The headline of this post is somewhat misleading but the point is that predictive models are too—even when used properly. Says catastrophe risk management expert Karen Clark: “Model users frequently forget that all models are based on simplifying assumptions, and therefore all models are wrong.”

Clark’s comment appeared in a release by her eponymous firm consulting firm, Karen Clark & Company, announcing a report on the performance of so called “near-term” hurricane models. These models have suffered heavy criticism from Florida government spokesmen, as we reported early last year. The near- or medium term models were designed to replace standard models that failed to predict the anomalous 2004 and 2005 hurricane season.

In late 2006, Florida Governor Charlie Crist said RMS’s medium-term model was based on “unscientific” assumptions and amounted to “big insurance” taking advantage of the people of Florida.

Karen Clark & Company’s statements avoid such rhetorical flourish, but the conclusions of the consultant’s report might offer some vindication of Governor Crist’s pique. The near-term models, introduced by AIR Worldwide, EQECAT and RMS in 2006, predicted cumulative insured losses of 37.2 billion, $40.8 billion and $42 billion respectively—seriously short of the actual cumulative losses of $13.3 billion during the specified period.

“With the close of the 2008 hurricane season, and three years into the application of near term hurricane models, it is a good time to evaluate the models’ performance,” commented Karen Clark. “While it is still too early to make definitive conclusions about the near term models, with insured losses significantly below average for the cumulative 2006 through 2008 seasons, initial indications are there is too much uncertainty around year-to-year hurricane activity and insured losses to make credible short term predictions.”

While Clark’s critique appears fundamentally to be about the statistical limitations of models, last week members of a panel at the Casualty Actuarial Society’s (CAS) annual meeting inveighed against the abuse of risk modeling as an important contributing factor to the financial crisis. The actuaries criticized both over-reliance on the models and the use of faulty or incomplete assumptions.

According to a CAS report, David Ingram, senior vice president, Willis Re, “observed that the models missed that differences in the size of down payments would impact experience; increasing the pool of subprime borrowers would alter the characteristics from the select group of the best subprime borrowers of a few years ago to the riskier group of more recent years; changing the terms of mortgages from fixed rates to gimmicky rates would have a major impact; and there could be a national risk from subprime mortgages.”

The panel’s moderator, Thomas Hettinger, managing director, EMB America LLC, commented that opinions about the effectiveness of models would polarize into two camps, the “naysayers,” who would opine that models simply don’t work, and those who will embrace approaches to modeling as the methodology continues to evolve.

Both the Karen Clark & Co. and the CAS commentators contribute a worthwhile message of caution about predictive modeling: it has its uses but those uses are limited, by the quality of input data, assumptions and the simple fact that they represent nothing more than probability. As Ms. Clark notes, “Models are an attempt to replicate reality, but they are not reality.”

By Van Beach, senior consultant, Towers Perrin

There is little doubt that improved risk management will be a top priority for insurance carriers in 2009. How does this impact the CIO's strategic agenda? Even today, I'd generally be shocked if a CIO's response was a strategic IT spend for support of their actuarial department. However, as companies look to improve risk management, I think 2009 will be the year many realize that IT investments in this area can provide immediate impact to a company's ability to understand and manage their risks.

Most CIO's don't know how the magic happens behind the black curtain of the actuarial department and, given this area does not need to tightly integrate with the core insurance systems, it has been left to choose systems and build processes independent of IT guidance and support. In the life and annuities arena, this disconnect has roots with the introduction of desktop actuarial systems in the mid-1980's. These systems enabled actuaries to create and analyze financial models, price insurance products, meet regulatory requirements, etc. with little dependence on IT. Firing on all cylinders, the actuaries were off…

Over the course of the next 20 years, the demands upon these financial models have grown exponentially. Now, these models are used to produce a wide array of risk management calculations, require coordination across a wider user base, utilize an ever-increasing amount of data, and have become more complicated and computation intensive. Over time, the volume and complexities of these process demands have caused a drift in actuarial focus from analyzing risk to managing an increasingly manual and burdensome production of risk numbers. The actuarial department, as the risk engine for insurance companies, is now in need of a tune-up.

