Solvency Consulting Knowledge Series

Solvency II and catastrophe risks: Measurement approaches for propertycasualty insurers

Country-specific requirements or standard formula?

Authors: Dr. Kathleen Ehrlich Dr. Norbert Kuschel Contact solvency-solutions@munichre.com You can download the Knowledge Series at www.munichre.com May 2011

Altogether, the insurance industry had to shoulder losses of some US$ 37bn for natural catastrophes worldwide in 2010.1 The series of natural catastrophes experienced in that year continued in the first quarter of 2011: more floods and Cyclone Yasi in Australia, a second strong earthquake in New Zealand, and then the devastating earthquake in Japan. Events such as these make the requirement in the Solvency II Directive to maintain sufficient capital in future to cover catastrophe risks appear all the more reasonable. It defines catastrophe risk as the risk of loss, or of adverse change in the value of insurance liabilities, resulting from significant uncertainty of pricing and provisioning assumptions related to extreme or exceptional events.2 In the fifth quantitative impact study, insurance companies were able to test two valuation methods3: Method 1: Standard scenarios Method 2: Factor-based approach

Method 1 draws a distinction between natural catastrophes and man-made catastrophes. First, the capital requirements for each peril are aggregated at country level to determine the catastrophe risk capital per peril. Then, the capital requirements are aggregated using a correlation matrix prescribed by CEIOPS. This produces the natural catastrophe risk capital according to Method 1. The natural catastrophe risk capital and the risk capital for man-made catastrophes should then be aggregated on the assumption that they are independent of each other. Companies using the standard formula should opt for Method 1 if possible Method 2 should only be used if a company is not able to use Method 1.

Cf. MR publication Topics Geo Natural catastrophes 2010. Analyses, assessments, positions. Available online at http://www.munichre.com/publications/302-06734_de.pdf. 2 Cf. Solvency II Directive 2009/138/EC of 25 November 2009, Art. 105 2 (b). Available online at http://ec.europa.eu/internal_market/insurance/solvency/index_en.htm#november2009. 3 Cf. Solvency Consulting Knowledge Series QIS5: European Commission publishes instructions for fifth Quantitative Impact Study. Available online at: http://www.munichre.com/touch/ publications/de/list/default.aspx?category=22.

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Method 2 is factor-based, the capital requirement being calculated by multiplying a risk factor by a volume figure. The risk factors relate to individual events. The volume figure is calculated by apportioning the gross premiums written for a business segment to the events. The QIS5 results indicate that European non-life insurers need to allocate around a quarter4 of their entire risk capital to catastrophe risks (Figures 1 and 2). Risk capital requirements vary considerably between countries across ex Europe (Figures 3 and 4).7 For ample, Figure 3 shows that in three countries 90% of the risk capital requirement for natural catastrophes relates to windstorm scenarios, whilst they account for between 20% and 90% in six countries and 0% in five, the main risk exposure to natural catastrophes in three of those countries being in earthquake scenarios. In four other countries, flooding accounts for more than 80% of the main risk exposure. On average in the EU, just under 40% of natural catastrophe capital requirements relate to windstorm scenarios, around a third to flooding and 12.5% to each of earthquake and hailstorm. Figure 4 shows the distribution of the manmade scenarios fire, marine, thirdparty liability, terrorism, motor liability, credit and aviation by country. Across the EU as a whole, third-party liability risks are the most significant, followed by fire and terrorism.

Figure 1: Basis SCR for solo non-life insurers (diversified)5

% 100 80 60 40 20 0 Market risk Counterparty default risk Life Health Non-life Intangible assets BSCR 32.8% 7.0% 0.5% 52.4% 0.4% 100%

7.0%

Figure 2: Underwriting risk for solo non-life insurers (diversified)6

% 120 100 80 60 40 20 0 Premium and reserve Catastrophe Lapse Diversification Gross non-life underwriting risk 70% 50% 1.0% 20% 100%

EU insurers are at one on the valuation method: they are demanding that the module be revised, in particular as regards the valuation methodology, the calibration, especially the factors for natural catastrophes, its applicability to certain classes of insurance and regional markets, the data requirements, particularly for the valuation of natural catastrophes, the time and effort required to calculate risk capital.

The risk driver for property-casualty insurers is underwriting risk (> 50%), of which 44% is attributable to the catastrophe risk module. Cf. EIOPA QIS5 Report, p. 10 and EIOPA QIS5 Annex, p. 22, online at https://eiopa.europa.eu/ publications/reports/index.html. 5 Cf. EIOPA QIS5 Report, p. 67, online at https:// eiopa.europa.eu/publications/reports/index. html. 6 Cf. EIOPA QIS5 Report, p. 86, online at https:// eiopa.europa.eu/publications/reports/index. html. 7 Cf. EIOPA QIS5 Annex, p. 25 f., online at https://eiopa.europa.eu/publications/reports/ index.html.

