APRA Capital Review update on Insurance Concentration Risk Charge

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Stephen Green
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1 APRA Capital Review update on Insurance Concentration Risk Charge This note provides a brief update (as at 14 September) of what we know about the Insurance Concentration Risk Charge (ICRC) in APRA s current review of capital. September 2010

September) of what we know about the Insurance Concentration

2 APRA s recent activity in this area Date 13 May June September September 2010 Event Discussion paper ICA/APRA Seminar QIS Issued IAAust/APRA Seminar Message Technical paper expected in June Single site, single peril proposed Possible formula with multiple events Technical paper expected in July More questions on concentration risk No sign of technical paper Updated thinking on property cat approach Different formula suggested for multiple events The latest update APRA used the occasion of the 8 September Sydney seminar sponsored by the Institute of Actuaries to outline their current thinking regarding insurance concentration risk. Key points to emerge were: 1. There has been a significant rethink since the 30 June discussion. 2. The technical paper is well progressed, with the aim of a September release but no definite date. 3. Maximum Event Retention (MER) assessment will be on a whole of portfolio basis, not a single site, single peril basis. 4. The return period for the MER will be 1 in 200 years (0.5%), reduced from the previous 1 in 250 years (0.4%). 5. A new formula has been suggested to deal with multiple events in a year and recognise any aggregate reinsurance protection. 6. Partial recognition of diversification will be achieved by adding the ICRC to the Insurance Risk Charge before calculating the aggregation benefit with Asset Risk Charges. A further seminar will be held in Melbourne on 23 September, so if anyone would like to hear more or take up questions with APRA they can do so there. September

thinking on property cat approach Different formula suggested for multiple events The latest update APRA used the occasion of the 8 September Sydney seminar sponsored by the Institute of Actuaries to

3 What about non-property exposures? The suggested formula is clearly only intended for property catastrophe exposures. For the many insurers with some other form of insurance concentration risk, there was only the following news: The concept will be a 1 in 200 year event, with appropriate allowance for reinsurance protection and an attempt to avoid double counting with the premium liabilities. For Lenders Mortgage Insurance, APRA intends to follow the proposals in its 2008 discussion paper, and will need to recalibrate factors based on inputs to the QIS. The new formula for multiple events The formula suggested for the Insurance Concentration Risk Charge, to allow for multiple events in a year, is: ICRC = A² + B² xAxB where A is the net cost of a PML event (retention plus reinstatement), which is the current ICRC and B is a new formula for the net cost of multiple events in a year. B = the greater of the net cost of [three 1-in-10-year events, or four 1-in-6-year events] less 1.2 times the allowance in premiums for events. The square root formula allows some diversification between the two components. The components in the formula for B are set at the beginning of each year and require an estimate of the net retained cost to the insurer (including reinstatement) of the two alternative event scenarios. It is immediately clear that aggregate style reinsurance protection for multiple events will have a big part to play in the calculation of B. What will it mean for insurers? We expect most insurers catastrophe retention will be lower than the 1-in-6-year event loss. Thus, each of these four events would cost a full retention, and the four 1-in-6-year scenario would automatically give a higher value than the three 1-in-10 year event loss scenario. Assuming adequate reinstatements are available (and ignoring any aggregate protection), the first half of formula B will give a number equal to four times the catastrophe retention. If there are reinstatement premiums, or exhaustion of the first layer, the number will be greater. Aggregate protections, on the other hand, will act to reduce the net cost of at least some of the sequence of loss events in each scenario. The precise details of the aggregate protection (layers, deductibles and limits) will need to be factored into this calculation. September

protection and an attempt to avoid double counting with the premium liabilities.

4 page 5 link What about the average catastrophe cost included in premiums? If this refers to the expected retained cost only (not the full cost of catastrophe reinsurance premiums) it would typically be of the order of one to two times the retention. The actual value, however, depends on the volume of premium written. If, for example, it was 1.5 times the retention, then B would be 2.2 times the retention. In this example the Insurance Concentration Risk Charge would then be 2.6 times the catastrophe retention, compared with one retention in the current regime. At first glance, then, the Insurance Concentration Risk Charge looks set to increase by around two to three times under the suggested formula, before factoring in any aggregate reinsurance protection. Preparing for the QIS Given the potential significance of this change, it is worth beginning the preparation for the QIS. The first step is to get current estimates of the gross catastrophe event cost (whole of portfolio) at the following return periods: 6 years 10 years 200 years 250 years (current PML return period) The other critical estimate needed will be the average catastrophe cost included in premiums. Once this information is available, the calculations will be a little tedious but not complicated, requiring careful application of the reinsurance program to the estimated event costs under each scenario, with allowance for reinstatements and layer exhaustion. Implications If APRA proceeds with this suggested formula for multiple events, or something similar, the most likely result is a demand for aggregate reinsurance covers that will, along with protecting the insurer from multiple events, mitigate the higher capital requirements. With the formula as suggested, the final insurance concentration risk charge cannot be less than the current approach (which is A, one retention plus reinstatement). The increase above this amount can be mitigated by suitably designed aggregate cover, but to get the maximum benefit a large amount of aggregate cover will be needed (something close to three retentions in total), along with a low second loss retention. Conclusion If APRA does adopt the suggestion outlined at the 8 September seminar, the result will be a further increase to minimum capital requirements, and higher demand for aggregate reinsurance protection. September

The actual value, however, depends on the volume of premium written. If, for example, it was 1.5 times the retention, then B would be 2.2 times the retention.

5 Disclaimer This article is based on our current understanding of the proposals which are in draft form and in some cases, incomplete. It does not constitute either actuarial or investment advice. While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct. Further clarification can be sought from our consultants. Contacts Geoff Atkins Scott Collings Karen Cutter Copyright 2010 Finity Consulting Pty Limited Sydney ph: fax: Level 7, 155 George Street THE ROCKS NSW 2000 Melbourne ph: fax: Level 6, 30 Collins Street MELBOURNE VIC 3000 Auckland ph: fax: Level 27, 188 Quay Street AUCKLAND 1010 Finity Consulting Pty Limited ABN:

Contacts Geoff Atkins geoff.atkins@finity.com.

Discussion Paper. Maximum Event Retention for Lenders Mortgage Insurers. www.apra.gov.au Australian Prudential Regulation Authority.

Discussion Paper. Maximum Event Retention for Lenders Mortgage Insurers. www.apra.gov.au Australian Prudential Regulation Authority. Discussion Paper Maximum Event Retention for Lenders Mortgage Insurers September 2008 www.apra.gov.au Australian Prudential Regulation Authority Disclaimer and copyright This prudential practice guide