September 22nd, 2010

World Catastrophe Reinsurance Market: Part III, Catastrophe Model Developments, Impact of Changing Regulations

Posted at 1:00 AM ET

Catastrophe Model Developments

The increasingly complex nature of the reinsurance industry and the growth in alternative risk transfer instruments such as catastrophe bonds have reinforced the importance of catastrophe models and data management platforms in the risk management process. Such innovations have allowed (re)insurers to improve their understanding of natural perils while accurately estimating potential catastrophe losses to their portfolios and managing their exposures.

In addition to accessing all of the major commercial models, Guy Carpenter’s clients can benefit from our proprietary models that have been created with our vast data pool to analyze risks in areas where no commercial modeling solution exists. i-aXs®, our award-winning data management platform, also enables clients to evaluate loss potential from the onset of events and provides guidance all the way through the claims process.

New Probabilistic Flood Model for France

As part of Guy Carpenter’s drive for innovation, a state-of-the-art probabilistic flood model for mainland France was launched in June 2010. The model was developed in collaboration with JBA Consulting, a hydrological and hydraulic modeling expert, and Intermap Technologies, a global provider of high-quality 3-D digital elevation models.

By combining Intermap’s high-resolution digital terrain model of mainland France with JBA’s unique 2-D hydrodynamic modeling approach, Guy Carpenter’s France flood model contains the most detailed and uniformly accurate set of countrywide flood hazard maps currently available for the French territory.

The new flood model integrates these state-of-the-art flood hazard maps into the next generation of Guy Carpenter’s probabilistic model platform, providing clients with France’s first countrywide probabilistic flood model tailored for reinsurance and risk management purposes. Utilizing the latest and best technology, highly accurate flood plain boundary maps are available for the French river network, inclusive of water depths for a range of return periods.

The model incorporates a stochastic event set, with 4,000 synthetic events that have been extrapolated from observed data, reflecting the temporal and spatial correlation of flooding events between river basins. The model also contains historic event sets with the boundaries of 14 previous French flood events, including the Paris flood of 1910 (see Figure 8).

world-cat-2010-figure-8

Other flood types have also been incorporated into the model, including events that result from groundwater fluctuations and pluvial flood. Modeling of groundwater and pluvial flooding has been carried out for 43 urban areas of France. Such groundbreaking features provide clients with a valuable and robust set of tools for flood risk assessment across the entire French mainland, allowing them to make informed risk management and reinsurance decisions.

i-aXs®

Guy Carpenter’s i-aXs platform provides a full suite of tools to help users translate their data instantly, allowing for faster and better informed decisions. Delivered via an easy-to-use homepage, the award-winning platform integrates sophisticated data analysis systems, cutting-edge special technology and satellite imagery. i-aXs enables clients to view, graph and map their data, so they can assess one portfolio, combine multiple portfolios or drill down into the data to individual locations.

As part of the i-aXs platform, RealCatiX reports assist in monitoring and assessing potential losses to a portfolio as an event is unfolding. RealCatiX covers several perils, including hurricanes, typhoons, earthquakes, wildfires, tornadoes, hail, flood and straight-line wind. By combining satellite imagery with streaming hazard data showing precipitation bands, wind speeds, earthquake MMI and other related details, users are able to track the potential impact of an event on their portfolios’ locations.

For tropical cyclones, RealCatiX reports automatically calculate the portfolio’s exposure to current, forecast or observed wind fields. Users can drill down to view individual locations and all related policy details, enabling them to gauge in minutes whether a storm has affected (or is predicted to affect) a given portfolio.

world-cat-2010-figure-9

Additionally, by accessing the platform’s real-time hazard layers, users can gain a full view of a weather-related event - where it has been, where it is forecast to go - regardless of where the exposures are dispersed.

Updates to Models Licensed by Guy Carpenter

The three main commercial modeling companies, AIR Worldwide, EQECAT and Risk Management Solutions (RMS), have all announced plans to update their existing models or launch new products. Most of the planned changes relate to wind and earthquake risks.

AIR has already announced significant upgrades to its Atlantic hurricane and European windstorm models. RMS also intends to upgrade and expand its hurricane and European windstorm model offering early next year. EQECAT, meanwhile, has launched a typhoon model for Asia and updated its U.S. earthquake model.

AIR

AIR released its latest hurricane model for the United States in July. The new version contains hazard and vulnerability updates and uses the latest science, data and claims information from recent storms to provide a more detailed view of US hurricane risk. AIR said the model’s hazard module incorporates improved knowledge of the full structure of hurricanes, while significant enhancements have also been made to the vulnerability component of the model.

