05 May 2009

Published in: Cat risk - ILS

New index aims to simplify hurricane loss problems

The Willis Hurricane Index will facilitate timely understanding of insured losses and therefore rapid settlement of claims, explain Brian Owens and Dr Greg Holland.

In recent years, some of the most destructive hurricanes on record have moved through the Gulf of Mexico (GOM) on their way to making landfall on the US Gulf Coast. The names of many of these hurricanes are now synonymous with devastation and loss, including hurricanes Ivan (2004), Katrina (2005), Rita (2005) and Ike (2008). At latest count, the total combined insured losses from these four hurricanes are estimated at over $108 billion (Source: Munich Re/Swiss Re/Willis). While much of the focus on these hurricanes has been on their impact on property onshore, the damage to the onshore and offshore energy industry has been unprecedented, totalling almost $24 billion (source: Willis Energy Loss Database, WELD). This includes losses to oil and gas platforms, damage to underwater pipes connecting the platforms to storage and refinery facilities on-shore, operators' extra expense (OEE) and loss of revenue during the hurricanes, as well as revenue losses because of direct and indirect platform/pipeline damage.

Figure 1

Energy losses can take several years to be fully understood and reported to the insurance industry; losses from Hurricane Ike are still mounting, having increased from an initial estimate of $4.0 billion to $6.5 billion today. All this presents significant problems for the offshore energy insurance industry and nowhere, for the reasons just described, are the problems more acute than in the GOM. While global insurance capacity on offer to the industry as a whole has remained stable, according to the Willis Energy Review, insurance capacity in the GOM is expected to fall by 30% for the 2009 hurricane season. A new approach is required that will enable insurers to provide capacity to the market while at the same time facilitating transparent and quick settlement of hurricane-related claims. In February 2009, Willis Capital Markets launched a new product designed to provide such a solution. Called the Willis Hurricane Index (WHI), it combines variables that measure the magnitude of the key loss-causing physical attributes of a hurricane into a single index value.

The idea of a scale or index to assess the destructive power of hurricanes and/or as a basis for settling insurance claims is not a new one. Perhaps the best know hurricane scale of all is the Saffir-Simpson Scale (SSS) of hurricane intensity used by the US National Hurricane Center (NHC) in their hurricane forecasting and warning systems. It is a simple scale (table 1) in which all hurricanes are designated one of five intensity categories based on estimated windspeed.

Table 1

Saffir-Simpson Scale of hurricane intensity

Saffir-Simpson Scale Category	Wind Speed (mph / kmph)	Central Pressure (hPa)
1	74 – 95 / 118 – 152	> 980
2	96 – 110 / 153 – 176	965 – 979
3	111 – 130 / 177 – 208	945 – 964
4	131 – 155 / 209 – 248	920 – 944
5	> 155 / > 248	< 920

This category approach provides an excellent way of informing the public of the imminent danger. However it is unsuitable for the purposes of insurance claims' settlement because, as has been amply demonstrated by storms such as Katrina and Ike, intensity alone is a poor indicator of damage potential.

In addition to the SSS, other scales or indices (table 2) have been defined in the past, including ACE (2000), the PDI (2005), the CHI (2005), HHI and HII (2006) and the aptly named IKE (2008), all of which attempt to capture a hurricane's power and/or energy, which is physically related to damage, in a single measure. Among these, the CHI is has been most often used in the past as the basis for calculating and settling insurance losses.

