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Cost of Capital: A Powerful Approach to Catastrophe Portfolio Management

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Gross Consulting offers a proven methodology for utilizing catastrophe model output to manage a portfolio of catastrophe risks.

 

Our Cost of Capital methodology is powerful for understanding which geographical areas have the potential for severe catastrophe events. The cost of capital can be used as a risk load when pricing catastrophe accounts. It also can be used to indicate those accounts that contribute an inordinate amount of risk relative to the profit they generate.

 

Often companies manage catastrophe risk only when it has reached a crisis. They identify problem geographical areas and struggle to determine which sections of the business should be reduced or controlled.

 

Our approach is more comprehensive. It considers that all catastrophe risk needs to be controlled. As risk increases, due to growing exposure, the cost of capital (risk load) increases for all accounts in that area — new and renewal. Although these changing risk loads are gradual, they should eliminate situations where the catastrophe risk becomes problematic. This method encourages writing additional business in areas that are not accumulated in the current portfolio, resulting in greater diversification of catastrophe risk.

 

In the cost of capital method, a dollar cost of capital is allocated to each account. The cost is assigned in a proportion both to the probability and severity of catastrophe loss for the account in question, as well as the probability and severity of loss for the company in total for each modeled event.

 

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Looking at the cost of capital relative to the average annual loss on a map quickly highlights the geographical areas where there is more potential for severe catastrophe events for the corporation in total.

 

In this example, it is not simply the hurricane risk itself being shown — it is the accumulation level in conjunction with the hurricane risk. Note that in Florida, the Tampa and Miami/Palm Beach areas stand out as a darker red, as there is more accumulation of values in these areas.

 

Accounts being written in areas with more potential for severe events will receive a higher cost of capital (risk load) relative to the average annual loss than those in less severe areas.

 

 

Average Excess Loss Contribution

Another measure of the potential for severe events is the Average Excess Loss Contribution. The exhibit below shows how each region contributes to each point on the catastrophe loss distribution. The calculation of the Average Excess Loss contemplates only the events with losses in excess of the given threshold. For example, for the 10-year return period, only event losses greater than $25 million are considered in the average.

 

This measure is related to the cost of capital methodology in that the events that drive the tail of the distribution will be the events that receive larger cost of capital amounts.

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Impact of Underpriced Accounts

Accounts that are not priced appropriately for catastrophe risk can have a strong negative impact that can easily be overlooked in most years’ results. We can develop target pricing by account, including this cost of capital to reflect risk accumulation. This benchmark premium can be compared to actual collected premium at the account level to identify under priced accounts.

 

The impact of these underpriced accounts can be shown in aggregate, as in the exhibit below. This exhibit shows what the corporate cat distribution would like without the underpriced accounts. The amount of premium received for these accounts is small in comparison to the risk that they add.

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A detailed listing of each account in the underpriced category can be reviewed. The resulting scrutiny on these accounts generates valuable discussion regarding strategy and controls, and often identifies coding errors, that when corrected, can result in lower reinsurance costs and improved rating agency views.

 

For more information, please contact us.