SOME THOUGHTS FROM THE REGULATOR
IAN LAUGHLIN
Member
Australian Prudential Regulation Authority
Finity Niche Insurer Conference, Sydney
18 October 2012
Finity Niche Insurer Conference 2012
The Changing Landscape
Some Thoughts from the Regulator
Ian Laughlin
APRA Member
18 October 2012
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Introduction
Good morning – it’s good to be here again.
This is the Laughlin residence:
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This is a neighbour’s place – 100 yards from where it started:
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The year is 1936.
The location is the Waterford area about 30 kilometres south of Brisbane.
Here is a view of the same area from Google maps today:
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You can see that the property damage today from a similar event would be far
greater than in 1936.
These photos emerged recently when I was looking through some old albums of a
recently deceased aunt, and they prompted me to find out a little more. As a first
step, I went looking on the internet for cyclones in south east Queensland. What I
found was quite interesting.
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Source: Courier Mail 24 Feb 1936, from Trove service of the National Library of Australia
First, it seems the cause of the damage to the Laughlin residence was a tornado,
which caused destruction over a wide area through to Wynnum, east of Brisbane!
Tornados are sometimes associated with cyclones, so I found out what I could about
cyclones in the area. This shows cyclones in the 1935-36 season, and you can see
there were a couple that passed near south-east Queensland, but they seemed to
have been at different times to the tornado.
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That then led me to wonder how frequent cyclones were in south-east Queensland.
So I checked on the history of cyclones over the last 100 years or so.
Many of you will have seen this sort of map before, but it is interesting to note that
cyclones in the south-east of Queensland do occur relatively frequently. Even
northern NSW has been quite badly impacted by cyclones in the past.
This piece of simple analysis prompted me to think about insurers considering their
catastrophe risk exposures and their reinsurance arrangements.
So more about that in a few minutes.
Here is what I will cover today:
Today ...
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LAGIC latest
Natural Catastrophe Reinsurance
Reinsurance Arrangements Statement
ICAAP
Stress and Scenario Testing
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LAGIC Latest
As you well know APRA’s revised capital requirements come into force from 1
January 2013.
The LAGIC project has been a very significant undertaking – for both industry and
for APRA – extending over about three years. There have been four rounds of
consultation, the last of which has only just been completed, as well as many other
interactions with industry. This has proven to be well worthwhile, and we are very
pleased with the support we were given by industry during the development of
LAGIC. It has been generally constructive and undoubtedly helped produce a better
outcome.
Last week, we issued the final versions of the new and revised prudential standards
which implement LAGIC. Later this month all of the reporting standards will be
released in final form.
So we and the industry are now very much focused on implementation, which in
itself is a major undertaking. We believe industry is generally well prepared for the
new regime. Most senior management and most boards are well engaged in the
LAGIC rollout.
LAGIC introduces significant changes to reinsurance requirements, including the
whole-of-portfolio approach and the horizontal requirement within the prescribed
capital for insurance concentration risk. The latter is intended to address the risk
of multiple large events within a year, and for many insurers is likely to involve
different reinsurance arrangements to those used in the past. You will recall that
we delayed the implementation of the horizontal requirement until 1 January 2014,
to give insurers and reinsurers time to develop and put in place appropriate
reinsurance arrangements. We are now concerned however that insurers have
taken their eye off this particular ball, and are not making the most of the
additional time to prepare properly for the introduction of the horizontal
requirement. For example, the ICAAP must address the horizontal requirement
from the commencement of LAGIC. This means we expect insurers to calculate
their horizontal requirement at 1 January 2013, even though the horizontal
requirement does not come into force until much later, so that they can ensure
they are well prepared for its introduction.
This leads us nicely back to natural catastrophe reinsurance.
Natural Catastrophe Reinsurance
The industry has been a little more settled since we last spoke, in the sense that
the weather and earthquake gods have been a bit kinder.
In another sense, there are fresh challenges as we seek to learn the lessons from
the events of 2011.
At this conference last year, I set out some of those lessons, and today I will build
on those comments in two particular areas: catastrophe modelling and the
Reinsurance Arrangements Statement (ReAS).
Catastrophe Models
As you know, under LAGIC APRA sets a capital standard based on 1 in 200 probability
of sufficiency, and the minimum catastrophe reinsurance arrangements are derived
from this. APRA’s minimum requirement - and it is just a minimum - should be only
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one factor in considering appropriate levels of catastrophe reinsurance. The Board
should consider whether 1 in 300, or 1 in 500, for example, would better reflect its
risk appetite.
