the non-life catastrophe risk in the EIOPA publishes guidelines Authors Dr. Norbert Kuschel Katja Losko July 15 Introduction The history of the insurance industry has been repeatedly marked by numerous large-loss events. Such catastrophes can be caused by both natural hazards (windstorms, earthquakes and floods) and man-made losses (fire, terrorist attacks, motor vehicle accidents and liability claims). In the absence of appropriate riskmitigation techniques (e.g. reinsurance), the resultant large catastrophe losses can place an insurance company in a serious financial situation, which creates a risk for policyholders. An example of this was Hurricane Andrew in Florida in 1992, a natural catastrophe event that led to the insolvency of 11 insurance companies. 1 Assessing catastrophe risks is something insurers do every day. There are highly developed systems in Europe for recording and evaluating risks, especially natural catastrophe risks. However, appropriate risk spreads also have to be determined in the premium calculation for so-called man-made catastrophes, such as large fire losses or major liability claims. To ensure that insurance companies have sufficient capital available to meet all of their obligations even after such catastrophe losses have occurred, the standard formula prescribed under the new Solvency II supervisory regime provides for an independent calculation of the capital requirement in the non-life catastrophe risk sub-module. A detailed description of the methodology and an assessment of the quality of the calculations has already been provided in this series. 2 In the course of the stress tests for insurance companies in 14, 3 EIOPA discovered that after deduction of reinsurance the natural hazard scenarios had little effect. This is mainly due to the fact that many companies have already adapted their reinsurance programmes to the Solvency II requirements, but despite this, a minority of companies remain exposed to significant adverse effects on the net risk capital situation. In almost every case, it is worth considering the use of reinsurance solutions as provided for under the new Solvency II regulations. Munich Re has already advised clients on optimising their reinsurance programme for Solvency II and the results of these numerous projects generally reduced the risk capital for natural hazards for the companies concerned. 1 Insurance Information Institute Catastrophes: Insurance Issues-The topic, September 14, online at http://www.iii.org/issue-update/catastrophes-insurance-issues 2 Solvency II and catastrophe risks: Measurement approaches for property-casualty insurers, online at www.munichre.com 3 EIOPA publishes the results of the insurance stress test 14, online at www.munichre.com
Page 2/8 But what are the rules for recognising risk-mitigation techniques such as reinsurance in the non-life catastrophe risk sub-module? The delegated acts published in January 15, 4 which constituted the Level 2 text in the Lamfalussy process, only cover the recognition of reinsurance on a principles basis, providing no clear help on actual implementation. This raises numerous questions for both insurance companies and local insurance supervisors on exactly how the delegated act is to be applied: How can aggregating catastrophe events affecting several risk classes be identified and their impact quantified? How can a multinational insurance company break down gross losses by country or other component? What does an insurer do if, for example, a multi-country NatCat cover is in place? How can multi-line reinsurance treaties be recognised to mitigate risk? To answer these and many other questions, a working group under the leadership of EIOPA has worked over the last few years to produce guidelines. The aim of the Guidelines on application of outwards reinsurance arrangements to the non- life underwriting risk sub-module 5 (the Level 3 document in the Lamfalussy process) is to guarantee uniform application of the sub-module, including the treatment of reinsurance contracts concluded by companies. The Guidelines are aimed primarily at the supervisory authorities concerned by Solvency II, who are then responsible for implementation with the insurance companies. Non-life catastrophe risk in the framework directive and the delegated acts The Solvency II Directive obliges companies in future to maintain sufficient capital to cover catastrophe risks. The framework directive (the Level 1 document in the Lamfalussy process) defines these non-life catastrophe risks as follows: 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 (non-life catastrophe risk). 