The model also captures the possibility of a hurricane re-intensifying after landfall. Although AIR says this occurs in less than 5 percent of all landfalling hurricanes, the impact on inland losses can be significant (as demonstrated by Ike in 2008) and AIR has accordingly incorporated three new states (Illinois, Indiana and Missouri) into the model to provide more coverage of inland risk.

For Europe, AIR has updated its European windstorm model based on numerical weather prediction methodology that produces high resolution wind data. Other enhancements have been implemented, including the explicit modeling of storm clustering and updated damage functions based on recent storm surveys and extensive claims data from historical events.

EQECAT

EQECAT launched its new basin-wide Asian typhoon model in July to help (re)insurers assess the risk across the entire western Pacific basin (including Japan, China, Taiwan, South Korea, the Philippines, Thailand and Malaysia). In addition to capturing relevant spatial correlations for typhoons that impact more than one country, the model factors in the direct effects of wind, storm surge and typhoon-induced flooding. It also
considers local variations in building practices, design and building codes.

EQECAT has also updated its US earthquake model so that it now uses the 2008 U.S. Geological Survey earthquake model and incorporates soil-based attenuation and three dimensional vulnerability modeling approaches.

RMS

RMS aims to launch its batch of model releases in February of 2011, with major upgrades to its Atlantic basin hurricane model planned. This includes an update to the U.S. mainland and Caribbean model, while new hurricane models will be introduced for Bermuda, the East Coast of Canada, the Atlantic coast of Mexico and Central America (including Belize, Costa Rica, Guatemala, Honduras and Nicaragua). The updated model utilizes scientific advancements in wind and storm surge modeling and incorporates claims data from recent landfalls, building code compliance expertise and advanced re-sampling of historical observations to provide an updated view of hurricane-related risk, both on and offshore.

An update to RMS’s European windstorm product is also planned, with a comprehensive upgrade of all components of the model and an extension in scope to include the Czech Republic, Poland and Slovakia. RMS’s European earthquake model, meanwhile, is being updated for Greece and Turkey and extended to Bulgaria, Hungary, Romania and Slovenia. Finally, a new China typhoon model will provide a probabilistic risk solution for wind and associated flooding and an update to the existing Hong Kong typhoon model is also planned.

Impact of Changing Regulations

Such advancements in modeling technology have helped (re)insurers evaluate their exposures and deploy their capital as effectively as possible. This has become increasingly important as (re)insurers look to secure a competitive advantage while meeting regulatory requirements. In the near future, new proposed regulations, and Solvency II specifically, will impose challenging new capital requirements on European (re)insurers.

Solvency II

Solvency II is the European Union’s new regulatory framework for insurance companies that will be introduced in January of 2013. It is based on an economic assessment of the risk and capital of insurers, requiring them to apply economic principles when calculating their required and available regulatory capital. Solvency II will cover all of the risks faced by an insurer, such as market and credit risks that were not considered in its Solvency I predecessor. A particular feature of Solvency II is that it will give much greater consideration to the use of reinsurance for capital relief, and it is clear that catastrophe exposure will be a key driver in the calculation of the solvency capital requirement (SCR).

In the non-life underwriting risk module of the SCR, catastrophe risk is defined as “the risk of loss, or of adverse change in the value of insurance liabilities, resulting from the significant uncertainty of pricing and provisioning assumptions related to extreme or exceptional events.” (7)   Catastrophe risk stems from extreme or irregular events that are inadequately captured by the Solvency II capital requirements for premium and reserve risk, warranting a separate method to compute the catastrophe risk capital charge.

The SCR is the generic capital requirement that will be applied to all primary insurers and reinsurers across the European Union. Calibration of the SCR’s catastrophe sub-module is set to a 1:200 year return period (99.5 percent VaR) over a one-year time horizon. Under QIS 5, insurers using the SCR formula will have to calculate their catastrophe risk exposure using either standardized scenarios (Method 1) or factorbased methods (Method 2). Method 2 might be needed by companies to calculate capital requirements for exposures outside the European Economic Area, miscellaneous insurance business or non-proportional reinsurance.