Obviously it is not a simple matter to assess the level of cover necessary to meet
APRA’s standard and/or the board’s risk appetite, and models are used extensively
for this purpose. All models have limitations. The output is dependent on the data
provided, the assumptions in the model, the reliance on known history, which perils
are modelled, the sophistication of the modelling engine etc. The relevance of the
result of course is then subject to the vagaries of the real world (e.g. an unknown
earthquake fault!).
The major models undergo regular revision in light of
experience, but they will continue to have deficiencies.
The net result is that at best a model gives an estimate and its results are subject
to a significant margin of error.
This is very well illustrated on this slide reproduced from a Guy Carpenter paper,
Managing Catastrophe Model Uncertainty (2011), which provides a very good
explanation of the issue.
Note just how wide the band of uncertainty is in this illustrative example.
However, our reviews in the wake of last year's events suggest that management
and boards may not understand the degree of uncertainty in the model output, and
as a result they may be relying too heavily on these models in setting reinsurance
cover.
Over-reliance on catastrophe models
In some cases:
• blind acceptance of model output – internally or via broker
• use of multiple models with unclear rationale
• low level of understanding – inputs, assumptions, “black
box”
• lack of questioning
• lack of board oversight & challenge
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More specifically we found in some cases:
blind acceptance of model outputs - either internally or through reinsurance
brokers - in the purchase of their catastrophe cover;
use of multiple models to set their cover, but without clear rationale for the
weightings chosen;
a low level of understanding of the inputs and assumptions used and their
effects, and what happens in the model “black box”;
a lack of questioning of model results; and
a lack of board oversight and challenge in the use of the model.
With some insurers, there was recognition of model uncertainty, and a margin
added to the model output to compensate. The margins varied greatly between
these insurers. In some cases they were reasonably arbitrary; in others there was a
considered approach to dealing with un-modelled risks, such as demand surge, etc.
It is worth noting here that one side-effect of the spate of natural disasters in 2011
was a number of revisions to models, demonstrating that they are "work-inprogress". For example, updates have been made for northern hemisphere
windstorm, NZ and Japan earthquakes and locally, for storm, earthquake and
bushfire perils.
We are urging management and boards to recognize the limitations of models, and
to challenge and debate the model outputs, and in the process to recognize the
inherent errors in these outputs. This is a matter of good governance. The sorts of
things that should be considered include the following:
Model challenge
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views of model supplier re deficiencies etc
reasons for different results from different models
perils not covered by model
quality of data input
appropriateness of assumptions and settings
back-testing
how deficiencies addressed
allowance for uncertainties
the views of the model supplier as to any deficiencies and inherent inaccuracy
in their model output, how up to date the model is etc.
where different vendor models produce markedly different results, the reasons
why;
an assessment of the perils not adequately covered or not covered at all by the
model;
management's view of the quality of data provided as input to the model,
including its granularity (e.g. zone, post code or street address);
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the appropriateness of assumptions and settings (e.g. construction types,
subsoil composition) used in the model, and any weaknesses that they generate
in the output;
how well the model copes with back-testing against previous actual events;
how any deficiencies identified are being addressed; and
an appropriate allowance for model uncertainties.
A further challenge for management is to determine what extra information and
analysis will help the board in determining final reinsurance cover. What can be
done to bring the issue to life, so it not seen as simply an exercise for a computer
program? What history (such as meteorological records) is available that might help?
Has appropriate allowance been made for urban development and changes to
topography or water courses? Have there been changes in weather patterns? What
advice is available from reinsurers and/or brokers? What is the basis of their
advice?
And then, what if? What if a cyclone hit Brisbane for example? What if an
earthquake hit Perth? Scenario tests can be very helpful in addressing these sorts of
questions. This includes assessing the impact of past events on the current
environment to consider how the insurer would be affected. For example, a repeat
of the 2011 events could be used to test revised reinsurance arrangements and
ICAAP.
Or using my simple example, what impact would a repeat of the 1936 tornado have
on the now highly-developed suburbs of Brisbane? One can imagine an event such
as this generating interest from board members, and management using it as an
opportunity to inform the board about the various types of windstorms, their
frequency, and the risks they pose in south-east Queensland. The board might want
to understand how the insurer’s reinsurance arrangements responded, and how in
future they would respond to multiple such events (particularly in light of APRA’s
horizontal requirement). The board also might want to consider this in the context
of their risk appetite, and satisfy themselves that their ICAAP dealt adequately with
the possibility of such events.
There could be useful discussions with the board about the insurer’s catastrophe
model, how well calibrated it was for such an event, and whether the model
settings and data input in hindsight had been appropriate. This might lead to
questions about the relationship with the model supplier, and how the supplier
reviews such an event and whether it might result in refinements to the model.
