February 17th, 2010

Higher Pressure on Cat Risk Under Solvency II, Part I: Standard Formula Approach

Posted at 10:00 AM ET

Frank Achtert, Managing Director, Financial Intelligence Team, and Maximilian Strasser, Vice President
Contact

In 2009, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) issued details of its Level 2 implementation measures for Solvency II in three waves of consultation papers. The capital charge for the catastrophe risk sub-module (NLCAT), a key driver of capital for non-life carriers and reinsurers, is covered in various publications, primarily in “CEIOPS’ advice for Level 2 Implementation Measures on Solvency II: SCR standard formula - Article 111 Non-Life Underwriting Risk (former CP 48)” and Consultation Paper (CP) 71 - “SCR Standard Formula - Calibration of non-life underwriting risk”. It should be noted that the proposals made in CP71 are subject to a consultation process resulting in recommendations to the European Commission in spring 2010 and therefore, may not be final. Notably these rules have been not covered by CEIOPS’ final advice to the European Commission (EC) published at the end of January 2010.

Introduction


The objective of these articles is to provide, based on a review of CEIOPS‘ recent papers, a summary of how non-life cat risks are likely to be quantitatively assessed under Solvency II.  As shown in Figure 1, (re)insurers may quantify their individual catastrophe risk charge as part of one of three frameworks:

  • The standard formula
  • A partial internal model
  • A full internal model

solvency-ii-catbig

Figure 1: Methods to quantify non-life cat risk under Solvency II

All three frameworks provide capital charges that cover unexpected insurance losses at a confidence level of 99.5% over a one year period, which corresponds to a return period of 1 in 200 years.

  1. Standard Formula Approach

In CP48 and CP71, CEIOPS introduced a revised version of the non-life catastrophe risk sub-module. Considering Quantitative Impact Study (QIS4) outcomes, it made several changes to the calculations of the capital charge for catastrophe risk NLCAT.

  • Standardised Scenario Approach (Method A - previously called Method 2 in QIS4):  This approach is currently subject to review and harmonisation by an industry working group put in place by CEIOPS.
  • Factor Method (Method B - previously called Alternative Method or Method 1):  The factor method contains a new set of factors that are now split by natural peril for property and motor lines. Further, the newly calibrated factors reflect capital charges gross of reinsurance rather than net.
  • Personalised Scenarios (previously Method 3):  This method is no longer considered as applicable to the standard formula and is available only in an internal model framework.

Methods A and B have been designed to provide basic and quick estimates in the absence of more comprehensive, individual processes to compute the capital requirement NLCAT. As a consequence these techniques cannot recognise a number of portfolio attributes and might lead to less accurate results compared to the internal model approach. The main accuracy issues have been flagged such as insufficient reflection of geographical resolution, cross-country portfolios, portfolio and policy specifics as well as diversification and correlation. (For details, see section 2.)

Standardised Scenarios

 
Standardised scenarios will be embedded in the standard formula to calculate a capital charge from the catastrophe risk sub-module. These scenarios shall cover the enterprise’s unexpected losses with a confidence level of 99.5% over a one year period. A catastrophe cross-industry task force has been created by CEIOPS to construct the required standardised scenarios with help from the industry. The scenarios used in QIS4 varied significantly from country to country and were designed for risk carriers with relatively standard portfolios. Also, the QIS4 scenarios focused too much on large events without sufficient consideration of an accumulation of several medium-sized events. The proposed scenarios are expected to be better harmonised across countries and more detailed and comprehensive than those in the QIS4 specifications. The proposed scenarios are not necessarily expected to be available before QIS5 is released. However, the group is working towards finalising the standardised scenarios before the final implementation of Solvency II.

In order to develop improved standardised scenarios, CEIOPS has provided a list of perils by line of business (as shown in Table 1), also referred to as “events” (natural or man-made). Further, CEIOPS proposed the creation of databases listing (1) the existing country-specific arrangements (e.g., government pools) and (2) historical catastrophe losses for use as a benchmark for the scenario development. For insurance groups active in more that one member state, cross border scenarios will be considered by the task force.

At the moment, scenarios are planned for the lines and events listed in Table 1. Only fire and property and motor non-third party liability (motor non-TPL) will be affected by natural catastrophe scenarios.

Event

Line of business affected

Natural Perils

Storm

Fire and property; Other motor (Non-TPL)

Flood

Fire and property; Other motor (Non-TPL)

Earthquake

Fire and property; Other motor

Hail

Fire and property; Other motor

Man-made disasters

Major fires, explosions

Fire and property

Major Marine, Aviation, Transport (MAT)  Disaster

MAT

Major third party motor liability disaster

Motor third party liability

Major third party liability disaster

Third party liability

Table 1: Standardized scenarios as proposed in CP 48

 

According to CEIOPS, scenario losses for each country shall be based on a common set of definitions to increase harmonisation among them. For each standardized scenario the estimates shall represent gross losses by peril, while the (re) insurance risk carrier is expected to apply any existing proportional or non-proportional reinsurance individually.

