The year 2020 is just months away, and in the latest edition of EXPOSURE — the RMS magazine for risk management professionals, we consider some of the changes that the (re)insurance industry will have undergone in ten years’ time. Mohsen Rahnama, Cihan Biyikoglu and Moe Khosravy from RMS tackle the issues, examining the evolution of risk management, the drivers of technological change, and how all roads lead to a common, collaborative industry platform.Continue reading
From our numerous client conversations, climate change as a business issue has risen high on the agenda, and this has certainly escalated over the last twelve months. There is a growing recognition of the need to quantify the impact that climate change will have on your business. But – where do you start with this? One of the major challenges is knowing what question to ask. With the inclusion of climate change scenarios within the General Insurance Stress Test (GIST 2019), which the larger U.K. insurers and Lloyd’s syndicates are required to respond to, the Bank of England Prudential Regulation Authority (PRA) is outlining one approach.
RMS is particularly well placed to support insurers in responding to the “Assumptions to Assess the Impact on an Insurer’s Liabilities” portion of the climate change section within GIST, which examines how changes in U.S. hurricane and U.K. weather risk under different climate change scenarios may affect losses.
What do the 393 grounded Boeing 737 MAX aircraft have in common with BP’s “Deepwater Horizon” fire and uncontrolled oil release, or with Volkswagen’s (VW) “cheat technology” that ensured its diesel engine cars could pass stringent U.S. and European emissions test standards?
All three situations cost their respective companies tens of billions of dollars. Two of them concerned the development of in-house software that caused more self-inflicted damage to the company’s balance sheet than any corporate hit from an external cyberattack. And all three highlight defective risk management and regulation.
Volkswagen Group, BP and Boeing are all world class companies: ranked #18, #24 and #49 globally in the recently published Forbes Global 2000. For investors these are “blue chip” stocks: “… the stalwarts of industry – safe, stable, profitable and long-lasting companies, they represent safe, low volatility investments.” Investors might prefer to return to the original definition of “blue chip” in poker-playing, where it designates the highest value token but says nothing about the risk.
Around 98 percent of residential homes in New Zealand have earthquake insurance. This remarkable achievement is due to a unique partnership between the New Zealand government Earthquake Commission (EQC) working together with the insurance industry. From its origins in 1945 as the Earthquake and War Damage Commission – renamed as the EQC in 1993, the Commission is supported by an Act of Parliament which sees the Crown as the insurer of first resort for earthquakes in New Zealand. The EQC provides the first layer of coverage for 1.84 million residential properties across the country, with the private market delivering cover over this initial layer.
The EQC administers the New Zealand Natural Disaster Fund (NDF) which receives monies directly passed on by private insurers, from a flat rate levy imposed on all households who purchase a homeowner insurance policy. The EQC is also responsible for investing the fund and ensuring there is adequate reinsurance cover available.
The NDF has supported the country’s homeowners through a series of damaging events since the start of this decade, providing NZ$100,000 (US$67,332) of buildings and NZ$20,000 (US$13,466) of contents cover for each event. Before the Canterbury earthquakes in 2011-12, the NDF had NZ$6.4 billion (US$4.27 billion). By 2018, including payments for the Kaikoura earthquake in 2016, the NDF had just NZ$287 million (US$195 million) left and was perilously close to the NZ$200 million limit where the government is mandated to top up the fund.
In September, Typhoon Mangkhut wrought a path of destruction across the western North Pacific, causing damage from Guam, to the Philippines, Hong Kong, and southern China. For Hong Kong, Mangkhut was the second strong typhoon to impact the region in consecutive years, following Typhoon Hato in 2017. Damage was extensive – according to local media, at least 500 homes and high-rise buildings in Hong Kong, including apartment complexes and office blocks, were severely damaged.