Similarly, the board would very likely be interested in the reinsurer’s response, and
whether the experience might lead to a reassessment of risk in south-east
Queensland.
My point here is that it is important to engage the board in these sorts of discussions
to deepen its understanding, and to help it better do its job.
APRA too needs to better develop its understanding of models and their weaknesses
(including why different models produce different results for the same perils), and
of current practices. We are reviewing processes in a number of insurers and
conducting discussions with reinsurers, model vendors and reinsurance brokers to
better understand how the models are used, the governance arrangements in place,
what improvements could be made etc.. We are also interested in a more detailed
understanding of whether and how modelling error is addressed.
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Model challenge
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views of model supplier re deficiencies etc
reasons for different results from different models
perils not covered by model
quality of data input
appropriateness of assumptions and settings
back-testing
how deficiencies addressed
allowance for uncertainties
For more information on the use of models, see the draft Prudential Practice Guide
GPG116 – Insurance Concentration Risk, released in September.
Reinsurance Arrangements Statement (ReAS)
Our review of reinsurance arrangements statements post last year's natural disasters
indicated that while some are of quite good quality, many ReASs need significant
improvement. Areas of concern include the omission of critical details such as the
number of reinstatement covers, and unclear explanations of reinsurance programs.
In some cases, there were inconsistencies between the narrative descriptions and
diagrams.
We also found cases where there was a lack of information, explanation and/or
worked examples showing how the reinsurance would respond, particularly to
multiple events in the one year. It was also not always clear how the various
reinsurance covers complemented each other to provide comprehensive protection.
That is not a good report card, and clearly improvement is needed for many
insurers.
APRA is currently in the process of speaking to entities where it found any of these
issues, to ensure they are adequately addressed.
APRA review
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no gaps in cover
reinsurance programs adequately respond
ReAS is clear and accurate implementation of ReMS
gross exposures, probable maximum loss calculations and
hazards covered
• appropriate governance arrangements
• consistency between the ICAAP, the ReMS and ReAS
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As part of this process, and a more intensive review in 2013, we will be looking to
ensure that:
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there are no gaps in cover, or if there are gaps they are known and understood
and properly managed - for example with capital;
reinsurance programs adequately respond to differing levels of claims, and to
multiple events - the latter will include consideration of the LAGIC horizontal
requirement , sideways cover, and retention protection;
the ReAS is a clear and accurate implementation of the reinsurance
management strategy (ReMS);
gross exposures, probable maximum loss calculations and hazards covered are
well considered and justified;
there are appropriate governance arrangements in place; and
there is consistency between the ICAAP, the ReMS and ReAS;
APRA will provide feedback to individual insurers and the industry on the outcomes
of our reviews.
Note that whilst our focus has been on natural catastrophe events, our reviews will
include non-property and niche business (medical indemnity, liability classes, LMI
etc.)
An unsatisfactory outcome for an insurer will result in close supervisory attention,
including the possibility of a Pillar 2 adjustment to capital requirements.
Note that APRA is not an adviser. The quality and effectiveness of the reinsurance
arrangements and the ReAS are the responsibility of management and board. We
suggest that good use is made of actuaries and auditors (both internal and external)
to provide critical independent review of the ReAS and its use.
Indeed, we expect that the Appointed Actuary will review the ReAS, ICAAP,
strategic plan and business plan for consistency and gaps, as part of his or her
assessment of the suitability and adequacy of the reinsurance arrangements. We
would also expect any issues to be addressed in the FCR.
Internally, APRA will be conducting training for our front-line staff to ensure the
reviews are effective and efficient. We will also start work on a prudential practice
guide on the ReAS. We will be seeking to standardise the collection of major ReAS
components (treaty type, classes, limit, excess, premium, reinsurer) to complement
schematics and narrative.
Reinsurance counterparty risk
In 2010/11, APRA undertook a data collection to assess whether the failure or
significant downgrade of a major reinsurer was a material risk for the industry.
Pleasingly, the information provided showed that the industry is well diversified in
terms of reinsurance counterparties from a geographical standpoint and across APRA
and non- APRA-authorised reinsurers. In excess of 90% of the reinsurers utilised are
rated APRA grade 3 (S&P A-rated) or higher. As part of the LAGIC reporting package
APRA consulted on proposals to include reinsurance counterparty information in the
regular data collection. We plan to finalise our approach to ongoing counterparty
risk data collection in 2013.