The standardized natural and man-made catastrophe scenarios will be on a gross basis per event or peril and not by line of business. The Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) considered this approach to be more appropriate due to tail correlation across different lines of business. Natural catastrophe scenarios will cover perils arising from windstorm (including storm surge), flood, earthquake, hail and subsidence. Man-made events will cover motor, fire, marine, aviation, liability, credit and surety and terrorism. The standardized scenarios will not apply to non-proportional reinsurance underwriters. CEIOPS argues that the relationship between total insured value and the loss damage ratio is more variable between reinsurance undertakings from year to year than for direct or proportional reinsurance underwriters. This arises from the level of deductible at which non-proportional business is written and the pattern of the reinsurer’s participation in the program. CEIOPS believes that the complexity consequent upon allowing for non-proportional business is disproportionate to any potential benefits that may be gained by revising  “generic” scenarios that may cover the myriad variations possible in excess of loss reinsurance. Subject to the approval of their regulator, insurers and reinsurers will be able to use either full or partial internal models instead of the SCR scenarios to calculate their regulatory capital requirement. This can lead to situations that might provide opportunities to show that the company’s particular risk exposure qualifies for a lower capital requirement than the generic SCR formula, albeit with a higher burden of documentation. This is likely to benefit the providers of vendor catastrophe models and other products, such as Guy Carpenter’s recently launched French flood model, that enable insurers to model their catastrophe exposure with greater precision than the standardized scenarios.

Furthermore, because the basis of the catastrophe risk element in the SCR formula is individual catastrophe events, proportional and non-proportional reinsurance will have much greater scope for achieving capital relief than in the premium and reserve elements of the underwriting risk category, which are essentially volume-driven despite the fact that QIS 5 has newly introduced a company-specific adjustment factor for premium risk to more appropriately capture per risk excess of loss treaties. Stop loss covers and aggregate limits can be used, though the explanation of the net exposure estimate to the satisfaction of the regulator will be required. The inclusion of multiple events in the scenarios means that capital credit can be gained for buying cover with reinstatements. Catastrophe bonds and ILWs can also qualify for capital relief provided the basis risk inherent in these products can be shown to be minimal or, if material, the basis risk can be appropriately reflected in the SCR calculation.

What does this mean for buyers and sellers of catastrophe reinsurance? In central Europe a significant number of insurers are still not covered to the 1:200 return period. At its simplest, we would expect to see increased demand for top natural catastrophe layer given that the cost of the reinsurance is usually lower than the regulatory capital cost of retaining the risk, though this assumes that the small and medium-sized insurers will adopt a risk-based capital approach beyond SCR. Nevertheless, even the standard formula with its standardized catastrophe scenarios is improving the understanding of insurers’ exposure to different catastrophe perils.

Consequently, more insurers are seeking to protect their retentions after the catastrophe XOL with multi-peril stop-loss or aggregate XOL on their retention to protect against deviations to budgets. The use of a specified event or peril may also impress buyers to consider in more detail the possible accumulation over several lines of business with a consequential adjustment to the reinsurance structure, though this would also affect the seller with a concomitantly negative impact on capacity.

From the reinsurers’ perspective as sellers of protection, we do not expect significantly higher capital requirements because most European reinsurers are already using internal economic capital models and, in many cases, managing their capital to the demands of the upper echelon of rating agencies’ requirements. There is also an expectation that reinsurers’ revenues will increase as insurers review their catastrophe exposures and buy more to mitigate the higher capital cost. However, only time will tell if the extra reinsurance required will be of sufficient quantity and duration to have a sustainable and favorable impact on reinsurers’ earnings.

Domicile

Solvency II, tax legislation and more general regulatory changes have prompted some(re)insurers to reassess their domicile. The importance of Bermuda to the reinsurance industry grew during the last decade as the speed in getting regulatory approval to start trading combined well with the island’s favorable tax system and geographical proximity to the United States and Europe.

However, potential regulation changes have since prompted some (re)insurers to question whether Bermuda can maintain its status as the number-one location for (re)insurance companies. The emergence of other viable alternatives has seen the issue of domicile become an important consideration for businesses.

For years, Bermuda has been the domicile of choice of (re)insurance companies, attracting start-up companies in the wake of market-changing events, including Hurricane Andrew in 1992, the terrorist attacks of September 11, 2001, and Hurricane Katrina in 2005. However, rival domiciles have taken note of Bermuda’s success and
implemented their own business-friendly policies in an attempt to attract operations away from the island. The Republic of Ireland and Switzerland, in particular, have lured several (re)insurance companies over the last couple of years.

