loss or a series of losses. But parametric insurance principles are also applied to Agricultural crop insurance and other normal risks not of the nature of disaster, if the outcome of the risk is correlated to a parameter or an index of parameters.

Reinsurance sidecars, conventionally referred to as "sidecars", are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies written by an insurer or reinsurer and earn the risk and return that arises from that business. A re/insurer will only pay ("cede") the premiums associated with a book of business to such an entity if the investors place sufficient funds in the vehicle to ensure that it can meet claims if they arise. Typically, the liability of investors is limited to these funds. These structures have become quite prominent in the aftermath of Hurricane Katrina as a vehicle for re/insurers to add risk-bearing capacity, and for investors to participate in the potential profits resulting from sharp price increases in re/insurance over the four quarters following Katrina. An earlier and smaller generation of sidecars were created after 9/11 for the same purpose.

Alternative risk transfer is the use of techniques other than traditional insurance and reinsurance to provide risk-bearing entities with coverage or protection. The field of alternative risk transfer grew out of a series of insurance capacity crises in the 1970s through 1990s that drove purchasers of traditional coverage to seek more robust ways to buy protection.

Industry loss warranties (ILWs), are a type of reinsurance contract used in the insurance industry through which one party will purchase protection based on the total loss arising from an event to the entire insurance industry above a certain trigger level rather than their own losses.

Stop-loss insurance is insurance that protects insurers against large claims. Stop-loss policies take effect after a certain threshold has been exceeded in claims.

CRESTA was founded as a joint project of Swiss Reinsurance Company, Gerling-Konzern Globale Reinsurance Company, and Munich Reinsurance Company. CRESTA has set itself the aim of establishing a globally uniform system for the accumulation risk control of natural hazards - particularly earthquakes, storms and floods. Those risk zones are essentially based on the observed and expected seismic activity, as well as on other natural disasters, such as droughts, floods and storms. CRESTA zones regard the distribution of insured values within a region or country for easier assessment of risks. CRESTA Zones are the essential basis for reinsurance negotiation and portfolio analysis. Nowadays, CRESTA sets widely accepted standards which apply throughout the international insurance industry. CRESTA zone information is used by most insurers for assessing the insurance catastrophe premiums they will charge.

The Solvency II Directive is a Directive in European Union law that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency.

Insurance in the United States refers to the market for risk in the United States, the world's largest insurance market by premium volume. Of the \$4.640 trillion of gross premiums written worldwide in 2013, \$1.274 trillion (27%) were written in the United States.

Satellite insurance is a specialized branch of aviation insurance in which, as of 2000, about 20 insurers worldwide participate directly. Others participate through reinsurance contracts with direct providers. It covers three risks: relaunching the satellite if the launch operation fails; replacing the satellite if it is destroyed, positioned in an improper orbit, or fails in orbit; and liability for damage to third parties caused by the satellite or the launch vehicle.

Insurance-linked securities (ILS) are broadly defined as financial instruments whose values are driven by insurance loss events. Those such instruments that are linked to property losses due to natural catastrophes represent a unique asset class, the return from which is uncorrelated with that of the general financial market.

Insurability can mean either whether a particular type of loss (risk) can be insured in theory, or whether a particular client is insurable for by a particular company because of particular circumstance and the quality assigned by an insurance provider pertaining to the risk that a given client would have.

The German Nuclear Reactor Insurance Association is an association of German insurers of the nuclear industry located in Cologne. The German Nuclear Reactor Insurance Association also is involved in the reinsurance industry.

AIR Worldwide is an American risk modeling and data analytics company headquartered in Boston, Massachusetts, with customers in insurance, reinsurance, financial services, and government markets. AIR specializes in catastrophe modeling software and services to manage the probability of loss from natural catastrophes, terrorism, pandemics, casualty catastrophes, and cyber incidents. It is led by current President Bill Churney and operates nine offices internationally.

## References

1. See: Mitchell-Wallace, K. Jones, M., Hillier, J. K., Foote, M. (2017) Natural catastrophe risk management and modelling: A practitioner’s guide. Wiley ISBN   978-1118906040.
2. See: Edwards, Scott. The Chaos of Forced Migration: A Means of Modeling Complexity for Humanitarian Ends