Could cat models reduce capital requirements under Solvency II? Only if they are properly applied, writes David Banks.
The fast-approaching Solvency II regime could bring onerous new capital requirements for insurers and reinsurers, but catastrophe modellers are aiming to show that effective exposure modeling could reduce the burden and much of the complexity.
The chief risk officer for Allianz has even put a figure on the potential savings. Tom Wilson has compared the difference in capital requirement when using internal models versus the standard formula for several lines of business and found that internal models for catastrophe can reduce a company’s capital requirement by about 12%. Although Wilson did not explicitly mention cat models as a way to decrease capital requirements, the ‘QIS4 Benchmarking Study’ he cited compares capital requirements using the standard formula versus applying internal models for all major lines of business including property catastrophe.
Yörn Tatge, managing director of cat modeller AIR Worldwide GmbH, says the comparison is significant as it “puts a price tag on this subject”, in addition to the other benefits of using models. “The thing that drives the imperative for modelling from the rating agency’s point of view is the peak regions for a catastrophe, such as US windstorm, US earthquake and Japanese windstorm.”
“Rating agencies are talking about these perils and asking whether they can be properly modelled.
Doing so will give a company a lot of advantages when it comes to reducing the capital requirement.”
He adds that workflow overall must be sound and cat model output must be integrated into decision making and underwriting software. “All the major players are using two or three models. You tend to optimise your calculations into one model if you have a multi-model environment. For example, they might have internal models for the white spots where no pre-prepared models are available.”
Companies will have to satisfy regulators, rating agencies and business partners on their capital adequacy.
Vasilis Katsipis of AM Best, says that based on QIS4 (a study held to assess the impact of Solvency
II), estimates of cat exposure are part of a company’s capital modelling – and that effective modelling can have a bearing on capital requirement.
However, he says that companies with their own modelling capabilities are likely to have lower capital requirements than a company using a standard model. “Technically, we would expect companies that had their own modelling … to have more understanding and better management of their exposures.
They have stronger enterprise risk management, and probably have their own capital risk modelling capabilities and better capital structures as well.”
He says they are at the “higher levels” in insurance and already at the forefront of Solvency II. “The way to think about it is that the cat model is part of their internal capital model. The majority are using it for Solvency II, but it also brings its own business advantage.”
Julian Leigh, a senior consultant at Towers Perrin, adds that cat modelling does not automatically produce a lower capital requirement. “It’s not a straightforward quid pro quo. The company would have to show that it was also mitigating its risks in a sufficient manner. It’s not enough for a carpenter to have a hammer, it’s about how it’s used.”
He says a company must constantly update its modelling input methods, testing the models with likely scenarios and then adjusting decision-making, whether through risk mitigation or risk transfer.
Ming Roest, also at Towers Perrin, says that a cat model also needs to meet calibration and documentation standards. “If all that is the case and it has proved to have been a tool for reducing exposure then, potentially, it could lead to a lower capital requirement as a straightforward payoff for the exposure being less – but not necessarily.”
The types of exposures are also a factor. For example, modelling is most advanced for the global peak perils such as US windstorm, while modelling for central European flood is not as sophisticated. Roest says that it also depends on the products you are writing. For example, property catastrophe, marine and inwards reinsurance require a “more advanced model” than for example motor insurance in Europe.
“It also depends on the exposures, modelling is most advanced for the most obvious major exposures. If the exposure is for central European flooding then the modelling is not nearly as sophisticated as US wind.”
David Banks is Deputy Editor of Global Reinsurance