It is fair to assume that taxation is a key consideration when companies move. However, Bermuda continues to offer one of the most competitive tax systems in the world, with no levy on profits, income, dividends or capital gains. Although Ireland’s standard rate of corporation tax is among the lowest in the world (12.5 percent), it is still considerably higher than Bermuda’s. The UK’s corporation tax rate of 28 percent was instrumental in Brit Insurance’s decision to decamp to the Netherlands in 2009.

So what has prompted this wave of redomiciling from Bermuda? Tax is in fact an important reason. Following the global bailouts of financial institutions after the credit crunch, governments around the world are now looking to crack down on territories carrying the ‘tax haven’ stigma. In the United States, proposed legislation that seeks to prevent reinsurers from moving ‘excessive’ portions of their U.S. premiums to offshore affiliates to lower their tax burden is currently being debated in Congress in the form of the Neal Bill. A watered-down version of the bill has also been incorporated into the Obama Administration’s 2010 budget plan.

The debate has split the industry, with US-domiciled insurers in favor of the legislation and foreign reinsurers against. Indeed, although the bill is primarily aimed at the Bermudian market, the European insurance and reinsurance federation has stated its opposition, as it estimates the measure would double tax rates for European reinsurers that operate in the United States, significantly increasing costs and rates.

Therefore, the uncertain regulatory environment, combined with the increasing difficulty of obtaining work visas in Bermuda and the shortage of accommodation, offices and schooling on the island, has prompted some (re)insurers to move. Ireland and Switzerland have emerged as the new domiciles of choice with Beazley, XL Capital and United America Indemnity moving to Dublin, and Zurich welcoming ACE, Amlin Re, Catlin Re and Novae Re.

What has attracted these companies to Ireland and Switzerland? Both countries offer relatively stable tax systems and their corporate tax rates are below the European average. In uncertain times, larger countries can offer more security and capital-raising potential than smaller offshore territories and both Ireland and Switzerland have tax treaties with other major markets, including the United States. Their location is also
crucial as it allows companies to move closer to their clients. In addition, Ireland’s EU membership and stable regulatory environment makes it a very attractive destination. The role played by Solvency II is also relevant. In explaining its decision to establish a reinsurance platform in Zurich, Catlin highlighted opportunities arising from Solvency II as a key factor in setting up the operation.

However, all this does not necessarily mean we are going to see a mass exodus from Bermuda and other low-tax domiciles. Clearly, much depends on what, if any, legislation is passed in the United States. If no changes are implemented, Bermuda will continue to attract businesses. There are also subtle differences between the provisions of the Neal Bill and what the Obama administration has proposed. One key difference is over the definition of excessive reinsurance. The Obama Administration has proposed to use a 50 percent threshold while the Neal Bill would use an industry average. Paradoxically, if the Obama Administration’s proposal were to become law, U.S.-based (re)insurerscould be encouraged to open operations in Bermuda as it could significantly cut their tax burden.

But favorable tax rates only tell part of the story. Bermuda continues to be a well regulated (re)insurance domicile and, regardless of any tax changes, it has proved its worth to the industry and is, therefore, likely to remain one of the preeminent centers of insurance business in the world, especially for property catastrophe reinsurance. Indeed, Bermuda is itself looking to compete with other territories, the Cayman Islands particularly, by targeting opportunities in the insurance-linked securities market. Moreover, Bermuda has taken the lead in addressing some of the external concerns, meeting with US officials and tightening money laundering regulations.

Yet despite this, the financial crisis and the subsequent governmental push to close the tax gap have hit Bermuda’s dominance in attracting reinsurance business. The rise of alternative domiciles such as Dublin and Zurich pose a credible threat in becoming the destination of choice for (re)insurers. Although their rise is unlikely to herald the demise of offshore territories, Ireland and Switzerland will undoubtedly look to consolidate their recent success and challenge Bermuda’s established (re)insurance supremacy over the next decade.

Footnote:

7 Solvency II Framework Directive (Directive 2009/138/EC).

Click here to read Part I: Executive Summary, Catastrophic Events of 2010 >>

Click here to read Part II: Impact on Reinsurance Market, Catastrophe Bond Update >>

Click here to register to receive e-mail updates >>

Securities or investments, as applicable, are offered in the United States through GC Securities, a division of MMC Securities Corp., a US registered broker-dealer and member FINRA/SIPC. Main Office: 1166 Avenue of the Americas,New York, NY 10036. Phone: (212) 345-5000. Securities or investments, as applicable, are offered in the European Union by GC Securities, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., MMC Securities (Europe) Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance, or insurance product.

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