May 24th, 2010

Solvency II – Non-Life Underwriting Risk in Light of QIS 5

Posted at 1:00 AM ET

Frank Achtert, Managing Director, Financial Intelligence Team, and Sebastien Portmann, Vice President, Financial Intelligence Team
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On April 15th, 2010, the European Commission (EC) published its draft technical specifications for the next Quantitative Impact Study (QIS) 5, which will be implemented from August to November of 2010. Based on empirical evidence, the general calibration of the standard formula solvency capital requirement (SCR) may fall between the calibration of QIS 4 and the calibration seen in the rigid proposals of the various consultation papers (CP) submitted during 2009. This article takes a deeper look at the calibration of non-life underwriting risk as part of the overall SCR calculation.

Introduction

In addition to premium, reserve and catastrophe risks, the draft included a newly introduced sub-module for lapse risk within the non-life underwriting risk section that only applies in rare cases. As presented, the lapse risk is considered uncorrelated to premium and reserve risk. However, a correlation factor of 0.25 percent was introduced between catastrophe risk and the other non-life underwriting risk components.

Premium and Reserve Risk

The table below presents a comparison of the risk factors applied to net premium and net reserves under QIS 4, CP 71, the final advice and the QIS 5 draft for non-life premium and reserve risk.

nlu-may-19

1 In the final Advice NCR/GCR stands for Net Combined Ratio divided by Gross Combined Ratio

2 In QIS5 Draft NCR/GCR stands for Net-Gross Ratio

The EC has clearly responded to industry concerns claiming that the factors proposed during 2009 were disproportionately severe. QIS 5 draft specifications appear to be more in line with, but in general, above, QIS 4 factors.

To improve the risk-sensitivity of the standard formula in order to more adequately reflect the risk mitigation effect of non-proportional reinsurance, a company-specific adjustment factor for premium risk was introduced. The individual factor is based on the company’s prior year’s experience and is a function of the net to gross claims volatility by line of business. Despite the fact that the introduction of a company-specific adjustment factor is a first step in the right direction, limitations seem obvious. For instance, the factor is not necessarily representative of the level of future claims volatility experience of the company, given that the factor is derived from the company’s prior year’s claims only. Also, specific reinsurance features such as annual aggregate deductibles cannot be considered.

Reserve risk factors have been already adjusted for reinsurance and therefore no further adjustments are necessary, according to CEIOPS. The specifications also provided relief around geographical diversification efforts, compared with the levels seen in the consultation papers.

Catastrophe Risk

The technical specifications draft also shows how standardized catastrophic scenarios will be represented in QIS 5. They will represent a one in 200 year catastrophe loss for the insurer, derived from a one in 200 year industry loss level. These scenarios are still under development and completion is scheduled for June of 2010.

The technical specifications draft of QIS 5 provides illustrative natural catastrophe scenarios for several perils and countries and selected man-made event scenarios. The natural catastrophe scenario calculation uses the concept of total insured values (TIV) by peril and country on a Catastrophe Risk Evaluating and Standardizing Target Accumulations (CRESTA) zone level. TIV for each CRESTA zone are adjusted with a relativity factor and then aggregated. Correlation matrices are provided for countries and perils. Individual reinsurance structures are applied to the gross scenarios and account for the occurrence of two subsequent events with different weights for windstorm and flood.

The technical specifications draft did not provide scenarios for exposures outside the European Economic Area (EEA). It is assumed that risk carriers with material non-EEA exposure will seek approval for the use of (partial) internal models. Similarly companies with major non-proportional inwards reinsurance business are expected to develop internal models.

There may be instances where the use of these standard scenarios would not be appropriate. For example, when the risk profile of a company is not well represented by the standard scenario and the use of a partial internal model is not proportionate, a simple factor based method will be provided in QIS 5. The factors suggested in the draft to be used for the QIS 5 exercise are:

events1

The factors have been calibrated gross of reinsurance. This approach enables companies to apply the respective reinsurance program in order to estimate the net capital amount.

Conclusion

The final technical specifications for QIS 5, the next impact study, may deviate from this draft. However, it is likely that the QIS 5 capital pressure on non-life underwriting risk will be higher compared to QIS 4 results seen prior to the financial crisis and lower compared to the rigid calibration suggested in various consultation papers in 2009. It is noteworthy that the introduction of a company-specific adjustment factor for premium risk is a first step towards incorporating non-proportional reinsurance in the standard formula. Catastrophe scenarios are still under development and are expected to be completed by June of 2010.

Contact Information

This internal briefing was prepared by Guy Carpenter’s Financial Intelligence Team (FIT). Questions regarding this briefing may be directed to any of the FIT group members, listed below.

Frank Achtert, Managing Director, Munich                   +49 89.28.66.03.361
David Flandro, Managing Director, London                  +44 (0)20 7357 3267
Eddy Vanbeneden, Managing Director, Brussels         +32 2.674.98.11
Benoît Butel, Vice President                                        +33 1.56.76.48.26
Sebastien Portmann, Vice President, Zurich                +41 44.285.9322
Florent Scarabin, Vice President, Stockholm                +46 8 505.73549 

The data contained herein is provided for information purposes only. Guy Carpenter makes no representations or warranties as to the accuracy of such information nor is it obligated to update such information. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such.

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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