RMS senior director Laurent Marescot and Rohan Baxter, regulatory affairs manager for Europe, explain how bringing catastrophe models in-house to use in the internal model process offers a solution that better reflects a (re)insurance company’s risk profile, providing a more informed and beneficial approach to managing risk and capital under Solvency II.

Under Pillar 1 of the Solvency II (SII) framework, (re)insurers who are opting to use the standard formula to manage their risk-based capital calculations face potentially higher
capital requirements. In contrast, firms that develop their own internal model, integrated with external models and data, have an opportunity to optimize their capital and increase growth opportunities.

To manage catastrophe risk calculations, for example, embedding external catastrophe models into an internal model can offer substantial benefits, including optimal Solvency Capital Requirement (SCR) calculations. For instance, an embedded model can reflect exposure data quality and help identify areas of accumulation and diversification, as well as capturing full risk mitigation measures for which firms are credited. The resulting capital savings can also enable a business to underwrite more profitable risks and make more profitable investments.

However, for catastrophe models of complex perils, such as European windstorm or flood, where several key assumptions drive uncertainty, undergoing deep validation of the models is essential. Should firms use any element of a catastrophe model, including model loss output, to inform their internal model, regulators require that firms can demonstrate they have understood the assumptions and limitations of the model.

The best way for firms to address model validation in this situation is to bring catastrophe models, such as the RMS® Europe Windstorm Models and RMS® Europe Flood Models, in-house – as opposed to only relying on the final modeled loss output. By doing so, firms make validating the model easier since they can gain a far deeper understanding of the models and the impact of uncertainty on their book of business by having direct access to RMS modeling experts and engineers, the comprehensive suite of model documentation, and additional views of risk around model assumptions. (See the clustering example on the next page.)

Additionally, by bringing the RMS models in-house, firms may be able to have the models adjusted to reflect their own view of risk, overlaying RMS science with their own data and assumptions in a consistent way, moving beyond adding simple loading factors to loss results. Models in-house also deliver the highest granularity of loss outputs, on demand all around the year. Being able to make better and more timely decisions and testing the impact underwriting and risk
transfer decisions have on their capital requirements, as required by the Own Risk and Solvency Assessment (ORSA) that lies at the heart of Solvency II, are additional advantages to this approach.

SII benefits of embedding RMS Europe Windstorm Models

One example of how RMS works to help clients move beyond simple loading and develop more robust views of capital requirements is with the treatment of windstorm clustering.

Windstorm clustering, which is when two or more cyclone events occur close together in space and time, is considered by some of the large European regulators to have a significant potential impact on a company’s balance sheet. As such, many firms are required to account for windstorm clustering in their capital requirements. This means that the modeling community must provide meaningful transparency and validation of their clustering modeling methods and the data used.

To ease the validation process for our clients and enable more firms to embed the RMS Europe Windstorm Models in their internal model processes, we have addressed the challenge of managing windstorm clustering.

Firstly, characterizing windstorm clustering has presented by far the biggest hurdle for modelers due to the scarcity of historical data on clusters with which to calibrate models. To tackle this, RMS worked with several academics to gather more long-term data on storm clustering, helping to reduce the uncertainty in the most recent RMS Europe Windstorm Models release. In addition, while windstorm clustering is a real and observed phenomenon, the RMS clustering model can be turned on or off. This more flexible choice not only enables firms to better understand model uncertainty through a deeper understanding of the key model assumptions around windstorm clustering, they can also directly assess the potential impact on their book of business.

Solvency II uncertainty post-Brexit 

In the U.K., considered to be one of the most prepared markets for the new regime, 19 insurance entities had received approval for the use of a full or partial internal model under Solvency II as of January 1, 2016, including the Society of Lloyd’s. At the time of writing, the implications of the U.K.’s EU referendum were still being absorbed but there was a feeling it would not result in significant changes for London-based reinsurers. 

One option could be for the U.K. to seek equivalence with Solvency II as it is home to roughly 11 percent of undertakings currently subject to the regime. Even if the U.K. ultimately does not seek equivalence, the risk-based practices that have been developed for Solvency II will continue to benefit U.K.-based firms as they strive to meet rating agency, investor and other stakeholder expectations. 

While the journey in preparing for the regime has been far from easy for many firms, enhanced enterprise-wide risk management practices will benefit (re)insurers whether they are inside or outside the EU.

Laurent Marescot leads product management for the RMS Europe and Asia models.

Rohan Baxter is the head of regulatory affairs for Europe.