Consultant Wants to Double Check Modelers’ Earthquake Math

Karen Clark & Company wants to explain to insurers why a recent dramatic drop in their loss estimates for California earthquake should not automatically translate into a pricing change.

Clark, president of the Boston-based consulting firm, argues that insurers’ directors and senior management need to translate recent modifications by catastrophe modeling firms into a broader review of their book of business.

“There is not much understanding of why the loss estimates changed so dramatically and what is behind those changes,” says Clark. “Before companies radically alter their business decisions they should have a better understanding of the uncertainty behind the science.”

Prompting the changes was an August update by the United State Geological Survey (USGS) to the National Seismic Hazard Maps. The maps – which had not been updated since 2002 – are used by private catastrophe modeling firms like AIR, Eqecat and RMS as input into their own models when calculating potential losses.

Although changes vary by catastrophe modeling firm, insurance company and geographical region, Clark says some companies will see a 25 to 35 percent decline in California residential earthquake loss estimates. Even wider declines could be seen by insurers that only write in specific California regions.

For example, Clark says, an insurer that had a one-in-250-year earthquake loss estimate of $575 million last year could see the estimate drop to $400 million this year because of the model changes.

“The board and management cannot base their business decisions on point estimates from a model,” she says. “That is a very bad business practice for an insurer.”

According to Clark, the changes in loss estimates are in large part due to additional research on “attenuation equations” provided in the 2008 hazard map. Attenuation equations tell how a seismic wave disperses in a particular area and loses energy.

While a catastrophe modeling firm may add the new equations into their models and come up with lower loss estimates, Clark argues the additional data “does not reduce the level of uncertainty of the models.”  

“You can have three different modelers taking the new research and coming up with three different answers,” she says. “The guidance in the USGS report explicitly shows the uncertainty around the assumptions.”

Directors and senior management need additional transparency around the catastrophe model changes to make informed decisions, Clark says. 

“We believe you should look at specific scenarios to get more insight.”

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