How can reinsurance help lower the non

How can reinsurance help lower the non-life
catastrophe risk in the standard formula?
EIOPA publishes guidelines
Knowledge Series
Authors
Dr. Norbert Kuschel
Katja Losko
July 2015
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
1
2
3
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 2014, 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.
Insurance Information Institute “Catastrophes: Insurance Issues-The topic”, September 2014,
online at http://www.iii.org/issue-update/catastrophes-insurance-issues
Knowledge Series “Solvency II and catastrophe risks: Measurement approaches for property-casualty
insurers”, online at www.munichre.com
Knowledge Series “EIOPA publishes the results of the insurance stress test 2014”, online at
www.munichre.com
Munich Re
Knowledge Series
How can reinsurance help lower
the non-life catastrophe risk in the
standard formula?
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 2015, 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:
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.
−−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
4
5
6
7
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)
European Commission – Delegated act on Solvency II: “REGULATIONS COMMISSION DELEGATED REGULATION (EU) 2015/35 of 10 October 2014
supplementing Directive 2009/138/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 2015, online at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32015R0035
EIOPA – Guidelines on the Application of Outwards Reinsurance: “Guidelines on application of outwards reinsurance arrangements to the
non- life underwriting risk sub-module”, February 2015, online at https://eiopa.europa.eu/Pages/Guidelines/Guidelines-on-the-Application-of-OutwardsReinsurance.aspx
European Commission – Solvency II Directive: “DIRECTIVE 2009/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL
of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) 2009/138/EG”, December 2009,
online at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=OJ:L:2009:335:TOC
European Commission – Delegated act on Solvency II: “REGULATIONS COMMISSION DELEGATED REGULATION (EU) 2015/35 of 10 October 2014
supplementing Directive 2009/138/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 2015, online at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32015R0035
Munich Re
Knowledge Series
How can reinsurance help lower
the non-life catastrophe risk in the
standard formula?
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:
Non-life catastrophe risk in
the guidelines
−−Aggregation of natural catastrophes (natCAT), including catastrophe risks in non-proportional property reinsurance (npProperty), with
full dependency assumed
−−Man-made catastrophes (mmCat)
−−Other catastrophe risks in non-life
insurances (CATother)
The delegated acts define the rules
for calculating the 1-in-200-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-200-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
Windstorm
Flood
Nonproportional
Reinsurance
Earthquake
Hail
Non-life CAT
Other
Sub­
sidence
Transport
w/o MA1
NP Reinsur- Other
ance TransProperty
port w/o MA1 Insurance
Man Made
1Marine
2
Credit and suretyship
Motor
Vehicle
Liability
Marine
Aviation
Fire
(Buildings)
Liability
C&S2
NP Rein­
surance
Liability
NP Rein­
surance
C&S2
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How can reinsurance help lower
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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.
Step 1: specifying the
large loss event for every
sub-module
The diagram below provides a simplified illustration of a typical workflow:
According to the delegated acts,
companies should consider the specific features of the 1-in-200-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 200 year gross event
Step 2: Disaggregate
Step 3: Application of
reinsurance
Specifics of the gross event which
gave rise to gross catastrophe loss
for each catastrophe sub-module
(see figure 1)
Depending on the
r/i programme split
of 200 year loss
into appropriate
components as LOB,
region, …
Apply reinsurance protection to
specified levels
Catastrophes as aggregating
catastrophe (e.g. Earthquake)
events or risk catastrophe events
(e.g. MTPL)
Aggregating net results of sub
segments
Non-Life CAT
How to split the loss?
−− Max method
−− Spread method
−− Blend method
−− Individual method
Nat Cat
Windstorm
Flood
Nonproportional
Reinsurance
Earthquake
Hail
Non-life CAT
Other
Sub­
sidence
Transport
w/o MA1
NP Reinsurance Transport w/o MA1
Man Made
1Marine
2
Credit and suretyship
Motor
Vehicle
Liability
Marine
Aviation
Fire
(Buildings)
Liability
C&S2
Other
Property
Insurance
NP Rein­
surance
Liability
NP Rein­
surance
C&S2
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How can reinsurance help lower
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Step 2: disaggregating
the gross loss to appropriate
components
Example 1: Cross-border exposure
to the windstorm natural hazard
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-200-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-200-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.
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 cor­
relation of 25% between the UK
and Germany, the loss amount is
(1002 + 2 × 25% × 100 × 25 + 252)
= €109m, and hence the resultant
large loss from the two loss events
is 1.2 × €109m = €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-200-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
UK
Specified
windstorm
loss
Gross
event A1
(80%)
Gross
event A2
(40%)
Gross loss
Gross loss Gross loss
Max
Spread
method
method
100
80
40
25
20
10
30
0 (0/0)
26
Diversi­
fication
–16
–13
–6
–19
–
–
Total
109
87
44
131
131
131
Germany
8
120 131 (87/44)
105
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 2015, online at https://eiopa.europa.eu/Pages/Guidelines/Guidelines-on-the-Application-ofOutwards-Reinsurance.aspx
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How can reinsurance help lower
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standard formula?
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Example 2: Cross-border cover
for the windstorm natural hazard
(Windstorm-CXL)
€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 (€20m)
must be taken, so that the net SCR is
€32m.
The client has a cross-border CXL
covering UK and Germany windstorm exposure:” €80m xs €10m. For
simplicity, it is assumed that sufficient reinstatements are available. In
order to cal­culate the net loss if a
cross-border reinsurance solution is
in place, the total loss must be allocated to the countries concerned.
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 €20m 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 €10m 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
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.
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
120
111
111
20
20
UK
SCR
100
80
80
77
60
40
34
20
0
10
10
10
CXL
UK Event 80%
UK Event 40%
Fig. 4: Spread method for determining the effect of reinsurance
for cross-border covers (€m)
Gross loss – spread
w/o diversification
UK:80/40
Germany:30/10
140
120
100
80
80
60
70
40
Net SCR =
SQR (202 + 2 × 25% × 20 × 20 + 202)
=32
30
20
0
99
100
10
CXLLayer
10
10
UK Event UK Event
80%
40%
20
UK
10
10
0
10
10
20
Germany Germany Germany
80%
40%
32
SCR
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How can reinsurance help lower
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Example 3: Cross-border cover for
earthquake and flood
Articles 209–214 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.
As shown by the bordered boxes in
Figure 5, the reinsurance programme
covers the following relevant levels:
−−Earthquake in the EEA
−−Earthquake outside the EEA
−−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
−−Guideline 19:
Proportional reinsurance (quota
shares, surplus reinsurance and
proportional facultative contracts)
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:
−−Guidelines 20/21:
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 EEA” and
“Earthquake Non-EEA”. 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
Windstorm
Flood
Earthquake
Hail
EEA NonEEA
EEA NonEEA
EEA
EEA NonEEA
NonEEA
Non-life CAT
Other
Sub­
sidence
Transport
w/o MA1
NP Reinsurance Transport w/o MA1
France
Man Made
1
2
Marine
Credit and suretyship
Motor
Vehicle
Liability
Marine
Aviation
Fire
(Buildings)
Liability
C&S2
Other
Property
Insurance
NP Rein­
surance
Liability
NP Rein­
surance
C&S2
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How can reinsurance help lower
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standard formula?
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Conclusion
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.
The delegated acts lay down man­
datory 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 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.
© 2015
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(Munich Reinsurance Company) is a reinsurance
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In some countries, including in the United States,
Munich Reinsurance Company holds the status
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affiliated insurance and reinsurance subsidiaries.
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