- 31 -

The experience of the twenty-year period, suggests that the Caribbean countries would be damaged by two tropical storms each year and by a hurricane every two years. In general, climatologists view the 1969 to 1989 period as _below_ average in terms of cyclonic activity in the Atlantic. So far, nine hurricanes have hit the Caribbean islands in the 1990s, or an average of almost one per year, double the rate of the prior 20 years.

There are significant regional differences in exposure, however. Northern and eastern islands are more exposed than southern islands. The Leeward Islands including Antigua, Montserrat, St. Kitts and Nevis are viewed as being most exposed, while Trinidad and Tobago have minimal exposure.

Insurance loss modeling thus, involves three main steps: An assessment is made of the probability of the underlying natural phenomena, either hurricane storms or earthquakes and their intensities. This information is developed from historical meteorological and seismic data. The second step is to assess the exposure level and vulnerability of insured property to differing hazard intensities (as per the graph above). The third step is to combine the information from the first two steps and produce a probable loss distribution in dollar terms.

To illustrate, consider an extremely simple example of a small island, subject to only a category II type hurricane. The probability of such a hurricane striking the island is 10 percent. In other words, it can be expected that such a hurricane will hit the island once every ten years. The value of insured property on the island is $100 million. It is estimated that a category II storm hitting the island will cause $20 million in insured loss. This information can then be used to calculate appropriate annual insurance rates and to decide on the maximum capital ($20 million) needed in any given year to pay losses. Insurance loss modeling develops data on these two main figures -- annual average loss and probabilities of maximum losses -- from data on multiple meteorological or seismological events.

# **_The_** _Nature of Catastrophic Risk_

Catastrophic risks in primary markets tend to be spread temporally more than spatially. For example, prior to Hurricane Andrew, insurance companies added a 14 percent catastrophic property factor to insurance premiums in Florida. With residential insurance premiums totaling $1.2 billion in 1992, this resulted in the catastrophe portion of premiums of $168 million per year. This factor was based on loss data for 30 to 40 years. The assumption was that catastrophe losses would average out to 14 percent of the premium over 40 years. In any single year, a large hurricane could cause losses many times the $168 million in premium. However, the companies assumed that over a 30 to 40 year period they would break even.

The pricing of catastrophe reinsurance is based on the notion of spreading risk over time. The reinsurance company promises to indemnify the primary company for losses above a retention level. For example, a primary insurance company might purchase reinsurance for catastrophe losses between $20 million and $30 million. In pricing this $10 million layer of insurance, the reinsurer will first estimate the probability of loss in this range. Let us assume that this probability is 10 percent. In other words, the reinsurer believes that once every ten years the primary insurer will need to pay losses of