Guidance Note GGN 110.5

Concentration Risk Capital Charge

This Guidance Note details the calculation of the Concentration Risk Capital Charge for an insurer using the Prescribed Method to determine its Minimum Capital Requirement (MCR). Specifically, it sets out the issues that an insurer should consider in setting its Maximum Event Retention (MER) for catastrophe purposes. It is the responsibility of the insurer’s Board and senior management to ensure that the MER is set at a level which is consistent with the insurer’s risk profile and its reinsurance program.

Definitions

The MER is the largest loss to which an insurer will be exposed (taking into account the probability of that loss) due to a concentration of policies, after netting out any reinsurance recoveries. The MER must include an allowance for the cost of one reinstatement premium for the insurer’s catastrophe reinsurance.
Probable Maximum Loss (PML) is the largest loss to which an insurer will be exposed (within the realms of possibility) due to a concentration of policies, without any allowance for reinsurance recoveries.
Return Period is the expected average period within which a particular catastrophic event will re-occur. For the purposes of this Guidance Note, insurers will be required to assume a return period of 1 in 250 years, or greater.

Background

Insurers are exposed to the possibility of very large losses arising from their portfolios as a result of various natural catastrophes or other causes of large losses eg earthquakes, fires, storms etc. These catastrophic events will occur only rarely and yet their financial impact on an insurer can be very significant, possibly even resulting in the failure of an insurer.
Theoretically an insurer can calculate the maximum limit of its catastrophic losses in a particular geographical region as the total of the individual sums insured under all of its policies. Clearly, however, such an approach would require prohibitively large amounts of capital.
In practice, insurers use the concept of MER to estimate their exposure to catastrophic events. The use of MER allows insurers to:

(a) calculate the level of reinsurance cover which the insurer requires;

(b) apportion reinsurance costs fairly among different segments of business; and

(c) control exposures to geographical zones or business types, where the risks of catastrophic loss are higher than acceptable, having regard to the insurer’s risk profile.

Issues affecting the level of MER

In determining the level of MER for a given portfolio, the insurer should consider:

(a) the classes of business in which the insurer is engaged;

(b) the types of catastrophic risk which need to be addressed;

(d) the geographical zones in which the insurer transacts business;

(e) the effects of combined risks eg where an insurer provides coverage for both workers’ compensation business and building insurance in the same geographical area;

(f) how the geographical zones will be grouped for calculation purposes; and

(g) the insurer’s overall risk appetite and desired probability of ruin.

Specialist Insurers

Specialist insurers, such as providers of medical indemnity or mortgage lender’s insurance, may not be exposed to large losses from natural catastrophes. They may, however, still be exposed to large losses arising from groups of claims resulting from a common source. For example, a medical insurer may face a large number of claims arising from a class action related to a faulty medical procedure, while a mortgage insurer might be most exposed to a period of severe economic downturn.

Determining the level of the MER

The insurer should base the calculation of its MER on:

(a) the relevant area of concentration (eg geographic region);

(b) which peril produces the greatest MER;

(d) results produced by modelling the insurer’s own past experience; and

(e) any externally, commercially available data and modelling facilities, bearing in mind the appropriateness of these data to the insurer’s portfolio of risks.

The MER must be calculated in a manner consistent with the processes for setting, monitoring and altering the MER outlined in the insurer’s Reinsurance Management Strategy (REMS), as required under GPS 230 Reinsurance Arrangements.
It is common practice for insurers to use computer-based modelling techniques, developed either in-house or by external providers,to estimate likely losses under different catastrophe scenarios. Where an insurer uses such a model, the model must be conceptually sound and capable of consistently producing realistic calculations of the MER. APRA will expect the insurer to be able to demonstrate an understanding of the model used in estimating the MER. This understanding will include:

(a) the type of data and assumptions used in the model;

(b) the methodology used to incorporate the data and assumptions into the model; and

Insurers must be able to demonstrate that they have thoroughly researched the model and tested at least several different scenarios of return period for each type of catastrophic event that may affect their portfolio of risks. Similarly, an insurer must calculate its MER using data that is consistent, accurate and complete. Where an insurer lacks access to the relevant data, it must be able to explain the rationale for, and details of, any estimates of data that it uses. This would include analysis of the sensitivity of the results to changes in the estimates and assumptions.
In setting an appropriate level of MER, the Board must consider the insurer’s claims history, capital availability and reinsurance arrangements. While the MER will ultimately be governed by the insurer’s particular portfolio, some simple methods could be used to guide the decision. For example, insurers who have determined that their maximum event would be a natural catastrophe could apply the standard PML factors produced by the Insurance Council of Australia to their aggregate exposures. This will provide an estimate of the gross loss to which the insurer is exposed. The insurer could then apply their reinsurance protections to this amount to obtain their MER.
Similarly, the MER for a mortgage insurer will ultimately depend on the insurer’s portfolio of risks. However, as a general guide, the insurer could use the relevant part of the Standard & Poor’s model for calculating capital at the BBB level. This would involve assessing the insurance in force of the mortgage insurer, and applying the standard frequency and severity factors by LVR band.

Board and Management Oversight

GPS 230 requires insurers to have a REMS approved by the Board (or in the case of foreign insurers, a senior officer from outside Australia with requisite Board delegation) and by APRA. An insurer’s REMS must include details of the insurer’s systems for the setting, monitoring and altering of its MER. Guidance Note GGN 230.1 Reinsurance Management Strategy sets out matters that each insurer’s REMS must detail:

(a) the insurer’s willingness to take on catastrophic risks;

(b) how the insurer’s financial resources cover its calculated MER;

(c) the regular process by which the policies are reviewed by senior management, and (if relevant) by the Approved Actuary, in the light of the insurer’s results by class of business and geographical region, as well as current market conditions eg availability of adequate catastrophe reinsurance cover;

(d) the regular process by which the policies are approved by the directors; and

(e) the regular process by which the insurer’s compliance with its policies is independently reviewed.

Regardless of the methodology used, the Board should periodically seek the advice of its Approved Auditor, Approved Actuary, or other relevant expert, to review the calculation of the MER, and ensure that it is established at an appropriate level.

Reporting

APRA will review and agree with each insurer the adequacy and appropriateness of the methodology for setting its MER as part of APRA’s review of the insurer’s REMS.
An insurer must inform APRA of any changes to its MER arising as a result of changes in its REMS, risk profile, classes of business underwritten or reinsurance program.

Guidance Note GGN 110.5Guidance Note GGN 110.5

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