I think 2009 will see a significant number of companies get under the hood of actuarial departments, with IT as the lead mechanic.

With technology solutions to improve actuarial processes, actuaries can refocus on understanding and managing risk and become the high-performance engine needed to power today's risk-aware organization. Five key areas where strategic IT investment can improve risk management:

1. Ensure quality data: Like all analytical processes, the starting point is data and actuaries require a lot of it. In addition to inforce data, the volume and variety of assumption data required for the financial models presents a unique challenge.

2. Improve control and quality of the actuarial process: Version control, audit logs, security, etc. are needed to provide the confidence in results needed for actionable information.

3. Reduce the actuarial process burden: Automation of data manipulations and model runs, creation of repeatable process flows, etc. will enable actuaries to spend more time on risk analysis and less time on production.

4. Provide power: To understand risks, particularly those tied to future financial conditions, thousands of potential scenarios need to be considered. With greater access to computation power, the timeliness and quality of risk analysis improves.

5. Increase access to risk metrics: As process flows and computational resources improve, actuaries can focus on providing timely, appropriate risk information to a wider audience.

Technology can provide the means for actuaries to deliver better, more timely risk assessments, improved awareness, greater understanding, and actionable risk information to the organization. With the recent financial turbulence, delivering these types of improvements is of critical importance. For a 2009 IT strategy for risk management, there's no better place to start than under the hood with their company's risk engine -- the actuarial department

Three recent news stories have underscored the need for insurance underwriting to adapt to a constantly changing environment, as ISO CEO Frank Coyne recommended during his recent address at ISOTech: the California wildfires, the rise of deer collisions in the Eastern United States and the increasingly brazen and ambitious pirates of Somalia.

The wildfires show that attention to circumstances ought to affect how one takes on new business. While the unusually intense Santa Ana winds driving the scope of the fire are not predictable over the long run, other factors are. For example, unusually rainy seasons over the past two years have caused the build-up of fuel making it far likely that fires would destroy property if they were to be ignited. Also, property owners in pursuit of a more natural environment are building in wilder areas that are more subject to wildfires, according to RMS.

State Farm has calculated that deer-related automobile crashes have risen about 15 percent over the last five years, according to a report by the Property Casualty Insurers Association of America. The report doesn't comment on the possible cause of that increase, perhaps because it would be difficult to discern. Population is a likely factor, but so may be construction, which provides deer with food sources in more traveled areas. Whatever the cause, insurers need to adjust their pricing according to increased probabilities of deer-related collisions, based on the reported incidence of such crashes or other sources, such as information from state wildlife organizations about population changes.

The case of the Somali pirates demonstrates that the risks of a given geography can suddenly climb substantially. Piracy off the Horn of Africa has been rising steadily over the last few years, but recently it seems to have jumped in terms of both frequency and severity. While we noted a few days ago the predictable result of an asymmetrical confrontation between pirates and a Royal Navy vessel, the asymmetry is usually in favor of the pirates. These malefactors pounce on unsuspecting vessels that are seldom armed to resist forced boarders. Once the pirates are on board, the incident takes on the color of a hostage situation. And that's the M.O.: pirates don't seek to sell their booty but rather ransom it.

Earlier this year, Somali pirates hijacked a Ukrainian ship carrying 33 tanks and other military equipment. On Saturday they captured a Saudi supertanker of tonnage equaling about three U.S. aircraft carriers which was transporting roughly 2 million barrels of oil, according to an article in the Financial Times (FT).

The article notes that the pirates have become more sophisticated in their tactics and are capturing ships further out at sea. That's an important development because it is far more costly to escort ships than simply to patrol the area close to the choke point between the African continent and the Arabian Peninsula at the western end of the Gulf of Aden, where shipping enters the Red Sea on the way to the Suez Canal. The FT report cites Lloyds' Marine Intelligence Unit saying that 7 percent of the global oil supply passed through the Gulf of Aden in 2007.

Without consulting with a marine insurance specialist, I don't know what the implications might be for how the terms insurance policies are written. However, there is no question that underwriters need to keep on top of developing situations such as this one.

