Inside View - Four steps you must take now to avoid 'big wind' in 2006.

(From Reinsurance)

Byline: Ryan Ogaard is managing director and global leader of Guy Carpenter's

The 2004 and 2005 hurricane seasons have radically altered notions on how catastrophic risk transfer should be viewed. Given this elevated storm frequency and severity trend, which some climate experts expect to last decades, rating agencies have re-evaluated their analyses of catastrophe exposure and their conception of capital adequacy.

Three major rating agencies re-evaluated the way they treat natural-catastrophe risk in their capital adequacy models. For example: AM Best has reworked its natural-catastrophe stress test to measure capital adequacy after two major catastrophe events in one year. The new test examines the impact on capital of a second net-after-tax catastrophe loss from a one-in-100-year hurricane or a one-in-100-year earthquake, after having already adjusted the balance sheet for the greater of a one-in-100-year storm or a one-in-250-year earthquake. A one-in-100-year earthquake, instead of a one-in-250-year earthquake, is used in the new test because once an event occurs along a particular fault, some of the stress is released.

This conservative test assumes that lightning can indeed strike twice. AM Best's previous test used a second event of a one-in-50-year hurricane. Beyond using more extreme scenarios to test capital adequacy, rating agencies are also focusing on the use of the models themselves. AM Best is asking insurers to specify their assumptions on such items as demand surge, storm surge and losses to lines such as workers' compensation and auto.

Beyond the rating agency action, modelling firms are changing their models to reflect increased North Atlantic storm activity. The changes currently being implemented by catastrophe modellers are estimated to increase PML (probable maximum loss) anywhere from 30-100%. This estimate is based on the information available as of this writing; the full extent of model changes is not yet known.

Some insurance companies have expressed concern that this one-two punch of enhanced stress testing coupled with increased PML amounts from catastrophe models constitutes 'double counting' the impact of recent storms. AM Best has replied that prior estimates generated by the models were probably too low in retrospect, and that new output will more ...