Actuarial Standard of Practice No. 39

Treatment of Catastrophe Losses in Property/Casualty Insurance Ratemaking

STANDARD OF PRACTICE

TRANSMITTAL MEMORANDUM

June 2000

TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Interested in the Treatment of Catastrophe Losses in Property/Casualty Insurance Ratemaking

FROM: Actuarial Standards Board (ASB)

SUBJ: Actuarial Standard of Practice (ASOP) No. 39

This booklet contains the final version of Actuarial Standard of Practice No. 39, Treat­ment of Catastrophe Losses in Property/Casualty Insurance Ratemaking.

Background

Many property/casualty insurance products are, by their nature, subject to large aggregate losses resulting from relatively infrequent events or natural phenomena, i.e., from catastrophes. These losses can cause extreme volatility in historical insur­ance data and generally require separate and different treatment from other losses in ratemaking methodologies. Historically, the most common method was to cal­culate the ratio of actual catastrophe losses to noncatastrophe losses over a longer experience period, and apply that ratio to expected noncatastrophe losses in the ratemaking formula.

In 1992 and 1994, two events occurred that changed the actuarial profession’s view of catastrophe losses. The Hurricane Andrew and Northridge Earthquake catastrophes clearly demonstrated the limitations of relying exclusively on historical insurance data in estimating the financial impact of potential future events. In addition, property/casualty insurers (including self-insurers) and their actuaries began to focus on the impact that large individual events or sequences of events could have of the insurers’ solvency, cash flow, and earnings.

This actuarial standard of practice is intended to provide guidance to actuaries in evaluating catastrophe exposure and in determining a provision for catastrophe losses and loss adjustment expenses in property/casualty insurance ratemaking.

Exposure Draft

This standard was exposed for review in February 1999, with a comment deadline of June 15, 1999. Fourteen comment letters were received. The Subcommittee on Ratemaking reviewed all the comments carefully, and many of the suggestions were incorporated in the final standard. In particular, the subcommittee did the following: (1) revised the title and the scope of the standard to more explicitly recognize that the standard applied to ratemaking; (2) revised the text to indicate that the actuary was estimating a catastrophe provision not estimating actual catastrophe losses; and (3) more explicitly recognized that, in the end, the procedure that the actuary uses must reflect the expected frequency and severity distribution of catastrophes, as well as the anticipated class, coverage, geographic and other relevant exposure distributions. For a summary of the substantive issues contained in these fourteen comment letters and the task force’s responses, please see Appendix 2.

The subcommitee and Casualty Committee thank all those who commented on the exposure draft.

The subcommittee also thanks former member Robert W. Gossrow for his contributions during the development of this proposed ASOP.

The ASB voted in June 2000 to adopt this standard.

Subcommittee on Ratemaking of the Casualty Committee

Patrick B. Woods, Chairperson

                      Mark S. Allaben                                                     R. Michael Lamb

                      Charles H. Boucek                                                 Marc B. Pearl

                      Frederick F. Cripe                                                  Jonathan White

                      Gregory L. Hayward                                               Paul E. Wulterkens

Casualty Committee of the ASB

Michael A. LaMonica, Chairperson

                      Christopher S. Carlson                                            Robert S. Miccolas

                      Anne Kelly                                                             Karren F. Terry

                      Ronald T. Kozlowski                                               William J. VonSeggern

                      Ken W. Hartwell                                                     Patrick B. Woods

Actuarial Standards Board

David G. Hartman, Chairperson

                     Phillip N. Ben-Zvi                                                     Roland E. King

                     Heidi R. Dexter                                                       William C. Koenig

                     David G. Hartman                                                    James R. Swenson

                     Ken W. Hartwell                                                      Robert E. Wilcox

Section 1. Purpose, Scope, Cross References, and Effective Date

1.1 Purpose

The Statement of Principles Regarding Property and Casualty Insur­ance Ratemaking of the Casualty Actuarial Society states that consideration should be given to the impact of catastrophes and that procedures should be developed to include an allowance for catastrophe exposure in the rate. The purpose of this actuarial standard of practice (ASOP) is to provide guidance to actuaries in evaluating catastrophe exposure and in determining a provision for catastrophe losses and loss adjustment expenses in property/casualty insurance ratemaking.

1.2 Scope

This standard provides guidance to actuaries when performing profes­sional services in connection with ratemaking for property/casualty insurance coverages including property/casualty risk financing systems, such as self-insurance or securitization products, which provide similar coverage.

If the actuary departs from the guidance set forth in this standard in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to Section 4.

1.3 Cross References

When this standard refers to the provisions of other documents, the reference includes the referenced document as it may be amended or restated in the future, and any successor to it, by whatever name called. If the amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this standard to the extent it is applicable and appropriate.