In the weeks following Mangkhut, RMS worked with the Insurance Authority (IA) – the independent insurance regulator for Hong Kong, to help provide (re)insurers in the region with some context and scientific analysis around this event. According to data from the insurers gathered by the IA, Typhoon Mangkhut caused total insured losses of HKD 3.5 billion (US$448 million) in Hong Kong. This figure, collected as at October 12, three weeks after Mangkhut’s landfall, represents losses reported by insurance and reinsurance companies in Hong Kong. With the loss information provided by the IA and using the RMS China and Hong Kong Typhoon Model, RMS estimated Mangkhut to have a return period of 30 to 40 years in Hong Kong.1
The pace of change continues to accelerate across the insurance industry, whether it is from technology, regulation or market developments, and EXPOSURE magazine helps risk professionals to explore some of the key drivers of these changes.
In this latest edition available for distribution at the Monte Carlo Rendezvous and online, the lead story looks at the recent market activity from Tower Insurance in New Zealand. By adopting high-definition earthquake modeling, Tower gained the confidence to launch risk-based pricing for its customers, providing savings for the majority of policyholders, but increases for others. EXPOSURE looks at the implications of Tower’s actions and how this could affect the New Zealand insurance market.
High resolution modeling has also helped Flood Re in the U.K. to better understand how it can work towards its remit of delivering a flood insurance market based on risk-reflective pricing that is affordable to policyholders. EXPOSURE shows how innovative use of modeling could guide Flood Re when recommending investment measures to protect properties at risk of flooding.
Paul Burgess, Client Director, Asia-Pacific, RMS
Erica Xue, Senior Product Manager – Model Development, RMS
In a country that according to the United Nations, between 1995 and 2015 experienced the largest number of natural disasters globally, and with these losses largely uninsured, China is at the start of a journey to close its protection gap between economic and insured losses — during a sustained period of rapid GDP growth. Examples such as the devastating Sichuan earthquake in 2008 which killed more than 80,000 people and caused US$125 billion in economic losses saw just 0.3 percent of losses covered by insurance. Floods in southern China during the summer of 2016 saw economic losses of US$20 billion, the second costliest event of the year. But again, according to Munich Re, just two per cent was insured.
For insurers and consumers in the European Union, 2016 is a key year, since it is when the industry gets real experience of Solvency II, the newly implemented risk-based supervisory system. After a decade in the making, Solvency II officially came into force on January 1, 2016. While it had been a scramble by the industry to meet that deadline, ten months on as the road becomes less bumpy, what have we learned?
Insurers have met their numerous reporting requirements under the new regime, as well as calculated the Solvency Capital Requirement (SCR), prepared Own Risk and Solvency Assessments (ORSAs), and set out their risk management frameworks and rules of governance. Although this appears a straightforward task, in reality, the introduction of Solvency II has created a significant paradigm shift in insurance regulation, the biggest experienced in decades – with a corresponding cultural and strategic challenge to firms that do business in the European Union.
In September, I attended a conference in Slovenia’s capital Ljubljana, where industry participants gathered to assess where the industry has got to.
Has Anything Gone Wrong?
According Europe’s regulatory umbrella body, the answer to this question is an emphatic “no.” Manuela Zweimueller, the Head of Regulations at the European Insurance and Occupational Pensions Authority (EIOPA), added that although Solvency II is not quite perfect, regulators are continuing to refine the requirements. The main challenge according to EIOPA, is that Solvency II needs to be equally understood by regulators and (re)insurers over the next five years in order to close up the pockets of inefficiency and provide a level playing field for all those involved. EIOPA terms this “supervisory convergence.”
From the standpoint of European insurers and national regulators there are several core challenges. The German Federal Financial Supervisory Authority considers the combined demands of a complex internal model approval process, the need to work through complicated and lengthy reports and data, and appropriately train staff create challenges for supervised firms. From an industry perspective, Italian insurer Generali revealed that the main issues they face are around the complexity of internal model requirements and documentation. Both sides agree, however, that despite the burden of regulatory compliance and high level of technical detail involved, the use of an internal model for Solvency II to measure risk provides substantial benefits in the way of management, governance, and strategic decision-making. This makes Solvency II the only long-term solution for almost all insurers. For a brief discussion of the benefits of internal models, see my earlier blog post.