It is easy to underestimate the difficulty combating Somali piracy, both because of the vast size of the area in which the piracy is taking place and because of the nature of pirates' tactics. The number of pirates required to take a large ship is very small. How does one efficiently identify who are the bad guys from among a multitude of small vessels? Still, it seems that with a determined effort the problem of piracy in the Gulf of Aden could be eliminated or at least seriously attenuated. As the prizes grow larger and pirate chiefs grow richer, it will become easier to locate and punish the crime. Also, a determined short-term use of naval power could be very effective. Perhaps this would be a good opportunity for an American president of East African descent to demonstrate the legitimate use of American power as part of a multilateral military operation…

Over these last few tumultuous months, there has been no shortage of talk about risk management strategies. Could better ERM saved some companies from their current financial difficulties? Why did ERM strategies that were in place fail? Will more companies invest in ERM technology in the fallout?

In the pages of I&T -- both print and Web -- we've covered the topic, but at last week's 19th Annual Executive Conference for the Life Insurance Industry (quite a catchy name, eh?) held at the New York Palace Hotel, I got a new perspective on things from the point of view of insurance industry CFOs.

That perspective came in a Friday session moderated by Ernst & Young's Robert W. Stein and featuring Edward J. Bonach, vice president and CFO at Conseco, David A. Magers, EVP and CFO of COUNTRY Financial and Neil E. Salowitz, the marketing director of Principal Financial Group's insurance advisory group.

Most interesting, I thought, were the comments by some on the panel that asserted that, going forward, the market may create an environment where the products a company wants to sell and the ERM strategies it puts in place may clash with one another.

As COUNTRY Financial's Magers pointed out, many customers -- particularly those in the lower-mid and mid markets -- are realizing now for the first time that there is inherent risk in the market. Many are seeing their 401k plans decline for the first time after years of impressive growth. As a result, the panel agreed, the current financial crisis is breeding a large group of consumers that will be more careful and more involved in their future investments.

Bonach then took things a step further, expressing concern that this will lead to higher demand for more fixed and guaranteed products. Unfortunately, he continued, many guaranteed products are simply not sustainable. It will be key then, in the future, to have ERM plans in place that enable companies to balance the opportunities that abound to sell guaranteed products with the added risk inherent in those products.

Not at the panelists, however, agreed that guaranteed products alone would see increased interest from consumers. Principal Financial's Salowitz said he thought that consumers, as the crisis leads them to seek a better understanding of financial instruments, could actually be more amenable to non-guaranteed products. Consumers, he said, would emerge from the crisis with a better understanding of the nature of risk.

That said, everyone agreed that ERM would be an increasingly important part of companies' overall strategies. "If a company doesn't have a formal ERM plan in place," Salowitz said, "they may not be around in one or two years."

Observers of the impact of technology on society have suggested that Web 2.0 killed privacy while we weren’t looking: information formerly regarded as nobody else’s business has become front page material at millions of Facebook and MySpace pages across the country and, indeed, the world. However, individuals’ personal laxity about their private information doesn’t lighten insurers’ responsibilities in that respect, warned Shamla Naidoo, WellPoint’s vice president for security and compliance, speaking at I&T’s Executive Summit earlier this week.

Consumers routinely supply a variety of information to a variety of data collection points, such as social networking sites, Web-based e-mail service providers and search engines, in order to get access to services or simply communicate with friends and relatives. What consumers may fail to appreciate is not only how much that information can tell malicious parties about them, but that the original purpose of sharing that data may expire while the data remains available.

“What happens if two of those [data aggregating] organizations merge?” Naidoo said. “Maybe they collected that information to let me establish an e-mail account; does that purpose still remain?”

Naidoo’s point was that information shared has a life of its own. “It is easy to share you information and nearly impossible to unshare it,” as she puts it.

That’s a lesson that applies not only to private individuals but also to parties, such as insurance companies, that are trusted with protecting customers’ privacy. What it means in practical terms is that privacy measures implemented before Web 2.0 may be inadequate, as new risks emerge. To protect themselves from those risks, insurers need to ask which sources of customer information are reliable and safe and which are dangerous; and they need to ask what kinds of information shared may be repurposed in ways that could expose customers to harm, and insurers to penalties.