6 Taking account of the reasons below, the delegated acts 7 notably define the determination of the gross loss resulting from catastrophe events. 1. The scenario-based calculations for the catastrophic risk in non-life and health insurances should be based on catastrophe losses specified on a gross basis, i.e. without reinsurance. The risk-mitigating effects of the specific reinsurance contracts should then be taken into account in the calculation of the change in own funds resulting from the scenario. (Recital 49) 2. In modelling the risk in third-party liability insurance, it should be assumed that the risk of accumulation of a large number of similar losses is not material. (Recital 50) 3. When calibrating the natural catastrophes, a sufficient number of homogeneous geographical zones should be used for the modelling of the natural catastrophe risk. A value at risk with a confidence level of 99.5% should be applied to fix the risk weightings for these zones, and the correlation coefficients between the zones should be chosen in such a way that they express the dependencies between the risks in the individual zones. (Recital 53) 4. In the calculation of the capital requirement for the natural catastrophe risk, the sum insured should be fixed in such a way that it takes account of the contractual limits on indemnification in the event of a catastrophe. (Recital 54) 4 European Commission Delegated act on Solvency II: REGULATIONS COMMISSION DELEGATED REGULATION (EU) 15/35 of October 14 supplementing Directive 09/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), January 15, online at http://eur-lex.europa.eu/legal-content/en/txt/?uri=celex:315r0035 5 EIOPA Guidelines on the Application of Outwards Reinsurance: Guidelines on application of outwards reinsurance arrangements to the non- life underwriting risk sub-module, February 15, online at https://eiopa.europa.eu/pages/guidelines/guidelines-on-the-application-of-outwards- Reinsurance.aspx 6 European Commission Solvency II Directive: DIRECTIVE 09/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 November 09 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) 09/138/EG, December 09, online at http://eur-lex.europa.eu/legal-content/en/txt/?uri=oj:l:09:335:toc 7 European Commission Delegated act on Solvency II: REGULATIONS COMMISSION DELEGATED REGULATION (EU) 15/35 of October 14 supplementing Directive 09/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), January 15, online at http://eur-lex.europa.eu/legal-content/en/txt/?uri=celex:315r0035
Page 3/8 The overall capital requirement for the non-life catastrophic risk is then calculated by aggregating the risk capital requirements for the following risk classes assuming no dependencies: Aggregation of natural catastrophes (natcat), including catastrophe risks in non-proportional property reinsurance (npproperty), with full dependency assumed Man-made catastrophes (mmcat) catastrophe risks in non-life insurances (CATother) Non-life catastrophe risk in the guidelines The delegated acts define the rules for calculating the 1-in-0-years gross loss. No specific guidance is provided for the modelling of reinsurance. We will now look at the Guidelines, which specifically cover the recognition of reinsurance. Before reinsurance can be recognised, the 1-in-0-years gross loss must be determined for every submodule. The tree diagram below shows the sub-modules for non-life catastrophe risk (Non-Life CAT). Fig. 1: Structure of the sub-modules in the non-life catastrophe risk module Non-Life CAT Nat Cat Nonproportional Reinsurance Non-life CAT Flood Hail Windstorm Earthquake Subsidence Property Insurance C&S 2 Man Made 1 Marine 2 Credit and suretyship Motor Vehicle Marine Aviation Fire (Buildings) C&S 2
Page 4/8 In order to depict complex reinsurance programmes in particular, it is essential to understand the characteristics of the gross catastrophe events and to determine loss components on the basis of those characteristics, so that the company is then able to recognise accurately the risk relief provided by reinsurance. The granularity in the modelling is heavily dependent on the complexity of the reinsurance programme. The diagram below provides a simplified illustration of a typical workflow: Step 1: specifying the large loss event for every sub-module According to the delegated acts, companies should consider the specific features of the 1-in-0-years NatCat events. Many aspects can be derived directly from the definitions of loss events in the relevant sub-modules (cf. preceding section). It is essential to make use of the appropriate expert knowledge