1.4 Effective Date

This standard will be effective for work performed on or after December 15, 2000.

Section 2. Definitions

The definitions below are defined for use in this actuarial standard of practice.

2.1 Catastrophe

A relatively infrequent event or phenomenon that produces unusually large aggregate losses.

2.2 Catastrophe Ratemaking Procedures

Ratemaking procedures that adjust for the impact of catastrophe losses in the experience date and determine a provision for catastrophe losses and loss adjustment expenses.

2.3 Contagion

A lack of independence between the occurrence of losses among different entities.

2.4 Demand Surge

A sudden and usually temporary increase in the cost of materials, services, and labor due to the increased demand for them following a catastrophe.

Section 3. Analysis of Issues and Recommended Practices

In evaluating catastrophe exposure and in determining a provision for catastrophe losses and loss adjustment expenses in property/casualty insurance ratemaking, the actuary should be guided by the following sections.

3.1 Identification of Catastrophe Perils or Events

The actuary should take reasonable steps to identify the perils or events that have the potential to generate catastrophe losses that differ materially from the expected aggregate losses or the expected distribution of losses. These perils or events have at least one of the following characteristics:

a. The Potential to Display Contagion: Examples of perils that display contagion include windstorms, earth movement, and freezing.

b. Infrequent Occurrence: Some events that occur infrequently have the potential to produce losses that can significantly distort the historical experience. An example of such an event is an explosion that results in the release of toxic material. If the experience data contain such events, using this experience data without adjustment may overstate the catastrophe provision in the rates. If the experience data do not contain such events, using this experience data without adjustment may understate the catastrophe provision in the rates.

3.2 Identification of Catastrophe Losses

The actuary should identify, where practicable, the catastrophe losses in the historical insurance data. In doing so, the actuary should consider how accurately the catastrophe losses can be identified, and the extent to which they may have a material impact on the results of the analysis.

3.3 The Use of Data in Determining a Provision for Catastrophe Losses

The actuary may use historical insurance data and noninsurance data, as described in sections 3.3.1 and 3.3.2 below.

3.3.1 Use of Historical Insurance Data

The actuary should consider the following when using data available from insurance sources:

a. Evaluating Historical Insurance Data: The actuary should consider comparing historical insurance data to noninsurance data to determine the extent to which the available historical insurance data are fully representative of the long-term frequency and severity of the perils or events identified in section 3.1 that produced the catastrophe losses. Thus, in determining a provision for catastrophe losses, the actuary should consider the sensitivity of the provision to changes in the historical insurance data relating to the following: (1) the frequency of catastrophes; (2) the severity of catastrophes; and (3) the geographic location of catastrophes.

b. The Applicability of Historical Insurance Data: The actuary should consider the applicability of historical insurance data for the insured coverage. This includes determining (1) whether catastrophe losses are likely to differ significantly among elements of the rate structure, such as construction type and location; (2) whether such differences should be reflected in the ratemaking procedures; and (3) how to reflect such differences, taking into account both homogeneity and the volume of data. In addition, the actuary should consider whether there is a sufficient number of years of comparable, compatible historical insurance data.

c. Adjustments to Historical Insurance Data to Reflect Future Condi­tions: The actuary should consider making adjustments to the historical insurance data to reflect conditions likely to prevail during the period in which the rate will be in effect. Such adjustments should take into account the impact of changes in the exposure to loss, including coverage differences, the underlying portfolio of insured risks, building codes and the enforcement of these codes, and building practices; population shifts; costs; and demand surge during both the historical period and the period for which the rate will be in effect. These considerations become more important when a longer experience period is used because they can have a greater effect over longer time periods.

d. Stability of Outcomes Based on Historical Insurance Data: The actuary should con­sider the extent to which the provision for catastrophe losses would change if the catastrophe ratemaking procedure were to be carried out using different historical experience periods. If, in the actuary’s judgment, the procedure is too sensitive to the inclusion or exclusion of an individual catastrophe or sets of years, the actuary should consider modifying the procedure to reduce the sensitivity.

e. Differing Trends in Loss Data: Historical insurance data used to determine a provision for catastrophe losses will often extend over much longer time periods than data used in most other ratemaking procedures; thus, the effect of small differences in annual trend rates will be magnified. The actuary should consider the potential for catastrophe losses to trend at a rate materially different than the noncatastrophe losses and reflect such differences in the ratemaking process as appropriate.

f. Consistent Definition of a Catastrophe: In utilizing a catastrophe ratemaking procedure, the actuary often uses two sets of historical insurance data. The first set may be comprised of data from the ratemaking experience period from which the catastrophe losses have been removed. The second set may contain longer term experience for catastrophe losses. Collecting a greater volume of data for this second data set may be accomplished in various ways, such as by using a greater number of relevant years or by using relevant data for a broader segment of business.