The additional demands of complying with Solvency II, however, have partly given rise to a surge in M&A activity. By going under the wing of a larger business, only one solvency return needs to be filed, which results in efficiencies and cost-savings. According to the Association of British Insurers (ABI), firms in the U.K. alone have already invested at least £3 billion (US$3.7 billion) to comply with the new solvency regulations. Strategic M&A activity is likely to rise, especially for small to medium-sized insurers which face problems maintaining the same levels of profitability as they did prior to Solvency II, and are seeking ways to defend their positions in the market.
What Does the Future Hold?
What’s needed next, according to EIOPA, is a period of stability for Solvency II – though there are still many more challenges that lie ahead. For instance, in the short term, insurance firms will undoubtedly feel the pinch, with many needing to invest more time and money into efficiently reporting their solvency ratios to the regulators. But there will be a preliminary review of the new directive in 2018 when EIOPA will address some of the complexities.
More widely, fears are increasing over the economic reality of low interest rates (which are hitting the life insurance market the hardest), decreasing corporate yields, and stock market volatility with Brexit. Although the consequences of Brexit have not been as bad as expected so far, these factors will still need to be managed in the balance sheet.
And despite all the difficulties that lie ahead for the industry as a whole, EIOPA stresses that we must remember that the ultimate goal of Solvency II is not just to unify a single EU insurance market, but to increase consumer protection – and adopting a consumer-centered approach is beneficial for all.
Future hurricanes are going to cost the U.S. more money and, if we don’t act to address this, it will leave the government struggling to cope. That is the finding of a recent Congressional Budget Office (CBO) report which put it starkly:
“…over time, the costs associated with hurricane damage will increase more rapidly than the economy will grow. Consequently, hurricane damage will rise as a share of gross domestic product (GDP)…”
The CBO identified two core drivers for the escalating costs: climate change, which will drive just under half of the potential increases in hurricane damages while just over half of damages will come from coastal development. The four main four variables that would have the most impact were identified as:
- Changes in sea levels for different U.S. states;
- changes in the frequency of hurricanes of various intensities;
- population growth in coastal areas, and;
- per capita income in coastal areas.
Using Catastrophe Models to Calculate the Future Cost of Hurricanes
To inform the CBO’s research and creation of a range of possible hurricane scenarios based on future changes to the four key variables, RMS hurricane and storm surge risk experts provided the CBO with data from the RMS North Atlantic Hurricane Model and Storm Surge Model.
Through RMS’ previous work with the Risky Business Initiative we were able to provide state specific “damage functions” which were used to translate possible future hurricane events, state-specific sea levels and current property exposure into expected damaged. While we usually produce loss estimates for catastrophes, we didn’t provide the CBO with estimated losses ourselves – rather we built a tool so the CBO could “own” its own assumptions about changes in all the factors – a critical aspect of the CBO’s need to remain impartial and objective.
Solutions to Increase Coastal Urban Resilience
The CBO’s report includes suggested policies that could decrease the pressure on federal spending. The polices range from global initiatives to limit greenhouse gas emissions to more direct mechanisms that could shift costs to state and local governments and private entities, as well as investing in structural changes to reduce vulnerabilities. Such approaches bring to the forefront the role of local resilience in tackling a global problem.
However, therein lies the challenge. Many of the options open to society to increase resiliency against catastrophes, could have a less positive effect on the economy. It’s an issue that has been central to the wider debate about reducing the impacts of climate change. Limiting greenhouse gas emissions has direct effects on the oil and gas industry. Likewise, curbing coastal development impacts developers and local economies. It has led states such as North Carolina to ban the use of future sea level rise projections as the basis for policies on coastal development.
Overcoming Political Resistance
Creating resiliency in U.S. towns and communities needs to be a multi-faceted effort. While initiatives to fortify the building stock and curb global climate change and sea level rise are moving ahead there is strong resistance from the political arena. To overcome the resistance, solutions to transition the economy to new forms of energy must be found, as well as ways to adapt the current workforce to the jobs of the future. City leaders and developers should partner to find sustainable growth initiatives for urban growth, to ease the fears that coastal cities will wither and die under new coastal use restrictions.
