PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 303In practice, valuing an insurance company is often undertakenin a limited timeframe. Valuation is usually based on expectedvalue results for earnings with sensitivity tests related to changesin premium growth rates, changes in loss ratios, changes in hurdlerates, and changes in annual investment yields.The contribution from stochastic modeling for valuation isthat it would provide better definition of risk (the distribution ofpossible outcomes around the expected value) and could be usedto derive better estimates of the cost of capital.5.4. Exposure to Natural CatastrophesAs noted by Gorvett et al. [5], exposure to natural catastropheshas had a very significant impact on the performance of theproperty/casualty insurance industry worldwide. As a result, themajor catastrophic events during the past 15 years have acceleratedthe evolution of the modeling of natural catastrophes andalso led to a recent proposal to create a prefunded catastrophereserve on the statutory balance sheet.Though the range of sophistication of catastrophe modelsvaries widely, there are three essential elements of most modelsregardless of whether the model is deterministic or stochastic.First, there must be an estimate of the intensity of the underlyingperil. This estimate is often simulated based on historical informationabout catastrophes related to the particular peril. Second,for the underlying peril, the model requires an estimate of thetotal damage caused by the peril. For a given peril, the damageestimate primarily depends on the geographical location of therisk and the value and construction type of the structure affectedby the peril. The final key element is an estimate of the loss tothe insurer, based directly on the location of policies written andlimits provided.For the purpose of insurer valuation, the primary benefit ofcatastrophe modeling is related to scenario testing. While it is