risk homework

26 ACTUARIAL REVIEW NOVEMBER/DECEMBER 2013 • WWW.CASACT.ORG

Whatever Happened

By STEVEN SULLIVAN

100-Year Event?

to the

B y September 16, 2013, more than 4,500 square

miles of Colorado were under water. Th at’s

an area roughly the size of Delaware by some

estimates; others compared it to Connecticut.

Th e territory on the eastern slope of the Rocky

Mountains had already been subjected to

six straight days and 17 inches of rain, more than fi ve

inches above the annual average for the area. More than

1,200 people were missing, 19,000 homes were damaged

or destroyed, 12,000 people evacuated. Fatalities were

still unknown, but expected to be numerous. Television

images showed raging torrents in streams and creeks

that rivaled the last few hundred yards of the Niagara

River before the Falls.

Colorado was experiencing not just a 100-year event; this

was a 1,000-year event, a fl ood that even the National Weather

Service characterized as not only historic, but biblical.

Th at turns out to be a pretty good characterization of a

100-year event. Th ey’re big, we know them when we see them,

and we remember them: Hurricane Katrina in 2005; Super

Storm Sandy in 2012; the tornado that devastated Moore,

Oklahoma in 2013; the entire wildfi re summer of 2012. And if

one of them takes your loved ones, your home, or your posses-

sions, it doesn’t really matter if it makes the record books.

Th ey're big, we know them when

we see them, and we remember

them.

WWW.CASACT.ORG • NOVEMBER/DECEMBER 2013 ACTUARIAL REVIEW 27

Misleading Term

Th e term “100-year event” (or whatever number you want to

attach to it) expresses a probability rather than a certainty.

Events this extreme are commonly measured by how likely

they are to happen. In the case of Boulder, Colorado, a fl ood of

this magnitude is expected to occur only once in a thousand

years. Lesser catastrophes may happen more frequently, say

once every 100 years. But these are only guesses. Projections.

Th ere’s nothing to say that another 1,000-year event won’t

happen next year. Or next week. Or not for another 2,000 years.

Th e term became popular in 1973 when the National

Flood Insurance Program (NFIP) needed a standard to mea-

sure fl ooding across the country. Some areas are more prone

to fl ooding than others, some fl ood more frequently than oth-

ers, and some areas of the country haven’t kept records long

enough to ensure statistical accuracy for prediction. Neverthe-

less, the NFIP was mandated to map all

the fl ood plains in the country. Bringing

all these factors together, along with a

number of diff erent ways for measuring

fl ood magnitude, it compromised on

the 100-year frequency as a standard.

“Th e term ‘100-year event’ is mis-

leading and is often misinterpreted by

both the general public and insurance

professionals,” says Mark Bove, senior

research meteorologist with Munich

Re America. “A ‘100-year event’ refers

to a natural catastrophe that has one

percent annual probability of occurring at a given location. For

example, if Miami, Florida, is impacted by a 100-year hurri-

cane event in 2013, this doesn’t mean the next 100-year hur-

ricane in Miami will occur in 2113; the probability for another

hurricane in Miami in 2014 of the same intensity remains one

percent. Hundred-year events in consecutive years are rare,

but certainly not impossible.”

“We need to make sure we’re communicating that we

don’t mean this is going to happen only once every 100 years,”

adds Mary Frances Miller, an actuary with Select Actuarial

Services in Nashville. “It’s possible to get two in a row. Highly

unlikely, but possible. And we need to communicate that

it’s based on a model. It’s not like we’re absolutely confi dent

that the probability is one in 100. It might really be one in 60.

Or one in 200. We can’t confi dently say it’s not one in 10. It’s

unlikely, and it’s out on the I-don’t-really-know- how-unlikely

end of the scale.”

In other words, there’s nothing

certain about predicting any extreme

event. Yet certainty is what many people

are looking for. Certainty makes them

feel confi dent, and that confi dence can

get them into trouble.

Probably Questionable Behavior

Dr. Howard Kunreuther and Erwann

Michel-Kerjan, both of the Wharton

School at the University of Pennsylva-

nia, wrote an op-ed piece in Th e New

“We need to make sure

we’re communicating

that we don’t mean this

is going to happen only

once every 100 years.”

—Mary Frances Miller

28 ACTUARIAL REVIEW NOVEMBER/DECEMBER 2013 • WWW.CASACT.ORG

York Times (“Paying for Future Catas-

trophes”) after Super Storm Sandy. “Our

research shows,” they said, “that half

of all policyholders cancel their fl ood

coverage after only three or four years.

Why? Because they paid premiums

without getting anything in return and

are likely to think ‘Bad investment!’ But

insurance is a safety net, not a bet.”