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Figure 3: Natural catastrophe risks by country

Windstorm  Earthquake Flood Hail Subsidence

Solos Groups 0% 20% 40% 60% 80% 100%

Figure 4: Man-made catastrophe risks by country

Fire  Motor TPL Marine Credit Liability Aviation Terrorism Solos Groups 0% 20% 40% 60% 80% 100%

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In 2010, the European Commission presented a proposal for the valuation of catastrophe risks. It had set up a working group to that end, the Catastrophe Task Force, the main objective of which was to compile the input and guidelines needed to achieve standard treatment of catastrophe risks throughout the EU.8 The working group comprised super visors and representatives of reinsurance companies,9 modelling firms and brokers. In their comments on QIS5, many companies stated that the tested method for valuing catastrophe risks needed to be revised, and additional stakeholder groups were brought into the working group to do this.10 The supervisors finally decided on the input they would submit to the European Commission, which is responsible for the final wording of the regulations. Nevertheless, these efforts cannot obscure the fact that a standard approach cannot cover the individual risk profile of every insurer in the EU. The standard approach is currently designed in such a way that it satisfactorily depicts the risk profile of an insurer that corresponds to the European market average. However, if an insurers risk profile differs from the market average for example because of regional catastrophe-risk concentrations or a different distribution across the personal, commercial and industrial segments the standard approach cannot produce a risk capital figure that reflects the risk profile. It would be advisable for such companies to develop their own partial internal model.

Systems for recording and valuing the loss potential of natural catas trophes are already available in some countries, for example in Austria, where the HORA risk-zoning system, accessible to the public, has been developed for natural catastrophes, focusing primarily on flood risks. Over the last few years, the system has been extended to include information on risk exposure to earthquakes and hailstorms. A windstorm intensity and frequency map is currently being produced and will also be publicly accessible. The debate on the appropriateness of the calibration would be significantly defused if such systems were approved for the calculation of solvency capital using a partial internal model within the future supervisory regulations. In addition to the development of partial models, Munich Re also supports the use of USPs (undertakingspecific parameters), a third method tested in QIS4. Companies are able to determine their exposure to natural hazards by means of individualised scenarios or stochastic models produced by modelling firms, reinsurance brokers or reinsurance com panies. These models, especially those offered by modelling firms for catastrophe risks, comply with a common market standard and hence meet high quality requirements. Com panies using them use the results obtained mainly to define the limit for their catastrophe reinsurance cover. Nevertheless, the models cannot usually depict the impact of such risk-mitigation instruments, though as the standard formula can do so, it would be possible to achieve a degree of standardisation in the depiction of simple reinsurance structures.

The main advantage of using company-specific data is to be able to circumvent the certification that would be necessary if an insurer planned to use a partial model. However, it is difficult to define USPs in the catastrophe modules of partial models. As yet, no satisfactory solution has been found to the problem of deriving USPs from the stochastic models mentioned most of the proposals involve using a partial model. Moreover, according to the current state of the debate, the data quality requirements for USPs will be similar to those for partial models. A comparison of the use of USPs in QIS5 in the individual sub-modules of the underwriting risk module for non-life insurers shows that they are not being used in a standard way (Table 1).

Cf. Catastrophe task force report on standardised scenarios for the catastrophe risk module in the standard formula. Available online at: https://eiopa.europa.eu/publications/submissions-to-the-ec/index.html. 9 Munich Re was also represented in the working group. 10 Representatives from insurance companies and the CFO Forum have now joined the working group.

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Table 1: Possible use of USPs

Non-life premium and reserve Standard parameters/standard scenarios Undertaking-specific parameters (USPs) with standardised methods and parameters only Standard parameters USPs possible

Standard deviation NP adjustment factor Non-life cat Nat cat for individual natural hazards in each country Standard factors: other countries

Non-life premium and reserve No standard parameters Undertaking-specific data Standard scenarios: for EU countries No USPs

The application of USPs should always be brought into line with the requirements of the implementing measures. Standard parameters could then be prescribed for all submodules, which would also enable an insurance companys risk situation to be properly depicted using USPs.

Conclusion
Estimating catastrophe risks is a part of an insurers daily business, whereas developing its own partial model for evaluating risks involves substantial time and effort. There are highly developed systems available in Europe for recording and evaluating risks, especially natural catas trophe risks. Supervisors and the European Commission could therefore consider allowing companies to use systems commonly found in the market that they have already introduced and are using to evaluate their catastrophe risks without necessarily adopting the standard formula. Not only would this increase the quality of capital measurement, but it would also reduce the costs incurred by companies in committing resources to internal software development and certification processes strict requirements must be satisfied to obtain approval for USPs.

Solvency Consulting for your company

Munich Re assists its clients in all areas of Solvency II. Solvency Consulting has already amassed a wealth of experience in dealing with the standard formula, the development and use of internal stochastic risk models and their relevance to valuebased portfolio management. Munich Re also plays an active role in industry committees looking at regulation and specialist issues and ensures that knowledge and expertise are transferred and translated into practical recommendations for action on the ground. We are thus able to offer our clients real and ongoing help in preparing for Solvency II.

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