to be able to assess important factors such as the underlying risk profile, loss potentials and the legal environment (e.g. indemnity paid in motor liability insurance, compulsory professional liability insurances and changes in taxation). Companies should specify the losses defined in the various sub-modules as either aggregating catastrophe events (events with an accumulation effect on another group of contracts) or risk catastrophe events (events that affect specifically identifiable contracts or a single contract). Reinsurance solutions can now readily be recognised in standard situations, i.e. covers relating to events in which the policies affected can be identified. In other cases, a large loss has to be broken down in detail, and we consider this in Step 2. Fig. 2: Process for determining risk capital in the non-life catastrophe risk module Step 1: Identify the specifics of the 0 year gross event Specifics of the gross event which gave rise to gross catastrophe loss for each catastrophe sub-module (see figure 1) Catastrophes as aggregating catastrophe (e.g. Earthquake) events or risk catastrophe events (e.g. MTPL) Step 2: Disaggregate Depending on the r/i programme split of 0 year loss into appropriate components as LOB, region, How to split the loss? Max method Spread method Blend method Individual method Step 3: Application of reinsurance Apply reinsurance protection to specified levels Aggregating net results of sub segments Nat Cat Flood 1 Marine 2 Credit and suretyship Motor Vehicle Hail Nonproportional Reinsurance Windstorm Earthquake Subsidence Non-Life CAT Man Made Marine Aviation Fire (Buildings) Trans- Property port Insurance C&S 2 Non-life CAT C&S 2
Page 5/8 Step 2: disaggregating the gross loss to appropriate components The granularity of the breakdown depends to a large extent on the complexity of the reinsurance programme. There are three allocation methods: the max(imum) method, the spread method and the blend method. With the max method, the 1-in-0-years gross loss is allocated to the component accounting for the largest share, while with the spread method it is allocated to the components in proportion to their share in the overall gross loss. The blend method selects the higher of the two risk capital figures based on the net capital charge 8 produced by the max and spread methods. The Guidelines provide instructions on certain situations and on the choice of method. For example, for the disaggregation of the 1-in-0-years loss to regions in European natural hazard scenarios, the blend method is to be used for the windstorm risk and flood risk sub-modules, and the max method for the disaggregation of the earthquake risk and hail risk sub-modules. The example below illustrates the effect of the different methods. Please note that all calculations are based on our interpretations, and as such are in no way legally binding and do not necessarily reflect the opinions of EIOPA or national supervisors. Example 1: Cross-border exposure to the windstorm natural hazard We have simplified the example for ease of illustration. It concerns an insurer with windstorm exposure in the United Kingdom and Germany. For windstorm, two scenarios, A and B, are to be modelled and the blend method has been chosen for the allocation of the large loss. For brevity, we will focus on Scenario A. The gross loss amount for the UK and Germany is first calculated on the basis of the CRESTA zone profiles of both countries. Using the root formula and a correlation of 25% between the UK and Germany, the loss amount is (0 2 + 2 25% 0 25 + 25 2 ) = 9m, and hence the resultant large loss from the two loss events is 1.2 9m = 131m. The results are summarised in Table 1. The reason for using the blend method for windstorm is that it can either cross several countries or affect primarily a single country. By contrast, earthquakes or hail frequently affect a single country, which is reflected in the use of the max method. It is important to note that it is stated on a number of occasions in the Guidelines that companies should take their individual risk profiles into account. If the prescribed method is not appropriate, the company should select a suitable method and justify its choice to the supervisory authority. Step 3: recognition of reinsurance In many other cases, no fixed procedure is given in the Guidelines for the modelling of reinsurance relief, which is understandable in the light of the general complexity of reinsurance programmes in practice. Expert knowledge at the insurance company is of key importance. In addition to aspects of the standard catastrophe loss