Miller tells the story of a man in Mi-

ami who was rebuilding in the wake of

Hurricane Andrew in 1992, at that time

the worst storm in Florida history. He

was installing a set of glass doors that

clearly weren’t up to code and would

never withstand another hurricane. When asked why he was

doing this (aside from saving money, of course), he replied

that since Hurricane Andrew was a one-in-25-year storm, and

the doors were designed to last for maybe 20 years, there really

wasn’t anything to worry about.

“We chuckle,” says Miller, “but that just indicates a pro-

found misunderstanding of probability.”

Th e other extreme is becoming too cautious. Th e classic

example of this is fl ying vs. driving. Plane crashes are extreme-

ly rare, but they’re usually spectacular when they happen.

Traffi c accidents happen every day—many times every day.

Yet people tend to be more afraid of dying in a plane crash

than a car accident, even though their chances of dying in a

car are much higher.

Yet somehow we (or at least the media and politicians)

seem to admire the people who refuse to retreat, who are de-

termined to rebuild in the same fl ood plain after they’ve been

wiped out. Th e ones who decide not to make the same mistake

twice are viewed as quitters. So what is the proper response to

a 100-year event?

Th ere’s no easy answer to that question. It may be one

thing if you’re a homeowner living in New Orleans or Miami

or Boulder. It’s another thing if you’re an insurance company

covering properties in those areas.

Where the People Are

Th ere’s a diff erence between a 100-year meteorological event

and a 100-year insurance loss event, says Mark Bove. “Th e

former deals with the frequency and severity of the hazard at a

given location, while the latter is largely infl uenced by the built

human environment impacted by an event. It is quite possible

to have a 100-year (or longer return period) event occur in an

unpopulated area, causing little to no insured loss, while a

weather event of moderate severity, well below a 100-year re-

turn period, could cause a 100-year insurance loss if it impacts

a densely populated area with high insurance penetrations.”

“It all boils down to people,” says Tom Jeff ery, senior prin-

cipal scientist at CoreLogic in Madison, Wisconsin. “People

who live in coastal areas face a known risk, some more than

others. If they continue to live there, there is going to be a

recurring cost of damage.”

It’s too early at this writing to say how bad the 2013 wild-

fi re season was. Th ough memory of the more than 6 million

acres that burned in 2012 may have faded, the more than 3

million scorched acres so far in 2013 seem bad enough.

Th ere have probably been even worse fi re seasons before

recorded history, when lightning strikes ignited hundreds of

square miles of unpopulated wilderness and burned until

the rain eventually extinguished the fi re. Even when Native

Americans began to settle that wilderness, their nomadic

lifestyle enabled them to pull up stakes and move whenever

fi re appeared on the horizon and threatened their settlements.

Th at was their fi re insurance.

It’s not so easy for modern settlers. Wilderness is prime

real estate for those who can aff ord it, and those who can

aff ord it build expensive houses, communities, and busi-

nesses in what was once pristine prairie or forest. None of it is

movable. And in addition to those random lightning strikes, all

those people can accidentally or deliberately start fi res with a

careless match or a spark from a piece of machinery. So even if

Wilderness is prime real estate for those who

can afford it, and those who can afford it build

expensive houses, communities, and businesses

in what was once pristine prairie or forest.…So

even if wildfi res aren’t becoming more frequent,

they’re certainly becoming more costly and

destructive from a human standpoint.

WWW.CASACT.ORG • NOVEMBER/DECEMBER 2013 ACTUARIAL REVIEW 29

wildfi res aren’t becoming more frequent, they’re certainly be-

coming more costly and destructive from a human standpoint.

Th is extends to other types of natural disasters, too.

Th e numbers are daunting: Estimates for the cost of

Hurricane Katrina range from $108 billion to $150 billion with

more than 1,800 dead; Super Storm Sandy cost $65 billion and

killed 285; Hurricane Andrew destroyed $26.5 billion in prop-

erty and caused 65 fatalities.

“Th e incidence of extreme events is far more frequent,”

say Kunreuther and Michel-Kerjan in their New York Times

article. “Twenty of the 30 most expensive insured catastrophes

worldwide from 1970 to 2011 have occurred since 2001—and

13 of them were in the United States. Aside from the 9/11 ter-

rorist attacks, all were natural disasters. Th e increase is most

likely because of the location in high-risk areas of more people

and more valuable properties, along with a changing climate.”

An Understood Currency

Correctly assessing that risk is the work of catastrophe model-

ers. Using high-speed computers, modelers have learned

how to create complex programs that combine data of past

occurrences and emerging science to come up with a reason-

able probability for how many extreme events might occur in

a given time frame, how severe they might be, and the cost of

the damage they might infl ict.