By Joseph Herr, CFPIM, global director of ERM, Jefferson Wells

For years, nearly every financial services firm in the country has been performing risk modeling activities. However, few are actually managing the risk elements and even fewer are monitoring the entire risk environment. In the case of the current financial crisis, the root cause is most likely a combination of the lack of both disciplines.

In the case of the current financial crisis, it is safe to say that all institutions understood that there was an element of risk associated with practices such as sub-prime lending. Some of those in the industry point blame specifically at the Community Reinvestment Act (CRA) of 1977, while others point blame at predatory lenders, Congress, uneducated borrowers, greed and the housing downturn.

Unfortunately, all of this blame is only Monday morning quarterbacking and reactive thinking. The fact of the matter is that most institutions have a very narrow view of risk management, which captures less than 35 percent of all the risks that could impact their organization negatively. Consequently, a minimum of 65 percent of the risks that could impact their institution negatively are never even identified.

Case in point is that all of the above issues occurred at varying time intervals, especially the CRA, which was enacted in 1977. So why is the crisis happening now? The answer is that the risk environment has changed over time, however in most institutions; the assessment of risk modeling remained constant, never recognizing nor considering the consequences that the changed environment caused. If the financial institutions had developed a proactive risk management process that was embedded into the fiber of each business entity, then not only would the above risk elements had been "modeled," but a remediation plan would have been implemented.

It is time that all institutions redefine the way risk is managed to not only ensure that the root causes are truly mitigated, but also that the environment is monitored to understand when changes occur that may alter the way a risk is managed.

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About the commentator: Joseph Herr has more than 30 years of operation and business experience, specifically with strategic planning, process improvement, efficiency optimization, quality, risk management and compliance initiatives such as Sarbanes Oxley. He can be reached at 724-333-7051 or via email at joseph_herr@jeffersonwells.com.

The destination of AIG's subsidiaries remains one of the big questions about the near-time future of the insurance industry. The answer to that question continues to be postponed: as markets plummet worldwide, it's getting more difficult for AIG to find buyers. While the AIG question will ultimately have its resolution, its current status shows just how much of a beating the industry is taking due to insurers' exposure as institutional investors and, in the case of many life insurance companies, as securities lenders. However, as the economy worsens, insurers will increasingly feel the pinch of diminished premium revenue as well.

Insurers' exposure as investors can't help but increase consolidation in the industry as individual insurers' vulnerabilities make them attractive targets for M&A. As Celent's newly released report, "Bad News on the Street: Insurance IT Strategy and the Financial Crisis" puts it, "Companies will combine through government-forced shotgun marriages or voluntary elopements."

The Wall Street Journal reported yesterday that some merger sweet talk recently passed between MetLife and The Hartford, both of which companies' stock has taken a pounding in recent days. Those talks came to nothing, but The Hartford found a sugar daddy in the form of a $2.5 billion investment from Allianz.

Of course the hits insurers are taking from the investment side are only part of the picture. As the Celent report emphasizes, "in any economic contraction, the overall insurance market shrinks. If market turmoil persists, that process will accelerate. The report warns that a

lower revenue stream will worsen an already difficult expense situation. Insurers have been under expense pressures for some time. Across all lines, lower sales mean less revenue to support fixed expenses. To adjust the cost base, companies will reexamine spending, including technology.

The financial crisis comes in time for insurers to tune their 2009 IT budgets, and that will likely result in some downward revision. Nevertheless, the analyst firm doesn't anticipate any significant cuts:

Carriers know that a large portion of their IT spending is essentially fixed by maintenance requirements, and relief in this category is hard to come by. In addition, projects that span budget cycles cannot be unplugged easily without sacrificing the strategic value that is already partially paid for. The trend in subsequent years may be more open to downward revisions.

The overall picture is one of increasing austerity. Not only will insurers suffer diminished investment returns and lower premium revenue, they will be under intensified regulatory pressure, Celent asserts:

insurers' mark-to-market practices will come under much higher levels of scrutiny by securities analysts, rating agencies, and regulators. This means that keeping unrealized gains off the balance sheet and impairments out of the income statement will become much harder.