November 3rd, 2009

Cat Risk in a Solvency II Environment

Posted at 1:00 AM ET

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) refined the evaluation of non-life catastrophe risks under Solvency II in its Consultation Paper 48 “SCR Standard Formula: Non-Life Underwriting Risk” issued in July 2009.

QIS 4 Outputs and Industry Feedback

Under the Quantitative Impact Study (QIS) 4, the cat risk charge was derived using one of three approaches:

  • The factor-based approach (Method 1), under which a standard formula based on premium income by line of business is used, was selected by 31 percent of the non-life participants. This approach should be used only when scenarios are not available.
  • The first scenario-based approach (Method 2) uses regional scenarios provided by regulators that vary significantly by country. Thirty-nine percent of the non-life participants based their calculations on Method 2.
  • Newly introduced in QIS 4 was Method 3 under which companies have the choice to use personalized scenarios according to the classes of business written and geographical concentration based on their own assessments of non-life cat risk that is relevant to their risk exposure. Twenty-four percent of the non-life participants opted for this personalized approach.

Companies pointed out that the way the scenarios are selected could lead to cherry picking and that there is no consistency among the three methods or between scenarios aggregation and direct modeling results (all cat events modeled together).

Non-Life Cat Risk According to CP 48

Standardized Scenarios

As a result of the feedback of various stakeholders, CEIOPS decided that the cat risk charge in the standard formula shall be estimated through the application of standardized scenarios. The scenarios will be developed with the help of the industry being more detailed and comprehensive than those in Method 2 of QIS 4. The scenarios will be much more harmonized across all regions in order to generate a level playing field. The target is to finalize the scenarios before the start of the QIS 5 exercise which is scheduled for the second half of 2010.

The standardised scenarios will be assessed from an ongoing perspective, which will allow for changes due to demographic, legal, social or economic developments. They will be designed, quantified and reported with a common set of definitions. Cross-border scenarios will be created and the impact on each (re)insurer will be reflected through its market share.

Alternative Method

(Re)insurers will be allowed to use a factor-based alternative method (similar to Method 1 in QIS4) when standardised scenarios are not available or for specific cases, which will be defined at a later stage. (Re)Insurers will be required to apply the higher of the capital charge based on the standardised scenarios and the capital charge using the alternative method when the scenarios don’t match perfectly with their risk sources (for instance exposures outside the EU, non-proportional reinsurance, standardised scenarios not applicable, e.g., where these scenarios are contractually excluded).

CEIOPS will revisit the calibration provided in QIS 4 Method 1. For that purpose, a specific Cat Task Force has been launched. This Task Force shall propose new scenarios for QIS 5.

While QIS 4 Method 3 has been abandoned, CEIOPS reiterated that partial internal models will be allowed calculating the cat risk capital charge essentially allowing (re)insurers to use this methodology.

Capital Charge Calculation

For each standardized scenario the (re)insurer shall calculate the net amount of the gross share of the total loss according to the following formula:

Where the XL cover follows a proportional cover:
MAX ((L*MS*QS)-XLC, 0) +MIN ((L*MS*QS), XLF) + REINST

Where a proportional cover follows an XL cover:
MAX ((L*MS)-XLC, 0) *QS +MIN((L*MS), XLF) *QS + REINST

Where:
L= the total gross loss amount (provided as part of the information of the scenario).
MS= the market share (determined with reference to exposure estimates, historical loss experience or the share of total market premium income received. The total market loss amount of the catastrophe will be provided as part of the information of the scenario)
QS= quota share retention (allowance must be made for any limitations, e.g. event limits frequently applied to QS treaties)
XLC= the upper limit of the XL programme that is applicable in case of the scenario event
XLF= the XL retention of the XL programme that is applicable in case of the scenario event
REINST = the reinstatement premium or premiums
Aggregation of the catastrophe risk charges across events or relevant countries, including definition of correlations will be specified as part of the standardized scenarios.

(Re)insurers shall consider whether scenarios are applied adequately and seek to ensure that the limitations are addressed appropriately as part of their Own Risk and Solvency Assessment (ORSA). If the risk covered deviates significantly from the standardized scenarios, a partial internal model shall be applied.

Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide. To the extent that you discuss such statements with your clients, be sure to advise your clients that all such matters should be reviewed with their own qualified advisors in these areas.

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