According to Kay Cleary, an actuary and director at

the modeling company Risk Management Solutions (RMS),

catastrophe models have come a long way since they were fi rst

used in the 1980s to provide point estimates—like the 100-year

probable maximum loss (PML). But no matter how sophisti-

cated they are, they still can’t provide a straightforward right

or wrong answer.

“Th e 100-year PML just gives you a probability and a

number,” says Cleary. “It would be nice if you could just draw

a couple of lines and say ‘Th at’s my range of uncertainty.’ But

it doesn’t work quite that way because of the complexity of

what goes into it. With the advances in computer speed and

science, you can now drill down and determine the amount of

trouble you’ll be in, assuming you are in trouble. You can do

more sensitivity testing by varying some of the assumptions

and seeing how it shifts things around. You can learn a lot

more, a lot easier, and a lot faster by having more numbers to

look at than just a point estimate of PML.”

What models do provide, Cleary says, is an agreed-upon,

understood currency that enables insurers to quantify the risks

and trade them in the marketplace. “We hope the number is

close to reality, but even so, it’s an agreed-upon amount that

allows things to happen. Th e fact that it’s exactly right or ex-

actly wrong is obviously important, but what it mainly does is

enable us to do business. It’s kind of like a stock price. What is

a stock price, really, but an agreed-upon transaction number?

It’s not a real number.”

According to David Lalonde, a senior vice president with

the modeling fi rm AIR Worldwide, “the one percent exceed-

ance probability loss (or the 100-year return period loss) is

estimated to be just over $200 billion—a fi gure that could be

driven by an active and severe U.S. hurricane season or by a

combination of diff erent perils in diff erent regions, as was the

case in 2011. AIR estimates the average annual loss (AAL) from

natural catastrophes is $59 billion, in line with global catastro-

phes losses from 2012, which are estimated to be around $58

billion.”

So why are we seeing more of these events that are getting

so destructive and so costly? It’s tempting, of course, to blame

global warming. But scientists and modelers are cautious.

Mark Bove at Munich Re says we still don’t know enough

to be certain, but a warmer, moister atmosphere could be

30 ACTUARIAL REVIEW NOVEMBER/DECEMBER 2013 • WWW.CASACT.ORG

conducive to more tornado and hail events across the eastern

two-thirds of the United States. Climate change may or may

not produce more frequent extreme events but “those that

form could become more intense, reducing the return period

of severe hurricanes.”

“Climate change makes the model more complicated,”

says Mary Frances Miller. “I don’t know if it makes hurricanes

more or less frequent, there’s argument about that. But it cer-

tainly makes the modeling more diffi cult.”

Global warming, or climate change, is a long-term phe-

nomenon, adds Kay Cleary, and models are better suited to

much shorter-term projections—two to fi ve years—so models

typically don’t refl ect it. “We don’t know enough to do that re-

sponsibly. However, to the degree that there have been trends

recently and the impact of global warming is felt, we do look at

that information in light of the medium-term rate.”

Th ere’s a controversy in hurricane modeling between the

long-term rate and the medium-term rate, Cleary explains.

“Th e long-term

is based on the

112 years of data

that we have. Th e

medium-term

acknowledges that

there are cycles.

Right now we’re in

a somewhat higher

than long-term

average cycle. If

you look at the 112

year average, what

we expect in the

next fi ve years is a little bit higher than that. We don’t make an

explicit adjustment for it, but we think there is some implicit

acknowledgement of those impacts.”

“Attributing every weather anomaly to manmade climate

change—other than the higher temperatures the global

warming phenomenon is named for—is a high-stakes gamble,

rooted more in politics than in science,” says Nate Silver in his

2012 book, Th e Signal and the Noise: Why So Many Predic-

tions Fail—But Some Don’t. “Th ere is little consensus about

the ways that climate change might manifest itself other than

through temperature increases and probably rising sea levels.

Th e greenhouse eff ect almost certainly exists and will be

exacerbated by manmade CO 2 emissions. Th is is very likely to

make the planet warmer. Th e impacts of this are uncertain, but

are weighted toward unfavorable outcomes.”

Improved models now account for a previously unrecog-

nized peril: storm surge. Storm surge is a hybrid, neither wind

nor fl ood. Even relatively weak wind events can push huge

volumes of water to surge over the land, causing billions of

dollars of damage.

“It has to do with bathymetry, the study of the underwater

landscape,” Cleary says. “Water pushing against the ocean

fl oor starts to build up and inundates the land, creating a surge

fl ood. Initially, it made a lot of sense to have surge factor off

the wind, but we found that surge has its own characteristics

not necessarily related to the wind. We upgraded our model to

account for not only the severity of what can happen, but also

the types of things to worry about.”