Initiating these conversations will go a long way to removing the barriers to success in curbing greenhouse gas emissions and limiting coastal growth. With an already polarised political debate on climate change this CBO report may provoke further controversy about how to deal with the factors behind the increase in future hurricane damage costs. Though one conclusion is inescapable: catastrophe losses are going up and we will all be footing the bill.
This post was co-authored by Paul Wilson and Matthew Nielsen.
Europe’s windstorm season is upon us. As always, the risk is particularly uncertain, and with Solvency II due smack in the middle of the season, there is greater imperative to really understand the uncertainty surrounding the peril—and manage windstorm risk actively. Business can benefit, too: new modeling tools to explore uncertainty could help (re)insurers to better assess how much risk they can assume, without loading their solvency capital.
Spikes and Lulls
The variability of European windstorm seasons can be seen in the record of the past few years. 2014-15 was quiet until storms Mike and Niklas hit Germany in March 2015, right at the end of the season. Though insured losses were moderate, had their tracks been different, losses could have been so much more severe.
In contrast, 2013-14 was busy. The intense rainfall brought by some storms resulted in significant inland flooding, though wind losses overall were moderate, since most storms matured before hitting the UK. The exceptions were Christian (known as St Jude in Britain) and Xaver, both of which dealt large wind losses in the UK. These two storms were outliers during a general lull of European windstorm activity that has lasted about 20 years.
During this quieter period of activity, the average annual European windstorm loss has fallen by roughly 35% in Western Europe, but it is not safe to presume a “new normal” is upon us. Spiky losses like Niklas could occur any year, and maybe in clusters, so it is no time for complacency.
The unpredictable nature of European windstorm activity clashes with the demands of Solvency II, putting increased pressure on (re)insurance companies to get to grips with model uncertainties. Under the new regime, they must validate modeled losses using historical loss data. Unfortunately, however, companies’ claims records rarely reach back more than twenty years. That is simply too little loss information to validate a European windstorm model, especially given the recent lull, which has left the industry with scant recent claims data. That exacerbates the challenge for companies building their own view based only upon their own claims.
In March we released an updated RMS Europe Windstorm model that reflects both recent and historic wind history. The model includes the most up-to-date long-term historical wind record, going back 50 years, and incorporates improved spatial correlation of hazard across countries together with a enhanced vulnerability regionalization, which is crucial for risk carriers with regional or pan-European portfolios. For Solvency II validation, it also includes an additional view based on storm activity in the past 25 years. Pleasingly, we’re hearing from our clients that the updated model is proving successful for Solvency II validation as well as risk selection and pricing, allowing informed growth in an uncertain market.
Making Sense of Clustering
Windstorm clustering—the tendency for cyclones to arrive one after another, like taxis—is another complication when dealing with Solvency II. It adds to the uncertainties surrounding capital allocations for catastrophic events, especially due to the current lack of detailed understanding of the phenomena and the limited amount of available data. To chip away at the uncertainty, we have been leading industry discussion on European windstorm clustering risk, collecting new observational datasets, and developing new modeling methods. We plan to present a new view on clustering, backed by scientific publications, in 2016. These new insights will inform a forthcoming RMS clustered view, but will be still offered at this stage as an additional view in the model, rather than becoming our reference view of risk. We will continue to research clustering uncertainty, which may lead us to revise our position, should a solid validation of a particular view of risk be achieved.
The scientific community is still learning what drives an active European storm season. Some patterns and correlations are now better understood, but even with powerful analytics and the most complete datasets possible, we still cannot yet forecast season activity. However, our recent model update allows (re)insurers to maintain an up-to-date view, and to gain a deeper comprehension of the variability and uncertainty of managing this challenging peril. That knowledge is key not only to meeting the requirements of Solvency II, but also to increasing risk portfolios without attracting the need for additional capital.