Reinsurance companies have to pay out large sums of money in claims if and when a catastrophe occurs. Each time a hurricane, a flood, or any other catastrophe hits, insurance companies lose money. The monetary losses can be quite significant since catastrophe by definition refers to a natural disaster.

Hence, it is in their best interest to try to predict when catastrophes can possibly occur and what can be the financial impact of such events. Over the years, reinsurance companies have realized that statistical modeling techniques can help them predict the timing and magnitude of a catastrophe with a high degree of accuracy. This prediction is done using a process called catastrophe modeling. In this article, we will have a closer look at what catastrophe modeling is and how it impacts the reinsurance industry.

What is Catastrophe Modelling?

Catastrophe modeling is a computer technique that helps reinsurance companies simulate potential catastrophic events based on historical data. The technique also allows reinsurance companies to ascertain the monetary value of the loss that they are likely to face if a catastrophe were to occur. Advances in information technology allow computers to use a complex model which takes into account past data as well as current factors to come up with a fairly accurate prediction.

Reinsurance companies started using crude forms of computerized catastrophe modeling a couple of decades ago. However, in the past few years, technology and data modeling techniques have grown at a breakneck speed. This means that there have been significant advances in catastrophe modeling techniques.

The earlier catastrophe models were only based on risks arising from natural events. However, over the years, the scope has been expanded to include events such as war, terrorism, cyber-attacks, etc.

Catastrophe models have very wide applicability. The model can be used to predict different types of losses such as losses in terms of human lives or in terms of destroyed property. Catastrophe models can help predict not only the timing of a disaster but also its magnitude.

Components of a Catastrophe Model

A catastrophe model is a complex computer model which is based on a very large number of calculations. These calculations are heavily influenced by input parameters entered by the insurance company. Hence, there is always a chance that biased assumptions can significantly alter the results of the module. Internally, this complex model is based on several small sub-modules. The details of these sub-modules are as follows:

1. The first step in catastrophe modeling is called event modeling. This is a very important component of the overall predictions made by the model. The purpose of this module is to use historically available data about natural calamities such as floods, earthquakes, hurricanes, etc. This data is then combined with advanced statistical techniques to come up with the probability of any of these events occurring at a given time and at a given geographical location.

2. Once the type and timing of natural calamity have been predicted, the next step is to predict the intensity with which such a catastrophe may occur. This is because a low-intensity natural calamity can have almost no impact whereas a high-intensity one can cause almost total destruction. Since the data related to the intensity of past natural calamities is available, the distribution of their intensity can be found out and this enables making an accurate guess about the possible intensity of a catastrophe.

3. The next step in the process is to estimate the loss of life as well as property that is likely to result from a catastrophe. Since data related to losses suffered in past calamities is present, making an educated guess is not a difficult task.

4. Lastly, reinsurance companies need to translate the loss into a monetary value. This can seem to be a straightforward exercise but can be quite complicated. This is because there are various clauses in reinsurance contracts that govern the amount of money that needs to be paid out. This could include deductibles, proportional co-pay, maximum limits, etc. As a result, complex computer programs are required to estimate the total amount of monetary loss that reinsurance companies are expected to cover.

Types of Losses Modelled by Catastrophe Models

Over the period of years, reinsurance companies have realized that a lot of ancillary expenses have to be paid out along with the main claim as well. As a result over the years, they have started classifying their losses into categories such as direct loss, indirect loss, and residual loss.

1. Direct loss is the amount of loss that can be directly attributed to a natural calamity. This means that the loss of life and property that reinsurance companies have to compensate for can be considered to be a direct loss.

2. Indirect loss and not directly related to the natural calamity. However, they arise because of it. Additional living expenses and business interruption expenses are examples of

3. Residual losses are also related to natural calamities. For instance, when a natural calamity destroys all the housing and building in a particular geographical location, then the cost of building materials tends to increase. This is because a large number of people want to build their houses simultaneously. As a result, labor as well as the material can end up becoming expensive. This could also lead to delays in finding labor which ultimately might lead to escalating costs.

The fact of the matter is that catastrophe modeling is a very important concept in reinsurance. Reinsurance companies that have better catastrophe models as compared to their competitors have a competitive advantage.