The actuary should consider the catastrophe definition pertaining to, and the catastrophe potential in, both of these data sets to ensure that the definitions are not materially inconsistent. Specific areas to consider are consistency of the thresholds used to determine catastrophe losses and consistency in identifying specific catastrophes.

3.3.2 Use of Noninsurance Data and Models

If, after considering the items contained in section 3.3.1(a–f), the actuary believes that the available historical insurance data do not sufficiently represent the exposure to catastrophe losses, the actuary should consider doing one of the following:

a. use noninsurance data to adjust the historical insurance data;

b. use noninsurance data (including models based thereon) as input to ratemaking procedures; or

c. use models based on a combination of historical insurance data and noninsurance data.

The actuary should be satisfied that the resulting ratemaking procedures appropriately reflect the expected frequency and severity distribution of catastrophes, as well as anticipated class, coverage, geographic, and other relevant exposure distributions.

3.4 Using a Provision for Catastrophe Losses

In ratemaking, actuaries generally use historical data or modeled losses to form the basis for determining future cost estimates. The presence or absence of catastrophes in any historical data used to form future cost estimates can create biases that diminish the appropriateness of using that data as the basis for future cost estimates. The actuary should address such biases by adjusting the historical data used to form future cost estimates and determining a provision for catastrophe losses (after consideration of the issues and practices found in sections 3.1–3.3).

The actuary may employ other considerations and methods to adjust for catastrophes associated with casualty coverages. For example, such adjustments may include limiting losses in the underlying data and using increased limits factors or excess loss factors based on industry data or other sources, or adjusting for legislative changes, legal decisions, changes in the distribution of policy limits, and coverage provisions. In addition, other adjustments, such as supplementing state-specific data with countrywide data or company-specific data with industry information, may be appropriate.

3.5 Loss Adjustment Expenses

The actuary should be aware that the relationship of loss adjustment expense to incurred loss can be significantly different for catastrophe losses and for noncatastrophe losses. In some cases, the historical relationships of overall loss adjustment expense to overall incurred losses may produce inappropriate loss adjustment expense estimates for catastrophe losses. Similarly, the historical relationship of overall loss adjustment expense to overall incurred losses may produce inappropriate loss adjustment expense estimates for noncatastrophe losses if the historical period was impacted by catastrophe losses. The actuary should modify the loss adjustment expense procedure where necessary to develop a reasonable estimate of prospective loss adjustment expense for both catastrophe and noncatastrophe losses.

Section 4. Communications and Disclosures

4.1 Conflict with Law or Regulation

If a law or regulation conflicts with the provisions of this standard, the actuary should develop a rate in accordance with the law or regulation and disclose any material difference between the rate so developed and the actuarially determined rate to the client or employer.

4.2 Documentation and Disclosure

The actuary should be guided by the provisions of ASOP No. 9, Docu­mentation and Disclosure in Property and Casualty Insurance Ratemaking, Loss Reserving, and Valuations. If the actuarial work product includes mathematical modeling developed by some­one other than the actuary, the documentation should include the source of the model and how the model was used in the analysis. In addition, if the model is outside the actuary’s area of expertise, the actuary should be guided by the documentation and disclosure requirements of ASOP No. 38, Using Models Outside the Actuary’s Area of Expertise.

4.3 Disclosures

The actuary should include the following, as applicable, in an actuarial communication:

a. in addition to the disclosure covered in section 4.1, the disclosure in ASOP No. 41, Actuarial Communications, section 4.2, if any material assumption or method was prescribed by applicable law (statutes, regulations, and other legally binding authority);

b. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and

c. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.

Appendix 1 – Background and Current Practices

Note:  This appendix is provided for informational purposes, but is not part of the standard of practice.

Background

Historical Procedures

Prior to Hurricanes Hugo and Andrew, the predominant ratemaking procedures used to determine a catastrophe provision involved cal­culating the long-term ratio of such losses to noncatastrophe losses over a twenty- to thirty-year span. Catastrophes were identified either by some industry-dollar or loss-ratio threshold and typically represented weather-related perils such as hurricanes, tornadoes, or snow storms. Other physical catastrophes such as floods and earthquakes were usually covered by separate policies designed to specifically include such perils. A provision for casualty-related catastrophes was typically not included separately in the rates but was implicitly included with the contingency provision.