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Placement risk
The catastrophe events in Australia and New Zealand in 2011 led to some reinsurers
reducing or restructuring the cover they were willing to provide in the region, or
requiring significant price increases for some types of cover. Our concerns about the
placement risk this engendered have eased considerably as the market has
responded quite well. Again, we urge insurers to consider their horizontal
requirement needs well as early as possible to ensure that they encounter no
reinsurance placement problems leading up to the start of 2014.
ICAAP – a reminder
PCR, ICAAP
ICAAP
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The Prudential Capital Requirement (PCR on the slide) is the minimum capital
requirement under LAGIC (and is made up of two components, Pillar 1 and Pillar 2).
The PCR is a “hard floor” which must not be breached.
If capital does fall below PCR, the insurer needs to correct the position promptly to
avoid APRA taking serious measures and potentially taking control out of the hands
of the board and management.
Thus the insurer is expected to target a level of capital well in excess of PCR
consistent with its risk appetite, and to set a process for managing deviations from
that target under what we call the Internal Capital Adequacy Assessment Process, or
ICAAP.
You will see on the diagram that APRA’s level of supervision will become more
intense as the capital position approaches PCR.
As its name suggests, ICAAP is a process, but of course we are interested in both the
process and its effective management, and ultimately the outcomes of the process.
ICAAP was explained in our various consultation papers, and ultimately in the final
prudential standards made in May 2012. To provide further help, APRA has just
issued a Prudential Practice Guide (PPG). I urge you all to read that guidance.
I don’t want to repeat what has been published in the prudential standards and
practice guide, but as a reminder, at a minimum the ICAAP must include the items
on this slide:
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ICAAP
• policies, procedures, systems, controls and personnel
• strategy for ensuring adequate capital is maintained
• monitoring capital requirements and targets/ triggers
• stress testing and scenario analysis
• reporting on the ICAAP and outcomes
• capital impact of material risks not covered by PCR
• ICAAP summary statement.
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APRA expects that the ICAAP will be developed by the insurer’s senior management
with input from relevant business areas and experts. However, the ICAAP is
ultimately the responsibility of the Board. The Board should be actively engaged in
the development of the insurer’s ICAAP and its implementation, and must approve
the ICAAP.
There are two documents that need to be produced - the ICAAP summary statement
and the ICAAP report.
The ICAAP summary statement is a high level document describing and summarising
the capital assessment and management processes of the insurer. This document is
expected to be developed and available to APRA from 1 January 2013.
The ICAAP report is an annual report that will summarise the operation of the ICAAP
over the last year and give an overview of expected capital management actions
and issues for the coming period. It should include details of actual capital levels
and capital management actions during the previous period, and projected capital
levels and planned capital management actions. It should also summarise any
changes to capital targets or to other aspects of the ICAAP.
We expect the ICAAP, the ICAAP Summary and the ICAAP Report to be powerful and
useful tools for the board and that they will be integral to the management of the
business. APRA too, will pay close attention to them.
The main point that I want to leave you with is that the board and management
have responsibility for developing an ICAAP, and for setting target capital and
managing the capital position around that target in accordance with their ICAAP.
This includes the use of reinsurance.
It is critically important that this is done well.
Stress Testing
Let me make a few comments on the role of stress testing in developing ICAAP and
managing capital levels.
APRA expects stress testing to be used both in setting the insurer’s risk appetite and
in the insurer’s ongoing capital management. It therefore should be an integral part
of the insurer's ICAAP.
Rigorous, forward-looking stress testing supports capital and reinsurance
management by assessing the impact of severe events, including a series of
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compounding events or changes in market conditions that could adversely impact
the insurer.
Stress testing is done in various ways, but one approach involves a plausible but
very adverse scenario and an assessment of the impact of that scenario.
I mentioned earlier that insurers should make greater use of scenario testing as part
of the development of their ReMS.
Stress testing and scenario testing are powerful tools. They help APRA and
management and board to understand the capacity of the organization to cope with
the specified stress or scenario, and they also provide insights into vulnerabilities of
the insurer. From this, lessons can be learnt that might lead to changes in strategy
or operations or to capital management.
There is also a very useful concept called reverse stress testing. This is a little
different, in that it seeks to determine a scenario that for example, would cause
the company to breach its regulatory capital requirements. This can give fresh
insights into vulnerabilities, in a way that will be well-understood by the board.
We want to encourage management and boards to consider stress testing as one of
the more important weapons in their ICAAP armoury, and to use it accordingly.
Closing Remarks
Thanks for your time.
I hope this has given you a feel for likely areas of attention as we move into the
implementation mode for LAGIC.
Questions
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