Catastrophe models in the property/casualty insurance sector have been under intense and increasing scrutiny for more than a decade. The 9/11 terrorist attacks, coupled with significant losses from events such as earthquakes, tropical windstorms of various intensities (from both a frequency and severity perspective), tornadoes and hailstorms, European windstorms, and large scale flooding have led many to question the credibility and or usefulness of these models.

This is unfortunate. The larger-than-expected losses the industry has suffered in the last several years should not cast doubt on the reliability or credibility of the models, but instead should lead insurers to re-examine how they use these extremely sophisticated exposure rating tools, as well as the quality of the enterprise risk management frameworks in place throughout the industry.

Any significant event—be it a major hurricane, a devastating earthquake, or a sudden surge in legal actions against particular classes of insureds—will quickly deplete premiums and earnings and lead to capital impairment. Unlike most other insurance risks, increasing the volume of catastrophic risk in the insurance portfolio will increase the probability of capital impairment. Because one will never be able to perfectly quantify the risk, it is imperative to focus on exposure accumulations and the subsequent hedging of them.