Issues

In the late 1980s and early 1990s, catastrophes produced record levels of damage, and it became evident that adjustments to historical ratemaking proce­dures were necessary. Hurricanes Hugo, Andrew, and Iniki produced aggregate losses exceeding previously expected possibilities. These huge losses brought to light other issues such as population shifts, non-adherence to building codes, and exposure con­centration, none of which had been addressed previously. In addition, the occur­rence of earthquakes in both San Francisco and Northridge, and a major flood in the Midwest during this period heightened the need for develop­ment of improved ratemaking procedures for these perils. Finally, catastrophes that had not been contemplated previously, such as the World Trade Center bombing and the Oak­land Hills fires, raised other questions concerning how to provide for such losses in the rate.

In addressing these issues, catastrophe models, which previously were used by com­panies to determine their probable maximum loss under various scenarios, were adjusted for use in ratemaking. However, since these models were often multidisciplinary in nature or proprietary, it was often difficult to (1) ascertain the underlying assumptions of the model, and (2) obtain regulatory approval of rates based on these models.

Other issues have also emerged, making assessment of catastrophe exposure even more difficult. Examples of such issues include coverage changes, such as the greater use of guaranteed replacement cost on homeowner policies or the use of separate wind deductibles; the emergence of state-run catastrophe funds; and the availability of catastrophe options.

Current Practices

Subsequent to Hurricanes Hugo and Andrew, numerous enhancements and alter­natives have been developed that improve on the traditional, long-term catastrophe ratemaking procedure.

One procedure uses the traditional excess wind approach but supplements or replaces the historical insurance data with hypothetical losses from an infrequent event (for example, a fifty-year event) as calculated by a catastrophe simulation model. Historical events of greater severity than the modeled fifty-year event are elim­inated. Separate excess factors are calculated from the historical insurance data and for a hypothetical year constructed to include the modeled fifty-year event. The excess factor is calculated as a weighted average of those two separate factors.

A second procedure involves loading catastrophe reinsurance costs into the rate cal­culation. With this procedure, the rates are initially calculated using losses net of the catastrophe reinsurance. The company’s overall catastrophe reinsurance costs are allocated to state and line, and those allocated costs are added to the calculated rate net of reinsurance.

A third procedure separates catastrophes into hurricane and nonhurricane components and treats each separately. This enables the actuary to focus on the particular difficulties, low frequency and high severity, in estimating hurricane losses. One specific procedure that is used for nonhurricane catastrophes is to relate catastrophe losses to amount of insurance years. A long-term ratio of catas­trophe losses to amount of insurance years is calculated and used to load the ratemaking experience period for expected catastrophe losses. This procedure has also been used for hurricanes, using noninsurance data such as long-term hurricane frequencies to adjust the historical insurance data.

A fourth procedure that has been used for nonhurricane catastrophes is based on frequency. With this procedure, daily frequencies are calculated over a long period and each day is ranked using that frequency. A set percentage of days with the highest frequencies is considered excess. The losses incurred on those excess days are compared to the losses incurred on all other days in order to calculate an excess factor.

In considering earthquakes and hurricanes, the predominant approach currently used to calculate expected catastrophe losses is computer simulation models. These models make extensive use of noninsurance data to estimate the overall frequency of these events, as well as the frequency of the key defining characteristics of these events. Based on these estimated frequencies, a large number of catastrophes are simu­lated across a broad geographic area. For each simulated catastrophe, the model translates the event or phenomenon into a specific “hazard” parameter, such as wind speed or ground shaking, at all locations impacted by the event. Based on engineering analysis and prior catastrophe losses, the hazard parameter is trans­lated into a damage ratio, i.e., ratio of losses to amount of insurance. These damage ratios are applied to the current or projected amounts of insurance and, when adjusted by the estimated frequencies of the specific catastrophes, produce the expected catastrophe losses.

Since our knowledge of catastrophes is not complete and is still evolving, com­puter simulation models are also evolving. The expected catastrophe losses calcu­lated from these models can be subject to significant variation, since different models (i.e., both models from different developers and different versions of models from the same developer) will obviously provide different answers.

All of these procedures may or may not be supplemented with a risk load calculated in accordance with ASOP No. 30, Treatment of Profit and Contingency Provisions and the Cost of Capital in Property/Casualty Insurance Ratemaking.

Appendix 2 – Comments on the 1999 Exposure Draft and Subcommittee Responses

The exposure draft of this actuarial standard of practice (ASOP)—formerly titled Treatment of Catastrophe Losses in Property/Casualty Insurance­—was issued in February 1999, with a comment deadline of June 15, 1999. Fourteen comment letters were received. The Subcommittee on Ratemaking carefully considered all comments received.

Click here to view Appendix 2 in its entirety.

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