While model blending has become more common in recent years, there is still ongoing debate on its efficacy and, where it is used, how it should be done.
- If there are multiple accepted models or versions of the same model, how valid is it to blend different points of view?
- How can the results of such blending be used appropriately, and for what business purposes?
In two upcoming posts, my colleague Meghan Purdy will be exploring and discussing these issues. But before we can discuss best practices for blending, we need to take a step back: any model must be validated before it is used (either on its own or blended with other models) for business decisions. Users might assume that blending more models will always reduce model error, but that is not the case.
As noted by the 2011 report, Industry Good Practice for Catastrophe Modeling, “If the models represent risk poorly, then the use of multiple models can compound this risk or lead to a lesser understanding of uncertainty.”
The fundamental starting point to model selection, including answering the question of whether to blend or not, is model validation: models must clear several hurdles before meriting consideration.
- The first hurdle is that the model must be appropriate for the book of business, and for the company’s resources and materiality of risk. This initial validation is done to determine each model’s appropriateness for the business, and is a process that should preferably be owned by in-house experts. If outsourced to third parties, companies must still demonstrate active ownership and understanding of the process.
- The second hurdle involves validating against claims data and assessing how well the model can represent each line of business. Some models may require adjustments (to the model, or model output as a proxy) to, for example, match claims experience for a specific line, or reflect validated alternative research or scientific expertise.
- Finally, the expert user might then look at how much data was used to build the models, and the methodology and expertise used in the development of the model, in order to discern which might provide the most appropriate view of risk for that company to use.
Among the three major modeling companies’ models, it would not be surprising if some validate better than others.
After nearly 25 years of probabilistic catastrophe modeling, it remains the case that all models are not equal; very different results and output can arise from differences in:
- Historical data records (different lengths, different sources)
- Input data, for example the resolution of land use-land cover data, or elevation data
- Amounts and resolution of claims data for calibration
- Assumptions and modeling methodologies
- The use of proprietary research to address unique catastrophe modeling issues and parameters
For themselves and their regulator or rating agency, risk carriers must ensure that the individuals conducting this validation and selection work have the sufficient qualifications, knowledge, and expertise. Increasing scientific knowledge and expertise within the insurance industry is part of the solution, and reflects the industry’s increasing sophistication and resilience toward managing unexpected events—for example, in the face of record losses in 2011, a large proportion of which was outside the realm of catastrophe models.
There is no one-size-fits all “best” solution. But there is a best practice. Before blending models, companies must take a scientifically driven approach to assessing the available models’ validity and appropriateness for use, before deciding if blending could be right for them.