scenarios, other criteria such as features of the risk profile and the legal environment should be taken into account. For example, if the assumptions for the prescribed method for disaggregation of the 1-in-0-years gross loss are not compatible with the risk profile, a company should consider what method is suitable and put it to the supervisory authority. A typical case often found in practice is a cross-border NatCat cover. Example 2 below illustrates the modelling of reinsurance. Table 1: Gross risk capital for cross-border windstorm exposure ( m) Country Specified windstorm loss Gross event A1 (80%) Gross event A2 (40%) Gross loss Gross loss Max method Gross loss Spread method UK 0 80 40 1 131 (87/44) 5 Germany 25 30 0 (0/0) 26 Diversification 16 13 6 19 Total 9 87 44 131 131 131 8 EIOPA - Guidelines on the Application of Outwards Reinsurance: Guidelines on application of outwards reinsurance arrangements to the non- life underwriting risk sub-module, Guideline 8, February 15, online at https://eiopa.europa.eu/pages/guidelines/guidelines-on-the-application-of- Outwards-Reinsurance.aspx
Page 6/8 Example 2: Cross-border cover for the windstorm natural hazard (Windstorm-CXL) The client has a cross-border CXL covering UK and Germany windstorm exposure: 80m xs m. For simplicity, it is assumed that sufficient reinstatements are available. In order to cal culate the net loss if a cross-border reinsurance solution is in place, the total loss must be allocated to the countries concerned. 111m with the max method. Since the blend method is prescribed for windstorm, the higher of the figures produced by the spread method ( 32m) and the max method ( m) must be taken, so that the net SCR is 32m. The substance of the risk mitigation mechanism must also be taken into account at each stage. Thus, many of the comments in the Guidelines reflect fundamental aspects of riskbased modelling principles customary across many markets. For example, the Guidelines state that reinsurance components are recognised in the order specified in the reinsurance programme. The levels at which the reinsurance protections apply are first determined (intersections in the non-life SCR tree). This is covered in Guideline 15 and explained in Example 3 below. As a first step, the max method is applied as illustrated in Figure 3. The plafond and retention of the CXL are shown on the left of the graph. The columns UK Event 80% and UK Event 40% show the 80% and 40% loss events for the UK and the effect of the CXL. According to the max method, the loss is allocated to the country with the largest share, i.e. the UK. The subsequent steps are thus based on the total loss amount of 131m (Event A1: 87m, Event A2: 44m), which is allocated to the UK. The effect of the CXL on the 80% and 40% loss events are modelled on this basis. The loss net of reinsurance is m and the relief provided by reinsurance 111m. The steps for calculating the risk capital (SCR) according to the spread method are based on the two windstorm events with gross losses of 80m and 40m for the UK and 30m and m for Germany. The overall result is shown in the righthand SCR column. The net SCR is calculated taking account of the correlation between the UK and Germany and amounts to 32m. Thus, using the spread method the CXL can reduce the gross SCR from 131m to 32m, producing risk relief of 99m, which is lower than the Fig. 3: Max method for determining the effect of reinsurance for cross-border covers ( m) Gross loss Max UK: 87/44 Germany: 0/0 140 1 0 80 60 40 0 80 Gross loss spread w/o diversification UK: 80/40 Germany: 30/ 140 1 0 80 60 40 0 80 CXL- Layer 77 34 111 CXL UK Event 80% UK Event 40% UK SCR Fig. 4: Spread method for determining the effect of reinsurance for cross-border covers ( m) 70 UK Event 80% 30 UK Event 40% 0 UK Germany 80% Net SCR = SQR ( 2 + 2 25% + 2 ) =32 0 Germany 40% Germany 111 99 32 SCR
Page 7/8 Example 3: Cross-border cover for earthquake and flood As shown by the bordered boxes in Figure 5, the reinsurance programme covers the following relevant levels: Earthquake in the Earthquake outside the Flood The modelling then assumes that the levels above them, indicated by broken borders in Figure 5, are affected by the reinsurance protection. In the example therefore, reinsurance should not be additionally modelled at the NatCat level, as it would result in reinsurance relief for NatCat exposure being doublecounted. Reference is made to this essential point a number of times in the Guidelines in conjunction with Articles 9 214 of the delegated acts. It is also emphasised that the relief from reinsurance calculated