February 18th, 2010

Higher Pressure on Cat Risk Under Solvency II, Part II: (Partial) Internal Model Approach and Conclusion

Posted at 12:00 PM 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.  

 

           2.  (Partial) Internal Model Approach

(Re)insurers may develop their own calculation processes within full or partial internal models to derive capital charges for catastrophe risk. The process must be calibrated to return a 99.5% confidence level over a one year period and must be fully transparent, documented and approved by the supervisors. Ideally the process enables reporting of scenarios by country, peril and line, with subsequent aggregation to final capital charge NLCAT.

Pricing and accumulation control departments in the (re)insurance industry have been using third party catastrophe models since the late 1980s. Most of these commercially available products are in their third generation of development and are well accepted in the market to address corporate risk management of natural peril losses. The three dominant firms providing these cat models are AIR Worldwide (AIR), EQECAT and Risk Management Solutions (RMS). In addition in-house cat models have been developed, such as the Guy Carpenter probabilistic modelling platform GCATTM. All of these models can be used in combination with Guy Carpenter’s proprietary simulation platform MetaRisk© to implement an internal model.

Results from such probabilistic models typically include exceedance probability curves, revealing confidence levels (derived from return periods) and their respective losses for the modeled portfolio.

Probabilistic cat models are tailored to illuminate diversification effects within portfolios, across countries and perils. Being designed for the risk management of (re)insurance portfolios, they bring clear advantages when used for the Solvency II internal model approaches:

  • The results from such models reflect high geographical resolution for both the modeled portfolio and the hazard component of the modelled region.
  • Most models can cope with cross country portfolios and reflect the hazard correlations appropriately.
  • Many important portfolio characteristics can be specified in the model software. Instead of relying on market averages, the model results reflect the portfolio specifics.
  • Policy conditions can be applied on a “by site” basis. Sub-limits, in particular, which can have significant impact on the capital charge estimates, can be considered during the calculations.
  • Typically the EP-curves can be aggregated by peril, region and line of business to derive a combined capital charge for the cat-component. This will reflect various types of diversification and correlation.

The specific implementation of the probabilistic model results into the capital charge calculation will depend on the risk carrier’s internal model process. Generally, once the risk carrier’s specific portfolio has been run through the cat models, the 1 in 200 year losses for each peril will be available by line, by country, both gross and net of reinsurance.

Compared to the methods available in the standard formula, the internal model approach is the more flexible and accurate as it is the only one that reflects the company-specific exposure profile adequately. However, this gain in accuracy goes hand in hand with a regular adjustment and approval process. One challenge in using vendor cat models is the fact that they are regularly updated, sometimes with important changes in result output. In case of a model version upgrade a risk carrier might have to go through a new approbation cycle with the regulator when the new model is implemented.

 
                3.  Conclusion

The latest set of advice and consultation papers produced by CEIOPS demonstrates a trend towards increased capital requirements; the risk capital needed to cover catastrophe risk does not make an exception in this respect. The standardized scenarios for the standard formula are still under development and not expected before the second half of 2010. The factors within the simplified factor method suggested in CP71 tend to result in higher capital charges compared to those of the QIS4 exercise. The factors are subject to the final set of advice expected at the end of March 2010. If the trend towards more rigid requirements prevails in defining the standardized cat scenarios, more mid-sized companies may consider whether a partial internal model is a more viable option. Risk carriers will look more toward (partial) internal model solutions in this case.

 
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

 

Link to Part I:  Standard Formula Approach

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