Table 2

Summary of other hurricane intensity impact indices 

Index	Created	Approach	Key Limitation
ACE	2000	Estimates total impact of wind speed on the underlying surface over a full season	No explicit capture of storm size and motion
PDI	2005	Estimates total impact of energy exchange between atmosphere and the surface over time	No explicit capture of storm size and motion
CHI	2005	Estimates impact of energy exchange from the atmosphere over spatial extent of storm at a point in time	No explicit capture of storm motion
HHI/HII	2006	Considers storm motion and size (HHI) and impact of wind speed (HII) at a point in time	Two separate indices
IKE	2008	Estimates the energy as the sum of surface winds for a specified wind range over time	Requires observational data that may not be readily available

Background research leads us to the conclusion that an effective index must include three critical physical parameters. All three of these parameters are available in the public advisories released by the NHC once a tropical storm has developed:

• the amount of energy dissipated at the surface as a proxy for the actual damage potential of the hurricane winds (including the development of high waves, currents and storm surge), this is measured by the maximum sustained windspeed recorded at a point in time;
• the radial extent and character of the surface wind field, as measured by the radius of hurricane force winds;
• the translational speed of the hurricane, or speed the storm system is moving, as an indicator of the length of time that damaging winds are experienced.

These three parameters are embodied in the WHI:

where vm is the maximum wind speed, Rh is the radius to hurricane force winds, and vt is the cyclone translation speed, as reported by the NHC. The first term represents energy dissipation, or destructive potential of the cyclonic winds. The second term uses the radius to hurricane-force winds as a convenient indicator of the extent of destructive winds. Finally, the third term brings in an assessment of the length of time the winds are experienced. This is important for direct wind damage as the impact of structural fatigue and debris grows with time, often rapidly, and is thus inversely related to the cyclone translational speed.

A key measure of success for the index will be its ability to accurately estimate the losses actually incurred by energy companies. Divergence between actual losses and those generated by the WHI is referred to as "basis risk"; to be effective, the basis risk needs be minimized, which requires calibration of the index against historical energy losses in the WELD. So how does the WHI stack up against recent hurricane loss? It explains almost 95% of the variance in loss data using the maximum of all observations in the region for each hurricane (figure 2).

Figure 2

The WHI is intended to be used by energy insurers and reinsurers to provide, via Willis, insurance capacity to energy corporations, as well as insurance and reinsurance companies looking to protect themselves from offshore hurricane-related losses.

The WHI allows for great flexibility in structuring insurance contracts. For example, a minimum and maximum value of the index can be defined that correspond to the attachment and exhaustion points of an insurance contract, purchased by Willis' energy clients. In excess of the contract attachment point, losses are paid out on a sliding scale as the WHI increases until the exhaustion point is reached. Alternatively, a simple binary trigger can be used where, if a storm exceeds a certain WHI value, the contract will pay out.

The WHI will be invaluable because:

• it will facilitate timely understanding of insured loss and therefore rapid settlement of claims;
• it will address the issue of losses creeping up over time, such as for Hurricane Ike, with the result that insures and their clients can quickly agree the basis for claims;
• it will provide a solution to the market without having to calculate exact exposure by client at a point in time, which is extremely complex and challenging for the offshore energy industry;
• insurance contracts based on it will be simple and clear.

The WHI has been defined for a large part of the GOM (Figure 3) in which offshore energy assets are located (an area bounded by the US Gulf Coast, west of 88°W and north of 26°N). The US NHC, which is responsible for hurricane forecasts and warnings for the GOM, issues updates on the location, extent of hurricane force winds, forward speed and maximum wind speed at least every six hours. This information, which is quickly and freely available, is then used to calculate the WHI value at each time-step for which the hurricane is positioned (by its reported latitude and longitude) in the box shown in Figure 3.

Figure 3

The WHI was developed by Dr. Greg Holland of NCAR and represents a significant innovation in the parametric transfer of GOM offshore hurricane risk. It was developed as part of the work of the Willis Research Network, a long-term and exclusive collaboration between Willis and 20 universities and academic institutions worldwide, to evaluate the impact of natural catastrophes on the insurance and reinsurance industries. The full details of the derivation are being prepared for publication in a scientific journal.

Brian Owens is with Willis Re, London, and Dr. Greg Holland with the National Center for Atmospheric Research, Boulder, Colorado

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