may not exceed the possible total amount of relief according to the reinsurance programme. The modelling can also take account of reinsurance solutions covering business units or specific classes of insurance. Where reinsurance protection also covers risks outside the non-life catastrophe risk sub-module, those risks may be taken into account in the calculation of the risk relief. It is possible, for example, for an insurer with a stop-loss relating to specific classes to reflect the expected basis and gross losses in determining the attachment point for catastrophes, risk capital for those risks being already calculated in the premium and reserve risk sub-module. In addition to catastrophe reinsurance, the Guidelines explicitly refer to other classic reinsurance products, namely: Guideline 19: Proportional reinsurance (quota shares, surplus reinsurance and proportional facultative contracts) Guidelines /21: Non-proportional reinsurance (non-proportional reinsurance per risk or event) Guidelines 15/23: Aggregating reinsurance contracts (stop-loss treaties, clash covers) Once the net loss has been calculated for every level affected, it must be aggregated again (cf. Guideline 27), starting with the lowest level, i.e. in the example Earthquake and Earthquake Non-. If the recognition of reinsurance is to be more finely tuned (than in the standard approach), and the large loss allocated accordingly, the corresponding net SCRs should be added together. Fig. 5: Example of the different recognition levels for reinsurance Non-Life CAT Nat Cat Nonproportional Reinsurance Non-life CAT Flood Hail Windstorm Earthquake Subsidence Property Insurance C&S 2 Non- Non- Non- Non- France Man Made 1 Marine 2 Credit and suretyship Motor Vehicle Marine Aviation Fire (Buildings) C&S 2
Page 8/8 Conclusion The delegated acts lay down mandatory rules for determining risk capital for the non-life catastrophe risk sub-module. The purpose of the Guidelines on application of outwards reinsurance arrangements to the non-life underwriting risk submodule is to achieve uniform application of the sub-module in all countries subject to Solvency II, including the use of risk-mitigation techniques such as reinsurance. In this Knowledge Series, we have looked at the methods and approaches set out by EIOPA in the Guidelines. Specific reinsurance products were considered and the effect of risk mitigation was illustrated. Most insurers in Europe already have substantial and adequate reinsurance protection to cover the risks and hazards taken into account in the non-life catastrophe risk sub-module. However, it is important for all insurers to take account of their own risk profile in determining risk capital. They must also explain to the supervisory authority in the ORSA Process how they have reflected their individual risk situation. As, in practice, highly complex reinsurance programmes are common, the Guidelines cannot provide guidance on the effect and recognition of reinsurance that can be applied in every case. Munich Re is able to provide valuable expertise for both the calculation of risk capital and the recognition of reinsurance contracts in the ORSA Process. Insurance companies can rely on the experience of a major reinsurer in dealing with the effect of reinsurance contracts from an economic perspective. This experience has already been put to good use in a large number of projects on which we have worked with our cedants. Munich Re and your company Munich Re assists its clients in all areas of capital management and Solvency II. Our experts have a wealth of experience in dealing with the standard formula, the development and use of internal stochastic risk models and their relevance to value-based portfolio management. We also play an active role in industry committees looking at regulation and specialist issues and ensure 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 efficient help in implementing Solvency II. 15 Münchener Rückversicherungs-Gesellschaft Königinstrasse 7, 80802 München, Germany Order number 302-08701 Münchener Rückversicherungs-Gesellschaft (Munich Reinsurance Company) is a reinsurance company organised under the laws of Germany. In some countries, including in the United States, Munich Reinsurance Company holds the status of an unauthorised reinsurer. Policies are underwritten by Munich Reinsurance Company or its affiliated insurance and reinsurance subsidiaries. Certain coverages are not available in all jurisdictions. NOT IF, BUT HOW Any description in this document is for general information purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any product.