Quantifying the Risk of Natural Catastrophes

Overview (via Understanding Uncertainty)

How do companies prepare for the financial impact of natural catastrophes? How can they possibly have an idea of what the potential cost can be for events that haven’t yet happened? Shane Latchman explains the way companies in the insurance industry are using catastrophe models to help make sense of a very uncertain future…

Introduction (Via Understanding Uncertainty)

Catastrophe modelling companies serve to measure the financial impact of natural catastrophes on infrastructure, with a view to estimating expected losses. Although natural catastrophes often have a grave humanitarian impact with regard to loss of life, this aspect is not currently included and only the event’s financial impact will be discussed below. The purpose of catastrophe modelling (known as cat modelling in the industry) is to anticipate the likelihood and severity of catastrophe events—from earthquakes and hurricanes to terrorism and crop failure—so companies (and governments) can appropriately prepare for their financial impact.

In this article we will explain the three main components of a cat model, starting with an event’s magnitude and ending with the damage and financial loss it inflicts on buildings. We then discuss what metrics are used in the catastrophe modelling industry to quantify risk.

The Three Modules (Via Understanding Uncertainty)

A catastrophe model can be roughly divided into three modules, with each module performing a different step towards the overall calculation of the loss that results from a catastrophe.
1. Hazard Module – The hazard module looks at the physical characteristics of potential disasters and their frequency, whereas the vulnerability module assesses the vulnerability (or “damageability”) of buildings and their contents when subjected to natural and man-made disasters.
2. The vulnerability module – After simulating an event of a given magnitude, the damage it does to buildings must now be computed. The extent to which a particular building will be damaged during a hurricane depends on many factors, but certain characteristics of a building serve as good indicators of its vulnerability and, in particular, of its likely damage ratio. The damage ratio is the ratio of the cost to repair a building to the cost of rebuilding it.
3. Financial Module - The damage ratio distribution for a specific event is then multiplied by the building replacement value to obtain the loss distribution (Figure 1 above, right plot). These calculations are done within the financial module which also incorporates specific insurance policy conditions that are crucial in accurately determining the insurer’s loss.

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