Uncertainty remains big factor in modeling risk

You are here:
Home
News

Uncertainty remains big factor in modeling risk

The 'black box' should be a tool to help inform decisions, says Guy Carpenter.

December 12, 2011

Insurance companies that understand the vagaries of model uncertainty and take a disciplined, holistic approach to managing the catastrophe modeling process are well positioned to adapt and outperform the competition, according to a new report by Guy Carpenter.

“Despite considerable refinement of catastrophe models since their introduction in the late 1980s, uncertainly remains – and it is a significantly bigger factor than many users may realize,” said John Major, director of actuarial research, GC Analytics, Guy Carpenter & Company. “While advances over the years have reduced the band of uncertainty around a typical probable maximum loss estimate, the consideration of smaller areas of geography only introduces more uncertainty.”

The report addresses the merits of adopting a multi-model approach to estimate risk and control uncertainty. Three strategies for using multiple models include: model blending, model morphing and model fusion.

Also, the “black box” should no longer be left to make the decisions, according to the report. Rather, it should be considered a tool to help inform decisions made by (human) professionals. This is an intuitive and straightforward prescription, but making it happen will require the consideration and engagement of virtually every group in the industry.

Guy Carpenter suggested the following steps should be taken:

Modeling firms need to step up and lead the discussion about uncertainty despite the apparent competitive disadvantage of transparency.

Primary writers need to be smarter consumers of models and model output, curtailing the blind application of “portfolio optimization” in favor of a broader ERM-based multi-model approach. They also need to rethink their attitudes about nontraditional risk transfer products.

Reinsurers, already sophisticated model users, should not take advantage of information asymmetry, but rather explore which new products might make sense.

Rating agencies and solvency regulators need to equally investigate the models to determine when a model is being appropriately utilized. They need to understand that “the map is not the territory” – model output is relative information, not absolute gospel, and firms need time to absorb and act upon this information when model changes occur.

Boards of directors, investors and stock analysts need to understand cat risk in the same terms – being estimated with significant uncertainty – as other financial risks. Insureds and the public need to understand that no one really knows the right answer.