Factor Method

The Factor Method applies specified factors to premium volume. CEIOPS is fully aware that a simple factor approach will have limitations caused by:

  • Unequal data on catastrophe risk across European markets
  • Pool arrangements that exist in some affected countries
  • Regional differences in hazard levels resulting in differences in the factors that represent a 1 in 200 year event by country
  • Differences in risk profiles among companies across countries within a line of business

However, CEIOPS considers the factor method to be a key approach in cases when a standard scenario is not appropriate and the company is not striving for a (partial) internal model solution (CP71). The factor method might be used when:

  • The portfolio character of the risk carrier is not well represented by the standard scenario, i.e., the portfolio is different from the industry average
  • The risk carrier writes business in the miscellaneous line of insurance not covered by the standard scenarios
  • The risk carrier writes material non-proportional reinsurance
  • The risk carrier has significant exposures outside the Economic European Area (EEA)

CP71 includes a newly calibrated set of factors, reflecting calibration and benchmarking studies carried out following the QIS4 exercises. The new factors are designed to estimate capital charges gross of reinsurance and each enterprise is expected to apply its individual reinsurance to derive the net capital charge. Further, for the lines fire and property and motor non-TPL the provided factors have been split by natural peril. Currently the factors are uniform for all EU countries. The following changes have been made by CEIOPS since QIS4 to improve the results:

  • Factors have been calibrated gross of reinsurance so that companies can apply their own reinsurance programs.
  • Factors have been calibrated by peril for the property and motor lines of business
  • Benchmarks have been carried out by CEIOPS in collaboration with major market participants and cat model vendors in order to compare QIS4 results to additional opinions offered by third parties.
  • An aggregation method between events and lines shall be provided at the same time that the standardised scenario approach is released

 

The new and QIS4 factors are compared in the table below.

Line of Business

Event

Factors (QIS4 - net)

Factors
(CP71 - gross)

Motor 3rd party liability (TPL)

Motor 3rd party liability disaster

0.15

0.40

Other Motor (Non-TPL)

Storm

0.075

1.75

Flood

0.075

1.13

Quake

0.075

1.20

Hail

0.075

0.30

Marine, Aviation, Transport (MAT)

MAT disaster

0.5

1.0

Fire and other property damage

Storm

0.75

1.75

Flood

0.75

1.13

Quake

0.75

1.20

Fire, Explosion

0.75

1.75

3rd party liability

3rd party liability disaster

0.15

0.85

Misc.

Misc. disaster

0.25

0.40

NP reinsurance  - property

Property disaster

1.50

2.50

NP reinsurance  - casual

Casualty disaster

0.5

2.50

NP reinsurance  - MAT

MAT disaster

1.5

2.50

Table 2: Net factors  before calibration (QIS 4) and gross factors after calibration (CP71)

The table demonstrates that the new factors are much higher than the older factors. The impact on a company’s specific charge will depend on how its reinsurance program compares to the one implicit in the older (net) factors. To derive the net capital charge, the companies will deduct their individual reinsurance programs in the same manner as they would if they used the standard scenarios.

Standardised Scenarios and Factor Method


Method (A) and (B) can be combined when appropriate. When a company calculates an event loss with both a standardised scenario and the factor method, the specific capital charge for that event shall be the greater of the two.
For both methods, according to CEIOPS’ advice, the capital requirement for catastrophe risk for a line of business must not exceed the net retention by line after reinsurance, increased by a possible reinstatement premium. (See Figure 2.)

solvency-cat-2big

Figure 2: Net capital requirement for layer with one reinstatement

Link to Part II:  (Partial) Internal Audit Approach and Conclusion

Contact Information
This internal briefing was prepared by Guy Carpenter’s Financial Intelligence Team (FIT) and Guy Carpenter’s European Cat Initiative (ECI). Questions regarding this briefing may be directed to any of the FIT or ECI members, listed below.

 

Susan Witcraft, Managing Director, Minneapolis                   +1 952.832.2143

Frank Achtert, Managing Director, Munich                            +49 89.28.66.03.361

Eddy Vanbeneden, Managing Director, Brussels                  +32 2.674.98.11

David Flandro, Senior Vice President, London                      +44 (0)20 7357 3267

Benoît Butel, Vice President, Paris                                        +33 1.56.76.48.26

Sebastien Portmann, Vice President, Zurich                         +41 44.285.9322

Maximilian Strasser, Vice President, Munich                         +49 89.28.66.03.325

The information contained in this internal briefing is proprietary and confidential and is intended for the use of employees of Guy Carpenter & Company, LLC and its affiliates (collectively, “Guy Carpenter”). If you are not an employee of Guy Carpenter, you are hereby notified that any disclosure, copying, distribution or the taking of any action in reliance on the contents of this internal briefing is strictly prohibited. If you have received this internal briefing in error, please immediately notify Guy Carpenter to arrange for return of the original documents to us.

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