Paying for the Risk

So who pays for all this? Th at, of course, is what insurance

companies are for, but many private-sector insurers have

“Water pushing against the ocean fl oor starts

to build up and inundates the land, creating a

surge fl ood. Initially, it made a lot of sense to

have surge factor off the wind, but we found that

surge has its own characteristics not necessarily

related to the wind.” —Kay Cleary

WWW.CASACT.ORG • NOVEMBER/DECEMBER 2013 ACTUARIAL REVIEW 31

increased premiums in high-risk areas to make it virtually

impossible for some people who want insurance to aff ord it.

Some carriers have exited certain markets altogether. And

most carriers depend on reinsurers—like Munich Re and

Swiss Re—to share much, if not most, of the risk.

But there are other mechanisms as well. States prone

to natural disasters, particularly along the coasts, fund wind

pools that off er high-risk coverage at lower rates. Wind pools

grew out of the FAIR (Fair Access to Insurance Requirements)

plans that were formed in 1960s when many insurers pulled

out of areas hit hard by rioting and civil unrest. One of the

largest wind pools, Florida’s Citizen’s Property Insurance

Corp., covers nearly $500 billion in assets. Most wind pools,

however, aren’t nearly so well-endowed and must resort to the

reinsurance market as well.

In 1968, the federal government instituted the NFIP to

subsidize premiums for people living in fl ood plains. But

claims from the disastrous 2005 and 2008 hurricane seasons

forced the NFIP to borrow $18 billion from the U.S. Treasury,

which it hadn’t yet repaid when Super Storm Sandy hit in

2012.

In July 2012, Congress passed the aptly named Biggert-

Waters Flood Insurance Reform Act, which attempts to make

the NFIP more fi nancially stable and ensure that fl ood insur-

ance rates more accurately refl ect the real risk of fl ooding.

Th e act institutes changes in fl ood hazard mapping and fl ood

plain management, but primarily it gradually eliminates the

subsidies that enabled many insureds to pay lower premiums

than are refl ected by their risk.

“Th e Biggert-Waters Act is moving exactly in the right

direction,” says Howard Kunreuther. “It’s the fi rst piece of

Congressional legislation that I’m aware of that has risk-based

rates, not on all homes but on second homes and on repeti-

tive-fl ooding homes. With risk-based rates you can give a rate

reduction when people mitigate.”

Mitigating Circumstances

Risk mitigation is something that Kunreuther has been

championing for years, though he admits it can be a tough

sell because it can be expensive for homeowners. Th e trick, he

says, is to give people a fi nancial incentive to relocate or retro-

fi t their homes to better withstand wind and water damage. He

advocates long-term loans and low-cost, long-term insur-

ance—perhaps as long as 20 years—that would be tied to the

property rather than the property owner. Th e cost of the loan,

he says, will be less than the benefi ts from the lower insurance

premium.

Even though risk-based rates make economic sense for

those who can aff ord them, they’ll still end up pricing many

low-income homeowners out of the market. “Our response to

that is to help them out by using vouchers,” says Kunreuther,

similar to the Supplemental Nutrition Assistance Program.

Th ey would receive the means-tested voucher, as well as a

loan, only if they agree to mitigate and make their homes

safer. “Mitigation will bring their premium down so much that

the actual magnitude of the voucher, even if they pay for the

loan themselves, would be less than just paying the diff erence

between what they can aff ord and the much higher insurance

premium.”

Politically, says Tom Jeff ery, mitigation can be a can of

worms because it ultimately impinges on individuals’ rights to

live and own property wherever they want to. And it’s not just

about the cost of individual insurance coverage. Th e levees

that were rebuilt to protect New Orleans from another Katrina-

level storm cost in excess of $14 billion. Estimates for building

a sea wall that would protect New York from another Sandy

run as high as $23 billion.

“It’s an awfully big undertaking,” he says. “In an area like

New York, it certainly would off er tremendous protection and

reduce or eliminate the tens of millions of dollars of damage

that could come in the future. And that’s the question every-

body wants answered: What can we expect in the future? No-

body knows. We can project based on what’s happened in the

past, but nobody knows if it’ll happen next year, in 10 years, or

in the next 100 years. All we know for sure is that there will be

another one sometime in the future.”

Steven Sullivan is a writer living in Baltimore, Md. ●

Politically, says Tom Jeffery,

mitigation can be a can of worms

because it ultimately impinges on

individuals’ rights to live and own

property wherever they want to.